Present Future Value
One way that we can think of money is not just how much it can purchase today, but also what it is capable of buying tomorrow. This is a basic principle of economics and is sometimes known as the Time Value of Money. For instance, if I purchase a car for $20,000 cash, that is $20,000 that I am not investing somewhere else. This could be the loss of something else I could be buying, or it can be the loss of value in investment. If I had put that in a savings account with a 1% annual rate of return, I would be losing $200 that year if I had merely let that money sit in a savings account. Now, that may not seem very much, but lets look at the other side of the coin.
Let’s say I spend $20,000 on a car, and make a minimum payment of $300 per month and the annual percentage rate is 5%. That’s about $1,000 that I’m spending on interest. Of course most people can’t afford to buy a car outright, and $1,000 a year breaks down to only $2.74 a day which isn’t too bad.
Thing’s get interesting when one is a consumer as opposed to a regular guy with money in a savings account. Let’s say I’ve spent $20,000 gradually over time, and that is the outstanding balance on a credit card. The annual percentage rate is likely to be much higher in this situation, let’s assume 13% because I think that’s the prime rate. If the minimum payment is $300 this would result in $2,600 a month in interest. If we divide by the monthly payment, roughly only 3 months of those annual payments are going towards principal – the rest is profit for the credit card company, and the principal is not being reduced.
This is the seductive attraction of credit cards – you are sacrificing tomorrows money for some extra enjoyment today. Obviously there isn’t anything wrong with credit cards per se – however the potential to get caught in an endless death spiral of paying increased interest and increased spending is a terrible dilemma that faces many Americans. The (now defunct) Dodd-Frank Act had made this painfully obvious, as credit cards were required to show how long it will take to pay off a card if only the minimum payment is made.