- Smart Investing
Why is Credit Card Debt So Scary?
You’ve probably heard the advice to avoid credit card debt at all costs. But most of us have borrowed on our credit card either intentionally or accidentally. So, why are we so scared of credit card debt anyway?
It’s so easy to get. Credit card companies generate fees from merchants as a primary source of revenue. But they also make millions on interest charges on its customers and this is actually the largest source of their revenue. So, most people’s mail is filled with offers for new credit cards and we are inundated with offers for credit cards everywhere we go. Then, once we have the cards, we are tempted into programs that allow us to pay over time for purchases. These offers are hard to resist and many of us don’t resist them. In a 2016 survey, only 58% of Canadians claimed to pay off their credit cards in full every month. Keep in mind that this survey was done by the Canadian Bankers Association (who issue credit cards and don’t want people to think we are paying lots of interest). Also, it is normal that people over-report their positive habits of paying off their cards every month. It’s likely that many of these people reporting going to the gym three times a week too! An American survey recently reported that 56% of Americans have had credit card debt for at least a year. It is likely that Canadians are in similar situations. In this same survey a startling number of 23% of Americans have held their credit card debt for more than 3 years.
Interest rates are super high. While it does vary, most cards have interest rates from 19.99% to 29.99%. Most people with reasonable credit can get a car loan or home improvement loan with an interest rate under 10% and many can get an interest rate under 5% these days. So the rates credit cards charge are incredibly high and no other lenders (with the exception of payday loan lenders) charge rates this high.
Interest is calculated daily, compounded and there are often fees. Rather than interest being charged monthly, interest is charged daily and it compounds daily. While there is a virtuous cycle of compound interest when investing (more here), when we are borrowing, this cycle can increase the amount you owe. For example $1000 borrowed @20% interest will grow to $1,220 in 1 year with daily compounding (note it is more than $1000 + $1000 X 20% because of daily compounding). Then, the amount owed starts to increase dramatically if the debt is held longer because of compounding.. When a company quotes an annual percentage rate (APR) then the rate already includes the daily compounding. (Source Nerdwallet.com calculator)
Rates can go up!! If you fail to make your minimum payment – which is generally the greater of 2 percent or $20 by your statement due date, the credit card company can increase your rate on your card anywhere from 2% to 6%. And this rate can last for a while. So the interest rate goes up and the debt goes up even faster.
Once you incur credit card debt it is hard to get rid of it. Most of us get credit card debt due to unexpected expenses or impulse purchases. And we have every intention of paying off the balance. But with the high interest rates adding on to the balance every day, the balance only gets bigger and becomes harder to pay off. You were probably surprised by the number of people carrying credit card debt and you can be assured that most thought that they wouldn’t be in this situation and had planned to only borrow from their card for a short period. If you didn’t expect to carry credit card debt but have it, you are certainly not alone.
In our next blog we’ll talk about the alternatives to credit card debt.
1 Abacus Data for the Canadian Bankers Association, December 2016