Compounding Interest

While compounding works to make you money when you are earning interest on savings or investments, it works against you when you are paying the interest on loans. To avoid compounding interest on loans, make sure your payments are at least enough to cover the interest charged each month. The good news is that the interest you are charged will be listed each month on the loan account statements you are sent by the bank or credit union, and fully amortized loans will always cover the interest costs plus enough principal to pay off what you owe by the end of the loan term.

The two most common loans on which people get stuck paying compounding interest are credit cards and student loans. Paying the minimum payment each month on a credit card will just barely cover the interest charged that month, while anything you buy with the credit card will begin to accrue interest on the day you make the purchase. Since credit cards charge interest daily, you’ll begin paying interest on the interest immediately, starting the compound interest snowball working against you. When you get a credit card, always pay the credit card balance down to $0 each month to avoid the compound interest trap.

Student loans are another way you can be caught in the compound interest trap. When you have an unsubsidized student loan or put your loans into deferment, the interest continues to rack up on the loans. Again, you’ll be charged interest on the interest, not just on the original loan amount, forcing you to pay compound interest on the loan.

Sacrificing Your Future Fun

When you graduate college, you are most likely to graduate with student loan debt and credit card debt.¹¹ Many students use credit cards and student loans to allow them to pay for fun today, such as trips, clothing, and expensive meals.

Getting into debt while in college forces you to sacrifice your future fun. Say you take out $100,000 in student loans instead of the $50,000 you need, doubling your monthly payment. You are not just making an extra $338 payment; you are also sacrificing anything else you can do with that money. You sacrifice that extra $338 a month, every month, for the next twenty-five years. You can’t use it to go to the movies, pay down other debt, save for a home, take a vacation, or throw a party. When you sign those papers, you sacrifice all those opportunities every month for decades. As a result, when you take out a loan, you should make sure it’s a good loan.

How Much Good Debt to Take On

A drink of water is refreshing on a hot day and is required to stay alive. Too much water, however, and you will drown.

During college and for the first few years after graduation, most students should only have two loans: student loans and possibly a car loan. We’ve already discussed your student loans, which should be equal to or less than your first year’s expected salary after graduation.

When you get a car, you should keep your car payment to between 10 and 20 percent of your monthly take-home pay. This means if your paycheck is $200 per week, your car payment should be no more than $80–$160 each month.

In total, you want your debt payments (plus rent if you are renting) to be no more than 44 percent of your take-home pay. If you are planning to build wealth, however, you want to cap it at 30 percent of take-home pay.

Benefits of a Credit Card

There are three main benefits of getting a credit card. The first is that credit cards offer a secure and convenient method of making purchases, similar to using a debit card. When you carry cash, you have the potential of having the money lost or stolen. A credit card or debit card, on the other hand, can be canceled and replaced at no cost to you.

Additionally, credit cards offer greater consumer protections than debit cards do. These consumer protections are written into law, and with credit cards you have a maximum liability of $50. With a debit card, you are responsible for transfers made up until the point you report the card stolen. In order to have the same protections as with credit cards, you need to report the card lost or stolen within 48 hours. The longer you wait to report the loss of the card, or the longer it takes you to realize you lost your card, the more money you may be responsible for, up to an unlimited amount.¹²

The final benefit is that a credit card will allow you to build your credit score, which is helpful in many aspects of life. While most people associate a credit score with getting better rates on loans, credit scores are also important to getting a job, lowering car insurance rates, and finding an apartment.¹³

How to Use a Credit Card

All the benefits of credit cards are destroyed if you carry credit card debt. Credit cards should be used as a method of paying for things you can afford, meaning you should only use a credit card if the money is already sitting in your bank account and is budgeted for the item you are buying. If you use credit cards as a loan, you are losing the game.

Every month, you should pay your credit card off in full, meaning you will be bringing the loan amount down to $0. If your statement says you charged $432.56 that month, make sure you can pay off all $432.56. If you do this, you won’t pay any interest on the credit card.

But what happens if you don’t pay it off in full? If you are even one cent short on the payment, meaning you pay $432.55 instead, you must pay daily interest on the entire amount from the date you made the purchases. Your credit card company, of course, will be perfectly happy for you to make smaller payments—that’s how they make money. It is not uncommon for people to pay twice as much as the amount purchased and take years to pay off a credit card when they only pay the minimum payment each month.

What to Look for in Your Initial Credit Card

1. Find a Low-Rate Credit Card

   Even though you plan to never pay interest, mistakes will happen, and you don’t want to be paying high interest while you fix a misstep. Start by narrowing the hundreds of card options to the few with the lowest APR (annual percentage rate).

2. Avoid Cards with Annual Fees or Minimum Usage Requirements

   Your first credit card should ideally be one you can keep forever, but that’s expensive to do if they charge you an annual fee or have other requirements just for having the card. There are many options that won’t require you to spend a minimum amount each month and won’t charge you an annual fee.

3. Keep the Credit Limit Equal to Two Weeks’ Take-Home Pay

   Even though you want to pay your credit card off in full, most people will max out their credit cards once or twice while they are building their good financial habits. If this happens to you, having a small credit limit makes that mistake a small mistake instead of a $5,000 mistake.

4. Avoid Rewards Cards

   Everyone loves to talk about rewards cards, but credit card companies wouldn’t offer rewards if they didn’t earn them a profit. Rewards systems with credit cards are designed by experts to get you to spend more money and pay more interest than you otherwise would. Until you build a strong habit of paying off your card in full each month, don’t step into their trap.