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CREDIT CARDS: THE FUTURE TRAP

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by David Barnett and Elchanan Abramowitz

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Did you know that 80 percent of consumers do not understand how the grace period on a credit card works? Considering that 60 percent of Americans carry credit card balances — the average household balance is nearly $8,400 — this ignorance is costing many people serious money.

 

A grace period is the time period beginning when a purchase is made till the time the credit card company expects to be paid back. During the grace period there is no interest charged. Essentially, this money is borrowed for free.

During the grace period there is no interest charge. However, an important exception to this rule is when a balance is carried from one month to the next. If one does not repay his or her balance in full, and the remaining balance is carried over to the next month, there is no grace period on new purchases. So, say, for example, that you owe $2,000 on your card and add another $1,000 in purchases. At the end of the month you will be charged interest on the entire $3,000 even though your card technically allows for an interest-free grace period.

Have you noticed that the grace period is getting shorter? It is no longer a month. In fact, according to CardWeb.com, the average grace period has been reduced to 21.2 days, down from 29.7 days in 1990. The shorter due dates, and more frequent billing makes it more likely for consumers to be hit with late fees. Consequently, the annual late fee revenue generated to bank credit card issuers has soared to $7.3 billion from $1.7 billion back in 1996. The shorter and more frequent billing cycles make it more important than ever to be vigilant about getting that check into the mail on time.

Speaking of checks, those “checks” that come with your credit card statement are offering you a loan, called a “cash advance.” Unfortunately, cash advances are not privileged with grace periods either. Making matters worse, many companies charge a fee for each cash advance you take. This fee is often about 2 percent of the amount borrowed. Therefore, a $1,000 cash advance will come with a $20 fee; this is in addition to the accrual of the usual hefty interest charges.

 

A common financial mistake we often see clients commit is to pay the minimum monthly payment. It will take years to repay your debt this way. And, if you continue to make purchases with the card while still paying the minimum, you may never repay the loan. Consider the following scenario from Mr. Robert Weed, Esq.:

Jane gets a credit card while she's in college and runs up $2,500 in charges. She feels this is a small balance, yet doesn't want it to grow any bigger. Therefore, she uses the card only to charge $25 hair cuts every month while faithfully sending in the $62 minimum payment per month. We’ll assume that the credit card carries 18 percent interest.

Do you want to guess how much Jane will owe at age 65? If you guessed that Jane would still owe the initial amount — $2,500 — you would be correct. How much total interest will she have paid over the 45 years? Believe it or not, she would have paid $20,500 in interest charges. And, of course, she would still owe the principal of $2,500!

By way of comparison, now let’s suppose that Jane never got that credit card. Instead, she paid $25 cash for her hair cut every month. If she had put the other $47 in an IRA with a mutual fund that averaged 10 percent per year over the 45 years, her IRA would be worth half a million dollars today. It is amazing how a small decision – to pay cash, and invest $47 a month – can have huge implications. Depending on Jane’s decision, she might be a 65-year-old woman with $500,000, or a 65-year-old woman with $2,500 in outstanding credit card debt.

Lastly, we recently asked our mailman, Mitch, what percentage of the mail he delivered was credit card solicitations. His estimate was that a full 10 percent of the first class mail was card offers. He mentioned that there is a way to limit the number of direct mail credit card solicitation that jam your mailbox. Call 1-888-5-OPTOUT. This will remove your name from pre-screening lists at the four major credit bureaus, and limit the amount of mail you receive which declares “You Have Been Pre-Approved.”

Dr. David Barnett, MBA and Dr. Elchanan Abramowitz, MBA are founding partners of Sterling Financial Services and Wealth Management. They provide portfolio management and financial advice to families and individuals. They can be reached at info@sfswm.com, and 1-888-592-9200. Questions and comments are welcome.

 


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