Dont fall in to the trap of compound interest!

07
January

We all love new stuff. It makes us feel good when we are finally able to but that new home, or new car, or new TV that we have been saving up for. It is the American way to obsess over our next purchase. We see advertisements all day every day about all of the better things out there that would make us happier or even better in one sense or another. For many of us having a single purchase in mind gives us an incentive to save. We can look at our separate bank account every day, endlessly pondering about how we can cut back elsewhere to get to that magic number to be able to afford that spectacular new item.

Unfortunately, many Americans lack patience. The obsession of ‘how can I get to that number’ can quickly turn to justification along the lines of ‘it will only take me X amount of months to pay it off’. We somehow reason internally that we can afford to buy that new TV or go on that vacation before we really have the money for it. Honestly, that really isn’t a big deal. Put your purchase on a credit card and pay it off in six months or a year, the interest paid really isn’t going to kill you, it probably won’t amount to being more than a couple nice dinners worth of money.

Our problem is that after that initial reasoning to buy the first item we are immediately thinking about the next item. I mean, seriously, who buys a $2000 TV and doesn’t get the proper entertainment center for it? This is when we run in to problems. That $2000 credit card bill can quickly turn to $3000. Interest will start to add up when you are not disciplined. As I said, I am all for buying yourself a nice toy every once in a while. But it is absolutely crucial that you pay it off before you buy the next one! If you are not regimented on those payments, and you keep adding to the total balance you will start to see the negative impact of compound interest.

Compound interest is the idea that you have to pay interest on previous interest charges. Let us say that you have a $5000 credit card bill with 20% interest. One month’s interest charge is only going to be $83. For most of us this is not the end of the world, it is just one night out a month to cover that cost. However, even if you do not add any additional purchases to that $5000 bill your next month’s interest charge will go up to nearly $85. This is the basic principle of compound interest, your will pay interest on your interest. This can be very bad if not managed properly. It can create a snowball effect on many American’s credit card statements. The monthly interest charge will keep going up by larger and larger amounts every month, it is a viscous cycle to be involved in if you cannot afford to pay it down ASAP, and the banks love it.

If you really need that TV I would recommend saving the cash so you do not need to carry a balance, but if you do decide that you just cannot wait any longer because the guys are coming over for opening day of the NFL season then you should first try to get a credit card with a 0% intro interest period and pay it down every month. Create a plan and stick to it. And please, do not buy that entertainment center until the TV is paid for!

This post was written by

jason – who has written posts on Budget Clowns.
Father of three and married to a lovely women. Always looking for ways to save money, and invest it properly for my children's future.

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