Wednesday, May 11, 2011

Don't Pay Credit Card Interest

Jokingly I tell my students that there are two great commandments in the Nondenominational Church of Finance:

1. Thou shalt not pay credit card interest on consumer goods, and

2. Thou shalt keep thy overhead low.

If you will endeavor to follow these two commandments then you will greatly improve your chances of achieving financial security in your life.

After Pam and I bought our first place we had no cash left anywhere. We had used all of our cash for the down payment and moving costs. After we moved in, our next problem to solve was how we were going to wash our clothes without a washer and dryer. In this situation (and with the first commandment in mind) I weighed the cost of financing a washer and dryer against the cost of going to a laundromat. I also considered the hassle of going to the Laundromat with three young children and I decided that "sinning" for a while was the best way out of this situation. We financed our new Maytag washer and dryer. From the date of purchase I was acutely aware that interest was accruing on our debt so for the next two months we took all our extra money and paid off the debt as fast as we could. (Note that in this case I could see no other course than to "sin" for two months, though the case could be made that a washer and dryer are more like capital goods for a household than consumer goods.)

Since then, there were about two other times when we couldn’t pay off our credit card balance immediately. In both cases the debt lasted about two months until it was completely paid off. So that makes three times in our whole lives that we haven’t immediately paid off our credit cards. I told this to a group of students recently and they were aghast. They acted as if I were a freak of nature because based on their experience everyone has credit card debt. I wanted to dispel that myth in their minds, so I made a provocative statement, “Rich people earn interest; poor people pay interest.” They gasped again at my bold language and then a discussion ensued.

Credit cards are for emergencies and for convenience. Pay off your credit cards in full every month. Make it a matter of principle to avoid paying credit card interest. Hell, make it a religion to avoid paying credit card interest!

Do you think you understand? Then here is a test question:

Question Scenario: Let’s say that while you are driving across the country your transmission breaks down. You have no money in your checking and savings accounts. You use your credit card for this emergency (as you should). Some days later while walking through the mall you see some cute clothes that you really want to have for $200. You decide to buy the clothes and pay with cash instead of increasing the balance on your credit card.

Question: Are you paying interest on the clothes?

Most people would rationalize and say that they are not paying interest on the clothes because they paid cash for them but this would be the sinner’s way of justifying the transaction. The fact that you had money that you could have used to pay down your credit card balance, yet did not, means that you willingly chose not to avoid the interest so that you could buy the clothes. Therefore the clothes cost you interest and you have broken the first commandment.

Sometimes students ask me how I can be so disciplined and control my spending so that I am always able to pay off my credits cards each month.

I respond, "Does it require discipline to not cut my arms with knives? [pause for absorption]...Likewise, it does not require discipline to manage my money, just a little foresight."

One time someone said to me, "I want to buy my toys while I am young enough to enjoy them and the only way I can afford them now is with credit...I mean...what if I die young?"

I responded, "You will probably live; so plan on it."

Another question I get is, “How can I build my credit without paying interest?”

I respond, “Let’s say some people offer to be your friends if you slash your arms with knives. Would you do it? Of course not. Then why would you pay interest to build credit? Don’t look to justify why you should have credit card debt. Instead, pass your classes and get a job. And don’t worry about not having friends that want you to cut your arms or pay interest.” (I know this is simplistic advice but I’m purposely trying to stop them in their tracks.)

I tell my students that when they buy a home someday, not to fall into the trap of thinking that they suddenly have to furnish their whole house with their credit cards. I tell them that if I walked into a home that had tin foil taped to the windows and no furniture in the living room, I would be more impressed with them than if they had a house full of nice things and a lot of debts to go with them. Remember, it is always better to be rich than look rich! Don't try to keep up with the Joneses. Live within your means and never try to impress other people with your worldly possessions. Buy things at the rate you can pay with cash. You'll have more things in life by following this wisdom than you would if you paid interest on things.

Would you sign up for every credit card offer you receive and then borrow to the hilt? Of course you wouldn't. Then why do so many people do practically the same thing when they borrow the maximum amount of money that a bank is willing to loan them so that they can buy a house that they can't really afford? Massive stupidity! That is all.

Yesterday I read a news report that said that 28% of all homes in the country are upside down in their mortgages which means their loan balance is greater than what they could sell their house for today. I'm comforted to know that my house is 100% paid for. (Granted it's only a modest home.)

A few years ago at the peak of the housing bubble, I had a striking and super bright student in her late 20s, tall blond, married, Seventh-day Adventist, and not from Imperial County. She openly challenged my advice in class by saying that it would be smarter to get a jumbo loan (interest only) on the largest property possible and then let the appreciation make you rich. We had this discussion before the housing bubble popped. As smart as she was, she was still young; she was still a sheep. Today she would probably be more inclined to agree with me. (Yes, there are specific circumstances under which it may be smart to have a mortgage but I will not teach the exception to the rule.)

I remember that during the housing bubble I would drive around and look at the flyers that are often supplied on For Sale signs. I used to think, "I know a lot about money and economics but I can't understand how people who earn a fraction of what I earn can afford so many things that I don't think I can afford. What is wrong with me?!"

Shortly after this the housing bubble popped, the truth came out, and my logic was vindicated.

Buy a modest home and be content with it.

Regarding cars: look at cars in terms of cost-per-mile. If you had to pay cash out of your pocket each time you drove your car to work or to the store, then you would readily appreciate the cost of driving an expensive car. Avoid thinking of a car as a means to impress others. Think of it instead as a wise choice or a foolish luxury--I say foolish because if your goal is to improve your financial position then the luxury car would be incompatible with that goal. In other words, buying the luxury car is incongruous behavior. Either change your goal or change your behavior. But don't be stupid. (Of course if you already have enough financial security then it is an entirely different matter to enjoy affordable luxuries.)

There is much more that I could say about money but I'll leave it at this:
Buy an efficient car (always try to pay cash for it).

Buy a modest home.

Rich people earn interest, poor people pay interest.

I'd rather be rich than look rich.

Live within your means.

Rich people do not conspicuously consume their wealth; the wannabe rich do. (The Millionaire Next Door)
PS I have never wanted to be rich, only financially secure.