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Get out of the Debt Sprial

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The Real Cost of Credit

If you don’t understand how compound interest works, you may be gambling on your future. Today, people rely on credit cards for the “quick fix” and end up paying for it later. When you buy on credit and only make the minimum payments, your new balance each month is the principal plus the interest … and that amount gets compounded month after month.

In other words, interest is computed on the prior monthly total of principal and interest until the debt if fully paid. For example, if you bought a $1,000 flat screen TV with your credit card at a 19% APR and just made the minimum monthly payments,* interest charges could really cost you over time:

Time Amount Paid Amount Owed Interest Paid
1 year $379 $793 $171
2 years $679 $629 $307
3 years $925 $490 $307
4 years $1,165 $330 $494
5 years $1,405 $136 $540
5 years, 8 months $1,550 $0 $550

By the time you pay the TV off using the “convenience” of credit, you’ll have paid $1,550 – that’s $550 extra – for a nearly six-year old TV! That’s a 55% increase! Do you see how much “convenience” can cost you?

*The amounts of amount paid, amount owed and interest paid are all rounded to the nearest dollar. Assumes minimum revolving payment is 3.5% of the outstanding balance or $20, whichever is greater. Assumes continued payment of the minimum amount. No additional debt is incurred and the payments decrease over representative time period. The illustration is hypothetical only. Each debt situation will vary.

  Fixed vs. Revolving Debt

Most credit card debt is “revolving” debt. Because of the way interest is calculated, it’s difficult to tell how long it’s going to take to pay off the balance. The problem is that revolving debt is compounded when you add additional monthly charges to the balance.

With installment loan debt, your payments are scheduled for a fixed amount payable over a specific period of time. You can easily tell when you will pay off the entire amount you borrowed and – even with a similar interest rate and monthly payment amount – your pay-off date will generally be much sooner than with a comparable revolving account.

This chart can help illustrate the difference:

  The Revolving Debt Trap

  Revolving Debt* (credit card) Fixed Debt** (installment loan)
Amount borrowed $15,000 $15,000
Interest rate (APR) 15% 15%
Monthly payment amount $525/month (revolving)* $525/month (fixed)**
Years to payoff 15 years 3 years
Interest paid $8,156 $3,674
Total cost $23,156 $18,674

 

*Assumes revolving payment (minimum) of 3.5% of the remaining balance or $20, whichever is greater. First month’s payment is shown and term assumed continued payment of minimum amount. No additional debt incurred and payments decrease over time period.

**Assumes payment of 3.5% of initial loan amount, no additional debt incurred and payment amount remains fixed throughout the term of the loan. This illustration is hypothetical only. Each debt situation will vary.

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Walter Brown

I am committed to helping others achieve their financial goals through increasing income and properly handling their money!

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