To be fair, there are millions of people and city governments (and a few states) that aren’t deeply in debt. However, an astonishing amount of Americans are in debt. And an astonishing amount of money is owed by American citizens. The following numbers are taken from www.nerdwallet.com.
As of July 2013, the average American household owed $7,149 worth of credit card debt. Not mortgage or student loan debt, just credit card. The average among indebted households is double that: $15,325. That is a mind-boggling amount of money. Not only is that amount ridiculously high, but dollar-for-dollar, that amount is dragging down wealth. The rise in household credit card debt is directly related to the amount of “wealth” a household has (and is a likely contributor to the widening of the wealth gap).
Let’s talk about credit card debt. Everything being discussed here applies only to credit card debt, and not mortgage or student loan debt. A credit card balance is the polar opposite to a balance in a 401k, IRA, or mutual fund. The longer you have a balance on your credit card, the more money you lose; the longer you have a balance in a 401k, the more money you receive. More importantly, every dollar that you pay in interest is negatively impacting your wealth 10 years from now.
Take, for example, $100. According to www.creditcards.com, the current national average for credit card interest rates is 14.95%. So, in one years time, that $100 would become $114.95. So you pay $114.95 in total, when you actually only received $100 worth of products or services. If, instead, that $100 had been invested in a mutual fund with an average 4% yield, that would have been $104 at the end of the year instead of $100. So you get $4 for doing nothing at all. With an amount as small as $100, the difference seems pretty small, but let’s take the same numbers and apply them to the average American household’s debt.
At 14.95% interest on $7,149, the same equation shows us that in one years’ time, that would turn into $8217.78, which means $1068.78 in interest! In direct opposition, in a mutual fund with an average 4% yield, that $7,149 would become $7434.96, meaning that you’d get $285.96 in completely free money. Even with that number, it may not seem like we’re not talking about that much money, but that is how wealth is built. Putting it a different way, $7149 in debt plus $1068.78 in interest equals -$8217, where $7149 invested yields $285.96 totaling +$7434.96. The investor is over $15,000 more wealthy than the debtor.
There is a school of thought that using a credit card is the best way to get a good credit score. The important edits in that school of thought are that wise usage of a credit card is a good way (not necessarily the best) to get good credit. How high your credit score is is only one factor in overall financial health. There are lots of people with amazing credit – and live from paycheck to paycheck and have nothing saved for retirement. Credit cards are best used as providers of “wiggle room”. For example, my wife and I recently moved, and needed to buy a washer and dryer. While we could have managed the full expense right then, coupled with all of the other costs of moving, we would have been living on top ramen and canned tuna for a month or so if we had. So we took advantage of an offer of 6-month interest free financing and paid the balance over the next three months.
A credit account should never be confused with a checking account. “Credit” is not “money”. It is the ability to borrow money from somewhere else now in return for a promise of paying back the original amount (principal) and a little more (interest) later. If you are in a position where you feel you need a credit card in order to make ends meet, then getting a credit card is probably the worst decision you could make. Interest rates on auto loans and mortgages are usually much lower than credit card interest rates.
If you have credit card debt now, the best thing to do is pay it off as fast as possible. Survive on top ramen and tap water until you can get your credit card balances taken care of, then only use your credit card in times when you could pay for a large expense all at once but it would put you in a tight spot. Or, use your credit card for nominal expenses (such as filling your car with gas) then pay the amount back the first month. Both are ways to build credit without sacrificing your future wealth.