Last time we saw how buying £550 worth of stuff on a credit card could take over eight years and £1,000 to repay.
Awful – but it gets even worse when you consider what else you might have done with your money.
Personally, I’d rather drink £550 in beer than pay it to a bank in interest, but I’d far rather save and invest it towards my goal of financial freedom.
A big deal: When compound interest works for you
Let’s assume that instead of using a credit card to furnish your bedroom, you saved up the money to buy your bed, mirror, picture of an attractive girl in the rain, and so on.
You paid cash, and had no more payments to make afterwards.
What if you take the money you would have paid in credit card interest over the next eight years, and instead invest it in the stock market?
Let’s keep the sums simple, and assume you saved £5 a month for those 99 months, or £495 in total.
According to the standard long-term study, the UK stockmarket has returned around 9.5% a year (or 7% above inflation).
Putting these numbers through a compound interest calculator:
- First payment: £5
- Regular monthly payment: £5
- Assumed growth rate: 9.5%
- Total after 99 months: £752
Does that astonish you? It should. Instead of spending £495 on interest, you’ve grown that £495 to £752 – so you now have 50% more money, not 100% less as when you spent on credit.
Shares should be held for the long-term – there’s no guarantee your £5 investment a month would compound by 9.5% in any particular year. But according to the history books, it’d be a good bet over eight years.
True credit: Save and invest for the long term
It gets better. Let’s suppose you discover you quite enjoy this investing lark, and decide to put that £752 you’ve now got towards your retirement.
We’ll assume you’re 30 – you bought your first bed eight years ago, after all – and you’ll retire when you’re 70.
What would the £752 be worth in 40 years, after you quit work?
Are you sitting down?
- £28,365
Incredible, isn’t it?
True, that’s in today’s money – after 40 years of growth adjusted for inflation (around 7%), you’d have more like £11,000 in real terms.
Still, that means you end up with 22 times more money than the interest you’d have paid if you’d bought the bed on a store card all those years ago.
Remember, you haven’t gone without here – you bought the bed out of your savings. We’ve only invested what you would have spent on the debt interest.
Another way of looking at it: When you buy on a credit card, your 70-year old self bought your 22-year old self a bed for £28,365! Not my idea of a great deal.
When you do these sorts of calculations, it’s easy to see that:
- Saving from a young age can make you rich.
- Spending on debt repayments will make you poor.
What’s the catch?
Economists will tell you that your bed is worth more to you when you’re 22 – you need somewhere to sleep – so it’s worth all that forgone cash.
A good bed might stay good for many years, whereas you can hardly wait until you’re 70 to buy your first.
There’s some truth in this – and there’s the time value of money – but the fact is that there’s always an alternative way to get a bed.
- You could get an old one from a friend.
- You could look on Freecycle.
- You could build a bed.
You only need to make do until you’ve saved up to buy the bed you really want, in cash, when you can afford it.
Personally, I would never pay a penny in interest to buy anything except property.
Life isn’t just about buying beds, but the principle is the same for the rest of your shopping. Delay and do without until you can afford to pay cash.
Don’t believe the hype, and don’t buy with debt. Divert your free cash into saving and investing instead.
Imagine you need a bed for your new home. Fair enough, you can’t sleep on the floor. Let’s see how deciding to buy on credit makes it twice as expensive.
First you go to IKEA a low cost retailer to buy a cheap, functional bed to spend the least productive part of the day.
Actually, it’s not your first visit to this store – you’ve a new pad to furnish, after all – and a few months ago you took out its store card.
With this you got 5% off your first purchase on the card, plus a free chopping board for your kitchen.
You can’t remember exactly what you used the 5% rebate for, but now you’re here you might as well use the store card to buy the bed, right?
You spend £350 on a keenly-priced bed and mattress. On your long trip from the bed department to the tills you also spend £200 on things you don’t need:
- Three picture frames
- A foot stool
- A new bathroom mirror
- An ice-cream making machine
- A set of solar-powered garden lights
Amazing the crap you suddenly want when you’re out shopping, eh?
Your debt starts to grow
Time passes and soon the bill comes. There’s a bit of interest to pay, but you only have to repay a minimum of 2.5% a month.
It doesn’t sound like much and you’re tight on cash – you’re refurbishing a new house, after all!
In fact, you only pay the minimum amount off every month. Why rush, when money is tight and the repayments are so affordable?
If someone actually asked you what the interest rate on your card was you couldn’t say. If you looked in the small print you’d find it’s 19%.
That’s about average for a major name High Street store card, where interest rates typically range between 15-30%.
Here’s what your decision to buy on credit costs you
Initial purchases
- Bed: £350
- Sundry other items: £200
- Total spent on card: £550
Debt terms
- Interest rate: 19% a year
- Minimum payment: 2.5% per month
The ultimate bill
- Total time to repay debt: 99 months
- Total interest paid: £497.76
- Final amount paid over 99 months: £1,048
Ouch! By paying off just the minimum amount each month, it takes you over eight years to repay the debt.
And just look at the interest bill – it’s virtually doubled the cost of your shopping trip!
Read it again: You pay twice as much as your bed and other stuff actually cost, and you’re still paying the debt off nearly a decade later.
It’s easy to see from this example how people who don’t pay attention can turn a few years of sloppy shopping into a serious debt problem, especially if they only repay the minimum amount each month (which barely covers the interest bill in the early years).
I’d avoid even £550 of shopping debt like the plague, but it’s small beer these days – the average young person in trouble who called the Consumer Credit Counselling Service in 2006 owed over £12,000. Two out of every 100 callers owed over £100,000!
If you owe less than them, these numbers should be motivation to get your debt down to £0. They are not an excuse to go higher – not if you want to get rich.
Most people in deep financial trouble began with a few hundred quid borrowed here and there. It adds up. Kill your debt!
The only good debt is debt you take on for investment. Unless you run your own business, that begins and ends with an affordable mortgage to buy property.
Get out of debt of any other kind, as soon as you can. Pay it off! Kill it dead!
- Borrowing to invest in shares is too risky. The market goes up over the long-term, but shares are volatile, and stocks could easily go down over the 3-5 year time period of a personal loan, forcing you to sell at a loss.
- Very occasionally debt might be acceptable if you need to buy something to earn more money, and you really can’t save it up. For instance, you may need specific training to upgrade your job, or buying an ice cream van could whip up a fortune. (Don’t laugh, it worked for Duncan Bannatyne
.)
You’ll have to use your judgment here. Buying a sports car with debt to impress your boss doesn’t count!
Why is mortgage debt okay?
The reason that that mortgage debt is good debt is that over the long term house prices tend to rise.
Over any ten year period houses have at least kept their value. A mortgage is for 25 years or so, over which time house prices might double or triple.
When you buy a house with a mortgage, you benefit in three main ways.
Utility
You have somewhere to live, that you are in control of.
Rising value
House price inflation combats the pernicious effect of compound interest on your debt. If house prices are rising 5% a year and your mortgage rate is 5%, your asset is rising as fast in value as your debt is growing.
Future asset
When you buy a house with a mortgage, you end up with a future asset that you own – for most people their biggest asset of all. In contrast, when you rent, buy a hamburger, or go on holiday to the Maldives, you’re just consuming; you’ll get no future financial value out of it. (Possible exception – borrowing to pay for study).
A mortgage is a dead debt, by the way…
Perhaps you think though my headline is misleading. Didn’t I say the only good debt was dead debt?
I did, but that’s because I happen to have learned along the way what the word mortgage means.
It turns out it comes from two parts:
- The French word mort which means dead.
- The Old English word gage, which means pledge.
So mortgage means ‘dead pledge’. Close enough!
Your debt makes other people rich. You’re borrowing from your future self, who will be poorer, less secure, or lead a less abundant life because you wanted something now, before you could afford it.
You must get out of debt. You can’t save while you’re in debt, and it grows like a weed. Kill it!
Avoid debt like the plague
The only good debt is debt taken on for investment. In personal finance terms, that means an affordable mortgage to buy property for the long-term.
We all know what bad debt looks like:
- Excess clothes piled up on store cards.
- A loan taken out to fund a holiday.
- Flashing the plastic to keep up with your mates.
- The last week of every month’s expenses being put on a credit card and never actually paid off.
- Sundry pointless items bought on the ‘never never’ as our grandparents wisely called what we call credit.
Bad debt – non-mortgage debt – will make you poor if you’re not doing very well already, and it will stop you becoming rich if you are.
To get the most from your money in the long-term, you need to know what you own, what you owe, how much you bring in every month from your earnings, savings and investments, how much goes out again, and thus whether you’re living beyond your means.
Completing this personal reckoning is step two of my rather dramatically entitled 10 eternally true steps to financial freedom.
If we don’t take stock, we’re liable to do silly things like:
- Saving into a bank account earning interest at 5% while simultaneously accruing interest on a storecard debt at 26%.
- Working overtime, then buying takeaway food and late night drinks as a reward and so, post-tax, negating the overtime we’ve earned.
- Devoting evenings and weekends to our investments, to the detriment of the job or second income stream that’s actually bringing in the loot.
- Spending hours looking for the cheapest books or CDs online, while paying thousands extra a year on an expensive mortgage that’s moved onto the lender’s standard variable rate.
- Talking celebrity gossip at parties, when we could be enthusing to a cute stranger about how we’ve reduced our grocery bill down to £30 a week.
Okay, maybe that last one is an acquired taste.
How to take stock of your finances
