Last month I wrote about the positive aspects of compound interest, including the fact that Albert Einstein considered it to be the 8^th wonder of the world. Now I want to give you some examples of the downside of compound interest. The same magical math that works to grow your retirement portfolio works against you with debt. 

We will start with a simple example: Let’s say you are at a party, and you meet a young couple visiting from Chicago. They are planning on escaping from the cold north and taking their kids to Disney World in Orlando, FL over the holidays. Since they just spent all their free cash buying a home, they mention in passing that this would be a “credit card vacation.” I’m sure as an AFG client, that phrase makes the hair on the back of your neck stand up, but let’s just pretend for a few minutes. 

According to the Federal Reserve, the average interest rate for people carrying a credit card balance is 23.37% as of August 2024. This is a record high, up from 22.78% the previous month. For this family, we will assume they are flying to Orlando, paying for a rental car, resort fees , meals, and accommodation. All in, they could incur a total cost for the week of $10,000. If this couple has a card that charges 23.37% and they pay the minimum of only $200/month, it will take over 14 years to pay off the trip. (Yes, 14 years.) The total of all the payments would be $37,742. That means for their $10,000 vacation, they will pay over $27,000 in interest charges—assuming their rate stays the same.

If they can manage to increase their monthly payment to $250/month, it will help significantly. It will only take 6 ½ years and the finance charges would be “only” $9,565. While it still almost doubles the cost of the trip, you can see clearly the impact of making more than the minimum payment on the total cost of this trip.

The same ugly math in the example above applies to home mortgages, which is why people are now so upset that 30-year mortgage rates are now well over 6%. Even though rates right now are more in line with where they were 20 years ago, the fact that we had rates in the 3% range a few years ago is adversely affecting the real estate market. 

The silver lining in all of this is that not all debt is created equal. While we highly discourage the use of credit card debt to finance discretionary spending, such as a vacation, it depends on the use of the debt. 

Debt can be a valuable tool. It is useful for the purchase of a hard asset, such as a home, which is expected to appreciate. Debt is also required many times to finance an education, which theoretically will lead to decades of potential earned income and prosperous career opportunities. Cars are often financed, which can be done wisely with close attention to interest rates and other loan terms. At times, it may be beneficial to finance necessities such as major dental work, hearing aids, or medical expenses to keep financial assets fully invested and even avoid investment related taxes.

We’ve observed that a low burden of debt correlates highly to the ability of a family to save and accumulate a nest-egg for retirement. The simple act of paying off credit cards each month, paying a few dollars extra on car payments or even the mortgage almost always translates into the ability to hit financial benchmarks and be well prepared for retirement. 

On the contrary: a large burden of debt correlates highly with a household’s inability to save for retirement. Unfortunately, there is a concept in the financial world called OPM—which means “Other People’s Money”. This concept is enticing. It encourages the use of debt to finance rental properties, businesses, and other investments. The idea is that you can get rich by leveraging other people’s money. Of course, to make this work, the interest rate you pay on the debt must be less than the return on the investment. After my many years as a practicing CPA, and now as a financial advisor, I can attest that I have rarely seen the OPM principle work well. In fact, the few times that I have seen it work is when the person using OPM is actively managing a business endeavor and making the leveraged dollars stretch as far as possible. Even then, I’ve observed that the attitude is to pay the debt off as quickly as possible.

So, beware of the enticement of easy credit or the idea that you can have it all. It will be much more satisfying for your soul to have as little debt as possible and avoid the negative side of compound interest.

Sources:
https://www.bankrate.com/mortgages/historical-mortgage-rates/?tpt=b
https://www.federalreserve.gov/publications/2024-economic-well-being-of-us-households-in-2023-banking-credit.htm
https://www.federalreserve.gov/Releases/g19/current
https://www.nerdwallet.com/article/travel/disney-family-vacation-cost

Kristina Bolhouse, CPA/PFS, CFP®

Vice President/Shareholder

© 2024 Kristina Bolhouse and The Arkansas Financial Group, Inc., All rights reserved.

The Arkansas Financial Group, Inc. is a Fee-Only Financial Planning Firm located in Little Rock, AR serving clients in Arkansas and throughout the country.

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