Friday, January 11, 2013

The Cost of Money

Because of the recession (and maybe even a layoff) there are a lot of people who find themselves in a lot of credit card debt, and trying to increase their savings.  How do you decide what should take priority?  Conventional wisdom with credit cards is that you pay off those with the highest interest rates first,  because they are carrying the highest cost of renting money (when I say renting money, understand that every time you use a credit card, not a debit card, you are renting money from the issuer of that card.  The interest rate is their charge for that money rental.), but you should also consider what return you can get on savings. It may be better to not try to save so much when the return is minor (around 2% in savings accounts) and you are borrowing at 19% or 29%.

For example, if you have a credit card balance of $5,000 at 29.9%, if you make the minimum payment it will take you 29 years and cost you over $18,000 in interest alone. If you have $5,000 in your savings account, you might be tempted to leave it there to collect interest. But unless you've found that unique bank that pays interest of 30%, you will lose a whole lot more than you gain by paying the minimum. By making the minimum payment you suffer "death by a thousand cuts". Each month over 80% of the minimum payment goes toward interest.  Read that again. The lender takes their cut first. Then pays off some of your balance.

The bottom line is this: If you can't lend money (invest) at a higher return than you can borrow it, then pay off your debts first.

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