Teachable Moments Series

Teachable Moments Series: The True Cost of Debt

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One may be tempted to buy on credit, but the next time you decide to buy something using a credit card go through this little exercise with your child. Suppose you buy a pair of pants for $40 using a credit card at a 19% annual interest rate, compounded daily. Compounded daily means you owe more and more on your credit card every day that passes. Most credit card companies compound interest daily after the initial grace period. It is interest-free money during the grace period. Now, suppose it takes you three years to pay off the credit card.

 

How much did the pants really cost you? 

$40 cost of the pants x 19% interest x 3 years with interest added daily = $71 

The $40 pair of pants will cost you $71!

Cost of debt: $71 - $40 = $31 

 

How much did the television really cost you? 

Let's look at an example of an even bigger ticket item like a television at $500 using a credit card at a 19% annual interest rate. Suppose it would take you three years to pay it back? How much did the television REALLY cost you?

$500 cost for the television x 19% interest x 3 years with interest added daily = $884 

The $500 television will cost you $884!

Cost of debt: $884 - $500 = $384

Here is a good calculator if you ever want to double check before deciding to make a purchase: https://www.calculatorsoup.com/calculators/financial/compound-interest-calculator.php We used the Compound(n): Daily (365/year).

In most cases it is cheaper to save the money and buy the item without using a credit card or pay off the credit card within the grace period before the interest begins to calculate. However, some of us can’t resist temptation (I struggle too), so then it is better to avoid a credit card (have one stored somewhere for emergencies only), but try to use a debit card or cash for purchases. Regardless, you need to be aware of the true cost of using a credit card. The credit card companies know. You should too.

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