Creating Your Own Mutual Fund
Lesson Nine: Credit Cards and Gaining the Upper Hand by Devlin Bronte Rachele
Credit cards are often viewed as a sucker’s bet. Most do not see them as an opportunity except as an opportunity to get into a life sucking debt cycle. Look at how many people around you are maxed out on their credit limits. Look at how they struggle to just make the payments. Each month they work hard to get their balances paid down only to have to run them up again to cover needs and wants which arise. I am sure how you have heard the horror stories of if you pay only the minimum balance on a credit card which is maxed out to $5,000 you could be paying for several decades to pay it off. It really does seem like an endless financial nightmare and it can be. However, there is another way to deal with credit cards as well as other debt instruments. There is a secret to credit cards and it is in understanding how they work.
Credit Cards are a revolving line of credit. This differs from other forms of credit in that it is renewed with each billing cycle. To illustrate how this works let’s use an example of a car loan and then compare it to a credit card. To more clearly show you how this works we will make the car loan on a similar quote as a credit card.
When you take out a loan to buy a car you create a loan with a set term. Your payment is designed to bring your loan to a close at the end of this term. For example let’s say you have purchased a car for $5,000 with a loan at 24% interest which is about par for most credit cards and for a term of 3 years which is what most credit cards base their term on. Your monthly payment would be about $196.16 and of that $100 of your first payment would go towards interests. This means that your interest payment for the first month would be about 51% of your total monthly payment. This leaves only $96.16 to go towards actually repaying the loan.
However, when we look at the 18th payment which is about halfway through the term of the loan we find that of our $196.16 payment that $61.72 is going to interest or servicing the loan while $134.44 is going to repaying the loan. This means the share of our payment which is going towards the interest has been reduced to about 31.5% of the payment and ever more of our payment is going towards the actual principle. At this rate the principle of the loan will be reduced at an ever more exponential rate bringing it to a close in about 18 more months and the car is all ours. This is of course if we just make the payments agreed upon by the loan. If we were to choose to pay a little more such as round it up to $200.00 a month we would find that we are reducing the principle at a bit higher rate and at the same time are reducing the amount we pay in interest.
Now let’s use the same numbers with a credit card loan. For our first payment we will pay the same amount of $196.16 and of which $100 will go in the form of interest to service the loan while $96.16 will go to the principle. But here is where the two loans greatly differ. With each subsequent payment of the car loan above you are actually paying on the same loan. When you make that first payment that is one less payment you have to make. Just like when you make the 18th payment you will have only 18 more payments to go and you own the car free and clear. With the credit card every payment cycle is a new loan. In other words if you owe $5,000 and make a payment of $196.16 in which $96.16 went towards paying off the loan the principle is now $4,903.84. Unlike the car loan this is now a new loan with a new balance and new payment. The next payment will be $192.39 on a loan of $4,903.84 and again the interest will be about 51% of the payment with only about 49% going towards the loan. Once you make your payment and the new billing cycle begins you will have a brand new loan with a new payment to go with a new balance. If you are paying the minimum payment you will still have 36 payments to go. Even if this is the 18th payment on your credit card you will still have 36 payments to go if you just pay the minimum payment. You can run the numbers using this rule and find that the interest payment is still about 51%
But it is even worse than this. In the example above I used the same program I used to find the car payment to find the credit card payment and this put a $5,000 loan at a monthly $196.16 a month giving quite a bit towards the principle. The actual credit card payment would work out to around $70 less at about $125.00 which means about $100 would go towards the interest while only $25 would go towards paying off the loan. So, this means your $5,000 loan is now $4,975.00 and this is the beginning of a new loan with a new payment of either $125 or $124 in which the majority of the payment would go towards the interest. When the balance is at halfway of the original amount it would be $2,500.00 and the payment would be around $62.00. The interest payment would be about $50.00 while only $12.00 would go towards the principle. In the very first payment of $125.00 only about 20% of it actually went towards the loan. In the payment of $62.00 again only about 20% of the payment actually went towards the loan.
However, if you continued to pay $125.00 each month, which was your maximum payment, regardless of what the minimum payment due is eventually the bulk of your payment will go towards paying off the principle as in the explanation of the car loan. You will actually have an end to the loan by continuing to pay the maximum payment regardless of what they tell you the minimum payment is. Unless of course if your balance is less than your payment. This is how you need to pay your credit card.
Rule of thumb is that the payment of your credit card will be about 2.5% of the balance and this will change each time you pay because at the end of the monthly cycle your balance is a completely new loan. You will still be paying 2.5% of the balance but that is the current balance. But if you pay the amount your payment was when your card was at its available limit every payment you will change the loan from an endless renewal loan to a 36 month loan. Now, this is only a rule of thumb because each card will use their formula and to find this for your card just take your minimum payment and divide it by the current balance you owe. This will give you your actual payment percentage.
Another thing you can do is as I did with the car loan. I plugged the information into a payment formula on a spread sheet and came up with the payment of $196.16 and you could pay that. You can take the amount of 196.16 and divide it by the maximum credit limit giving you a percentage of about 4% and use that instead of the standard 2.5%. Which ever one you decide to use this can be a very useful number as a tool to keep your debt under control. All too often people let their debt spiral out of control. However, if you decide that in your budget you can only afford $100.00 a month in a credit card payment you can take your ratio of 4% or 2.5% or whatever it worked out to and divide that into your payment limit.
So if you use 4% taking 100/.04=2,500. This means that if you only want to pay at the most $100.00 on your credit card you should limit your spending to $2,500 as a maximum. If you are using the rule of thumb ratio which is 2.5% you will find that 100/.025=4000 which means to keep your payment under $100.00 a month you should only charge at the most $4,000.00. However, keep in mind if you are to use the lesser of the two you will ring up a higher debt and at the same time pay less towards the principal which will take longer to pay off as well as free up available credit.
Another thing to keep in mind when using a credit card is if you wish to keep a healthy credit score you may want to limit your credit card spending to about a third of your actual limit. For example if you have a credit limit of $5,000 you would want to never spend more than $1,500 of it. You would still want to pay it off at a rate which is the amount you would have as a payment if the balance was at $5,000. But to keep a great credit score you would want to keep your balance less than $1,500. When you reach your limit it makes lenders edgy. It also could be a sign you are not good at managing credit. Another good reason to keep your balance less than a third of the maximum limit is for when you have emergencies. Sure, you may hit your limit with the emergency and this will affect your credit score. But if you stick to a repayment plan of constantly making a payment which coincides with the maximum limit changing the loan to a thirty-six month loan you will find that your balance will drop quickly and your credit score will rebound. So for credit score reasons and to help with possible emergencies it is a great idea to keep your balance at less than a third of your limit.
Another good thing to do with your credit cards is while you are creating your financial safety net as mentioned in Lesson One you include a net for your credit cards. I did this by looking at each card and storing away enough money to pay them off. For example if I had a card with a $3,100 limit and one with a $2,000 limit I would put aside $5,100 as an emergency fund to pay these off. But I also put this money in an income investment. This money is safe and is actually earning an income which helps me to make the payments on my credit cards. Eventually you could even squirrel away enough that the income from this investment pays your monthly payments.
One last thing I would like to discuss in this lesson is getting into trouble with a credit card. Yes, it is easy to go hog wild and spend or rack up the balance due to unfortunate events which require immediate attention. Main thing to keep in mind is if you stick to your limits and budget accordingly it will be easy to handle and just take time to get to the end of the tunnel. Keep your head and just remember as long as you keep to the maximum payment you set the debt will disappear and after a couple of payments it will melt away quickly.
But let’s say you run into deep water because of both miscalculations on your part, a disaster such as losing your job, and emergency expenses which arose, what can you do? Don’t despair and yes, it can be rough, but it can be fixed. Here are some things you can do to get back on track with your credit.
• First thing you should try is just to suck it up. Chances are you have to make only some slight rearranging of your budget and cut back on some things which aren’t necessities to get back on track. Chances are it would only be an austerity that will last just a couple of months. Sure, it could be longer but it is all time to look over what had occurred, evaluate, and develop plans for future hiccups in your finances.
• If you have managed to get yourself in very deep you could try to secure a consolidation loan. This is especially easy if you have assets which could be used as collateral. If you do secure one it will probably be at a far lower interest rate than your credit cards and at a far easy to manage payment. You may find that you have extra money leftover from your budget because of the reduced payment. Use it to build up a better financial foundation to help reduce the need to charge up your cards.
• If a loan is not available you can call your creditors and try to work it out with them. Simply explain the situation and see what they can help you with. Most credit card companies want their money back and to make the interests. They also prefer great word of mouth advertising as opposed to having to sell your debt to collections or other collection efforts which can sometimes produce bad press. I have helped several people deal with creditors and all but one had been more than agreeable and willing to help. But do this before your account becomes past due. Besides hurting your credit score allowing your account to become past due may tell the creditor that there will be problems and they may not be as agreeable or pliable. Calling before things get out of control will tell them you are interested in a resolution and are trying to be responsible.
• Debt Relief Agency—I actually don’t like these guys. First of all they know that credit companies are willing to work out deals as mentioned above. They know that credit companies will settle on lesser amounts to help resolve a situation and recover as much of their money as they can. Thing is you will still be paying the full amount of your balances plus fees and interests but the savings you could have worked out on your own will be going to the Debt Relief Agency. Biggest thing about a Debt Relief Agency is they will get any legal actions stopped and stop harassing phone calls. But this could all be stopped as well by being proactive and calling your creditors and working out a payment plan. By allowing Debt Relief Agency do it for you, your credit score will drop and noticeably.
• But if you’re at the point of needing legal protection why not just file Bankruptcy. This is a last ditch effort. One I would recommend if you are really over your head financially and you are receiving legal notices. Just file and then rebuild from there. Your credit score will become a smoking crater and you will be paying outrageous amounts for loans and have sub par credit cards but you will be starting with a clean slate financially as far as debt goes. You will be able to keep your assets for the most part. You will be able to rebuild your credit rating. If you file bankruptcy this year and over the next two years you are able to make all your payments on time your score could recover quickly.
You could also try to supplement your income or ask friends and family for help both with researching, dealing with creditors, and possible loans. Whatever your choice it can be fixed and isn’t the end of the world. As always there is potential to learn from what had occurred and come back even stronger financially.
In the next lesson we will look at how you can use credit used properly to help you not only in emergencies but also to build your wealth.
About the Creator
V. H. Eberle
I have been a student of human nature since I can remember. I hope that you feel free to explore my findings in these short stories and articles. Perhaps you will learn far more about yourself and others.
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