Credit Cards - good or bad?

We’re going to continue our discussion on credit cards. Credit cards represent the most dangerous form of debt, for a number of reasons, the most important being the enormously high interest rates that are associated with them. Yet credit cards do provide some benefits, and if utilized properly, can be an asset to your personal financial situation (pun intended!). Let’s discuss the benefits of credit cards.

1)Credit cards are convenient. No one can deny that! It’s no doubt easier to carry around a piece of plastic in your wallet instead of a wad of cash.

2)If used properly, credit cards can increase your credit score, which can go a long way in helping you to qualify for a mortgage in the future with more advantageous rates, should you need one. I will be speaking more about credit scores in a future post, but in short, every individual who has a social insurance number also carries a credit score, which is a summary of your credit history. If your credit history shows that you were a responsible credit card holder who always made your payments on time, your credit score will increase.

3)Credit cards can offer rewards and benefits in the form of cash-back returns, travel points, travel insurance, etc. Everyone loves free vacations, right?

These three benefits to carrying credits are the reason why there are an estimated 75million credit cards in circulation in Canada, an average of over 2 per person. Canadians spent about $265 billion on their credit cards in 2009. The reason why I’m telling you all this is because credit cards can be very good financial tools, if used responsibly. Let’s talk about the other side of credit cards – the things to be aware of if you do want to be a responsible credit card user.

As I explained in last week’s post, the reason for a credit card’s incredibly high interest rate is reflective of the borrower, not the lender. Credit cards are not collateralized by any hard assets, and therefore, banks are forced to charge high rates on their cards. Banks choose a rate that will ensure that even with a relatively higher number of unprotected (uncollateralized) credit defaults, their money lent out will still provide a profitable rate of return. As was also explained previously, debt works in the same manner as savings, and therefore, grow exponentially just like savings. Why does debt grow exponentially? Suppose you owe $10,000 on your credit cards, which incurs a 30% interest rate. After a year, supposing you do not make any payments on your card, your $10,000 will incur 30% interest, or another $3,000, so that your total outstanding balance owed to the credit card lender will be $13,000. However, in the second year, you won’t only incur $3,000 in interest – you will now incur 30% interest on your new $13,000 balance (instead of on your original $10,000 balance) which equals $3,900 in interest, which brings your total balance owing to $16,900 after year 2. Interest begets more interest, in the same way that savings compounded begets more savings. I’m sure that you can easily see now that over time, outstanding balances can grow very quickly. And remember how last post we saw the unbelievable difference in interest costs that result from taking a 7% mortgage instead of a 5% mortgage? Now imagine the difference between a 5% mortgage and a 30% mortgage.

To give you an idea of just how astronomical a 30% interest rate is, imagine a scenario where an individual owes $100,000 in credit card balances (unfortunately, hardly a rare circumstance in today’s world). At 30% interest, that individual can pay $30,000 back to the lender every year, and yet not a single dollar of that amount will go to paying down the principle of the debt owing. In the world of corporate finance (as opposed to personal or residential finance), there would never be a company that would even think to borrow at 30%. How anyone else would do that is beyond me!

Credit card companies know that obtaining a 30% return on their money (by charging a 30% rate) is a very rare opportunity to gain a return on investment that simply cannot be matched by any other investment in the world. In fact, the residential credit card industry is so popular amongst large corporations, that almost every large retail store in North America now offers them. Shoppers Drug Mart, Costco, Sears, Canadian Tire, even Walt Disney diversified from their primary business models to offer credit cards to their consumers. One company that got heavily involved and suffered for its forays into the credit markets during the recent economic recession was General Electric. One of the most respected and successful companies in the history of the global business world, GE’s stock price fell an incredible 83% in just over one year (2008/2009) as a result of huge losses suffered because of over-zealousness in the residential credit industry. Even during the stock market recovery of 2009/2010, GE stock has only recovered 26% of its value lost, and many analysts predict that it will never fully recover from the losses sustained due to credit write-downs. Notice however, that the list of companies that forayed into the credit card industry mentioned above is made up of only retailers (companies that service the general public directly, as opposed to wholesalers). Why is this so? Because (and I don’t mean to offend any of us residential consumers) no corporate financial controller in their right mind would ever borrow funds at 30%. Only residential consumers are foolish enough to do that.

What’s my point here? Credit card companies appreciate consumers who don’t fully pay back their borrowings on a timely month by month basis, because it gives the credit companies the chance to earn a 30% return on their investments. This is the exact reason why most credit cards will highlight a ‘minimum payment’ on their monthly credit card bills. The only point of mentioning a ‘minimum payment’ is to try to psychologically soothe a consumer into thinking that it’s okay to only pay back the minimum payment. It’s nothing more than a trap, plain and simple. In fact, non-profit consumer credit organizations have in the past tried to sue credit card companies for writing ‘minimum payments’ on their bills, because they believe the tactic is essentially an attempt to mislead the consumer.

I cannot stress this point more: do not ever borrow on your credit card if you cannot pay the full balance on time at the end of each month. And if you already have an outstanding balance, get rid of it in any way possible. If you cannot trust yourself to not spend beyond your means on a credit card, just don’t use one. The benefits of credit cards mentioned at the beginning of this post do not come anywhere close to justifying paying 30% interest on your borrowings.

Finally, one last point about credit cards and debt in general. I keep mentioning over and over that debt is nothing more than negative savings. In the posts about savings, I often talked about the essential importance of diversification – which means to diversify your investments in different asset classes (such as stocks, bonds, real estate, treasuries, etc.). What about debt?

Debt is the flip side of savings. And therefore, diversification is a very bad thing in debt. However, for some reason, people feel psychologically better about themselves when their debt is diversified. For instance, imagine a scenario where a couple is holding a $250,000 mortgage debt at 2.5%, a $35,000 car loan at 6%, student debt of $40,000 at 5%, and credit card debt of $25,000 at 30%. Now, supposing the house is worth $500,000 – so the couple technically has (gross) equity in their house of 500,000 – 250,000 = $250,000. If you add up all the interest payments on the couple’s debt – it will equal $17,850/year in interest payments.

Now here’s an interesting idea. Supposing the couple goes to the mortgage company and asks them to borrow an additional $100,000 against the equity in their house, at their regular mortgage interest rate of 2.5%. The couple then takes the $100,000 and pays off all the other debts that are currently outstanding. So now, the couple has only 500,000 – 350,000 = $150,000 in equity in their house. How much in interest does the couple pay every year in this situation on their mortgage? $8,750. Incredible! By combining all their debts into one (this process is called debt consolidation), the couple has managed to save 17,850 – 8,750 = $9,100 in interest payments each year.

Yet, many Canadians dislike the concept of debt consolidation. I can think of two reasons why - let me know if you think of any others:

1)Splitting up the total debt in different categories seems to psychologically diminish the value of the total debt being carried.

2)People are more protective of the equity in their house than their cash. In other words, psychologically, people put too much emphasis on having $250,000 of equity in their house instead of $150,000, when in reality, what really matters is your overall financial position, not just your stake in your house!

These reasons are entirely illogical, and are big personal finance mistakes for obvious reasons. Diversification is bad because interest rates are fixed, as opposed to rates on return on savings. If I put my savings in stocks, the rate of return I will receive is unknown and there exists a considerable risk for low returns or even losses. Therefore, as explained in previous posts, diversification of savings reduces risk and smoothes out rates of return. But debt is entirely predictable. When you borrow funds, you sign a contract with the lender, agreeing to a known interest rate. Therefore, you might as well consolidate all your savings into one debt at the lowest rate possible. This is analogous to a situation where rates of returns on your savings are guaranteed and there was no risk involved. If that was the case, of course you would put all your money into the investment that guarantees the highest rate of return! There is no difference with debt – it’s just the flipside of savings.

Point in hand: If you incur credit card debt – why not ask your mortgage lender to increase your mortgage, and pay off your credit card instead? This could save you many thousands of dollars in interest every year.

Next post, we will move on to other forms of debt, such as line of credits, credit union borrowings, student debt, etc., and then we will start talking about mortgage and house purchases.

To end, I want to propose a question, and see what you guys think. If I had $100,000 in credit card debt at 30% interest, and $100,000 in savings invested in stocks that earn, on average, a 30% rate of return, what should I do with my money? Should I pay down the debt or watch my savings grow?