Revolving credit card debt is a common problem for people across all income ranges. People who have ample income and can easily meet their minimum payments often don't think twice about what its really costing them in wealth.
In fact, keeping a balance on your credit cards is probably costing you much more than you think. Not only does it cost you in interest payments, but also an opportunity cost of not investing the funds you paid in interest.
What is Revolving Debt?
Revolving debt is a credit line that allows you to borrow again after you pay off the principal (or original amount your borrowed), up to the max amount of your credit line. Its revolving because you can borrow on it over and over again.
Credit cards fall into the revolving debt category because you can borrow from the credit card company over and over again, up to the maximum allowed on your credit line.
This differs from an installment loan, in which you borrow a one-time amount and then pay it off in fixed installment payments. Once you pay down the principal, you can't re-borrow on an installment loan.
Case Study on Revolving Credit Card Debt
In order to demonstrate the issue, let's examine a case study of Jillian and Judy to compare how they handle their use of credit cards, and what the true cost/benefit is to their wealth profiles.
Carrying balances on your credit cards is expensive.
Jillian is our big spender. She loves to shop. She carries four credit cards, with balances that add up to a total of $10,000. Here's her revolving credit card profile:
Jillian pays just $170.42 in interest every month, and she also pays a few hundred extra dollars in payments on each card, making her feel like she's paying down her debt. However, she uses her cards to make new purchases every month, and the actual balance hasn't budged in a while.
If Jillian continues to keep the same spending habits, she will pay over $10,225 in interest expense over the next 5 years, and $40,900 over the next twenty years.
The Opportunity Cost of Revolving Credit Card Debt
Meanwhile, Jillian's sister Judy has no credit card debt, and is depositing $170.42 into her brokerage account every month. She's saving for financial freedom, and plans to use the funds to help her buy rental property in the future.
For now, its invested in the market and she earns an average of 8% per year on her investment. Judy saves much more than $170.42 per month, but we will use that amount to demonstrate the total cost of Jillian's spending habits.
What to do if you have Revolving credit card debt
If you're currently carrying credit card debt, your best option is to pay it off as quickly as possible. Don't worry about saving money until its paid off (except for some emergency cash). Pour all of your extra dollars into paying it down, and get your balances to $0.
- Create your own debt profile, like Jillian's. Here's a free worksheet in Excel:
- Decide which you want to pay first – target either
- Lowest balance cards
- Highest interest rate
- Calculate how much you can spend paying down your cards
- Create a budget
- Reduce your cost of living
- Sell stuff around the house on Ebay, Facebook marketplace, or Craigslist
- Now the fun part – calculate how much you'll be able to save and invest after your revolving credit card debt is gone.
- Stay focused on your goals by tracking your progress every month. Create a chart and show your monthly balances decreasing. This is an exciting process!
Remember – every time you make a principal payment on your revolving credit card debt, you're increasing your net worth.
Is it ever okay to use credit cards?
Yes, its okay to use credit cards to make purchases that you can pay off in the same month. As a general rule, never buy anything with a credit card that you can't pay for in cash.
Here are three reasons to use credit cards for a positive effect on your financial outlook:
- Credit cards increase your credit score by building a credit history.
- Some credit cards offer rewards, like points for travel, cash back, or other rewards.
- Credit cards can be used at hotels and other venues to secure a deposit without having to use actual cash.
However, none of the above reasons result in a positive gain if you don't pay your credit card balances in full each month.
Do you use credit cards in positive or negative ways?