Imagine you need a bed for your new home. Fair enough, you can’t sleep on the floor. Let’s see how deciding to buy on credit makes it twice as expensive.
First you go to IKEA a low cost retailer to buy a cheap, functional bed to spend the least productive part of the day.
Actually, it’s not your first visit to this store – you’ve a new pad to furnish, after all – and a few months ago you took out its store card.
With this you got 5% off your first purchase on the card, plus a free chopping board for your kitchen.
You can’t remember exactly what you used the 5% rebate for, but now you’re here you might as well use the store card to buy the bed, right?
You spend £350 on a keenly-priced bed and mattress. On your long trip from the bed department to the tills you also spend £200 on things you don’t need:
- Three picture frames
- A foot stool
- A new bathroom mirror
- An ice-cream making machine
- A set of solar-powered garden lights
Amazing the crap you suddenly want when you’re out shopping, eh?
Your debt starts to grow
Time passes and soon the bill comes. There’s a bit of interest to pay, but you only have to repay a minimum of 2.5% a month.
It doesn’t sound like much and you’re tight on cash – you’re refurbishing a new house, after all!
In fact, you only pay the minimum amount off every month. Why rush, when money is tight and the repayments are so affordable?
If someone actually asked you what the interest rate on your card was you couldn’t say. If you looked in the small print you’d find it’s 19%.
That’s about average for a major name High Street store card, where interest rates typically range between 15-30%.
Here’s what your decision to buy on credit costs you
Initial purchases
- Bed: £350
- Sundry other items: £200
- Total spent on card: £550
Debt terms
- Interest rate: 19% a year
- Minimum payment: 2.5% per month
The ultimate bill
- Total time to repay debt: 99 months
- Total interest paid: £497.76
- Final amount paid over 99 months: £1,048
Ouch! By paying off just the minimum amount each month, it takes you over eight years to repay the debt.
And just look at the interest bill – it’s virtually doubled the cost of your shopping trip!
Read it again: You pay twice as much as your bed and other stuff actually cost, and you’re still paying the debt off nearly a decade later.
It’s easy to see from this example how people who don’t pay attention can turn a few years of sloppy shopping into a serious debt problem, especially if they only repay the minimum amount each month (which barely covers the interest bill in the early years).
I’d avoid even £550 of shopping debt like the plague, but it’s small beer these days – the average young person in trouble who called the Consumer Credit Counselling Service in 2006 owed over £12,000. Two out of every 100 callers owed over £100,000!
If you owe less than them, these numbers should be motivation to get your debt down to £0. They are not an excuse to go higher – not if you want to get rich.
Most people in deep financial trouble began with a few hundred quid borrowed here and there. It adds up. Kill your debt!
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Borrowing to spend for current consumption & recurrent expenditures, as opposed to borrowing to invest, is (arguably) sub-optimal in general, in both the public (state) and private (personal finance) spheres.
If you can’t afford it now, but expect to have increased earnings capacity in the near future, there might be sensible counter arguments in favour of using limited credit; but otherwise pulling money from the future at such a steep price (as in the example) is a poor exchange.
Making do and mend, and instead using the £550 in the example to invest in, say, VWRL Accumulating ETF (Vanguard Developed World Equity tracker) with a long term average expected real return, with dividends reinvesting, of 5% p.a. would be worth £1,100 spending power after 14 years of compounding, whereas the example with the store card effectively turned £1,048 into £550; i.e. a choice here between, on average, doubling your money (after inflation) over 14 years or nearly halving it over a period of a little over 8 years (99 months).
I know which of those two outcomes I’d choose for myself, but of course people’s needs, wants and values differ.