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Sunday, 13 October 2013

The corrosiveness of debt - part 2 (credit cards)

In part 2 of my look at the corrosiveness of debt, I am going to deep dive into credit card debt. In part 3 I'll discuss what constitutes "good debt" from "bad debt" and I'll finish this mini-series on the corrosiveness of debt with a look into our new bubble in the US economy – student debt.  So, in effect, you can expect a mini-series on debt before we turn to investing.

But why so much attention on debt, you may ask?  Because I strongly believe that debt is the key impediment, thrown up by our societal influences and/or our economic systems, to successful investing…

The dangers of credit card debt
First, two stories about my personal experience with credit cards in college as well as in my first post-college job. 

Back in 1989, I went on Spring break to the Bahamas with my Clemson University fraternity brothers.  I won’t get into the debauchery normal with Spring breaks – this is an investing blog after all – but rather, make the point that I had recently received a newly-minted American Express Optima card…that I was going to fully test drive!  (Let’s conveniently ignore the fact that AMEX would give a college student with no income a credit card with a $10,000 spending limit…)

A fraternity brother of mine & I agreed that we would buy stuff together (mostly Kalik, a local Bahamas beer) and at the end of our Spring break, he would pay 50% of the bill (my potential mistake number 1 – I took all of the repayment risk to the credit card company.  Fortunately, Scott was an honest person and did pay half of the bill).  My point in this little story is that by day 3 or 4, after charging far too much, incremental purchases on the Optima card (we actually started yelling OPTIMA in local establishments when we were about to make a new purchase) increasingly became ‘funny money’.  In other words, the balance was growing so quickly, I began thinking, what’s another $100?  From a percentage basis, it wasn’t sooooo much.  I had lost touch with the value of the underlying (and quickly growing) debt.  Fortunately, we did pay off the bill in its entirely when we returned to Clemson. 

Fast forward to my first job experience in New York City.  In 1990, the cost of living in NYC wasn’t cheap (I’m pretty sure that it’s still as bad, perhaps even worse).  I had a good paying job with Goldman Sachs but I still found myself running short every month (being a young, single bachelor in Manhattan requires a certain lifestyle!).  And so, every year (for the 3 years I lived in NYC) I would gradually build up my credit card balance (my actual mistake number 2 – in fact, a personal Full Monty mistake (Full Monty is a British expression meaning all out, complete) – I ran up a balance that I did not pay off each month). 

At the end of the year, I would have this monstrously-large credit card balance….that I would then have to use my annual bonus to repay in full.  Yes I was lucky to have this bonus available that I could use to repay my debt but I clearly remember to this day, nearly 20 years later, the horrible sinking feeling I would have using my ‘new’ money to repay debts for things that I had long lost forgotten I’d purchased.  Yet I would repeat this stupid mistake for two more years.

My lesson learned from these two stories - credit cards should only be used for short-term liquidity ‘float’ – i.e., you can borrow money at no-cost as long as you repay the balance every month, every time.  Because so many people fail this basic test every month, credit card companies make fantastic investments (think AMEX, Mastercard, Visa).  Why?  Because they are so profitable…due to those folks who have never learned the most basic of basic lessons – (i) credit card debt is NOT ‘funny money’ and (ii) don’t live beyond your means month to month.  I made both of these mistakes and learned the hard way.  Don’t do the same.

The cost of credit card debt – some numbers
As I write on, The credit card industry is a gimongously profitable business.  According to various sources (including a 2010 Federal Reserve Bank of Boston study - search for it, and others, this information is all out there), there are over 600 million credit cards held by US consumers.  Average credit card debt per household is in excess of $14,000.  This amount, no doubt, fluctuates over time.  I would venture to guess that average balances go up during the good times, when people consume more, and down in the dire times when people are concerned about the economy, their job stability, etc.  However, one could easily take the opposite position and believe credit card balances increase during bad economic times because people need the credit in order to pay bills and make ends meet.  Whether the former hypothesis is correct or the latter is doesn't matter - what matters is you should never, ever carry a balance on your credit card.  Why?  Simple mathematics.

The average APR on credit cards is over 14%.  Many cards charge far in excess of this amount.  This is extremely expensive money when one considers the cost of money to banks is currently close to 0%.  They charge this spread because they can.  No other explanation.  But rather than rail against these credit card companies your take-away here should be two-fold:
  • If the cost of this money is so expensive, I should prioritize paying off my balance....and keeping the balance at 0 every month (i.e., pay it off every month)
  • If they charge so much they are most likely very profitable.  Therefore, perhaps I should investigate investing in Mastercard, Visa and/or American Express?  This is an important mind-set change that I encourage you to develop over time.  One person's cost is likely to be another's profitable venture.

But back to my point - the cost of borrowing money from your credit card company is greater than the average returns from the stock market over the last 30-40 years.  Warren Buffett, perhaps the greatest investor in our lifetime has achieved 19.7% average annual returns in Berkshire Hathaway, his main investment vehicle, from 1965 to 2012.  The average annual return from the S&P 500 index (which includes the 500 largest publically-traded stocks in the US), including their dividends, was 9.4% over this time period.  Your takeaways?

  • If the cost of credit card debt is higher than the average stock market returns, then this is a bad trade.
  • Unless, of course, you're Warren Buffett - then you can capture a 4-6% spread by borrowing expensive credit card debt and investing this in the stock market!  Woo-hoo - road to riches, right?!  Well, no, as neither you nor I are anywhere close to Uncle Warren in investing prowess.

So, a final message to those currently carrying credit card debt – pay it off as soon as possible.  Use the ‘paying yourself first’ methodology that I cover on for credit card repayment.  Because, until you get control of this extremely corrosive debt, you will never ever become a successful long-term investor.  Unless you’re as good as Warren Buffett.  But you’re not.  And I'm not either, but I learned the hard way.  Don't do the same.  Pay down your that credit card balance to zero as soon as you can.  For your own good.

Next up – a look at what makes "good debt" and "bad debt" in part 3 and completing the debt series in part 4, student loans.  And why it impacts you and what you should do about it…

Until next time, read more about investing on