‘Twas some days before Christmas, and wherever they headed
The same question kept popping: “Will you pay cash or credit?”
It’s beginning to look a lot like Christmas, as they say, and this year specially, as we seem to take some comfort in the possibility of sharing a collective celebration.
The will to make the best of the holiday season is very real. However, it may have its financial drawbacks. Rationally we know we probably should spend less, but emotions pretty much rule this time in the calendar.
The real danger lies when people spend what they don’t have. So instead of being able to start investing, they might just witness compound interest working against them due to debt. Notably, credit card debt.
But let’s start at the beginning.
What is debt?
Debt can be defined as “an amount of money borrowed by one party from another”. By borrowing money, individuals and other entities are able to make larger purchases than they would normally be.
The borrower may pay the lender back at a later date, usually with interest. You’ve probably heard it before: buy now, pay later.
Here lies an important distinction. Because in the end, debt is more closely related not to the amount borrowed, but to the amount owed.
Interest can then be seen as the price someone pays to use that money. For instance, in France, considering April 2020 data, the average interest rate on new revolving loans granted by consumer credit specialists was 12.88%, according to Banque de France.
The question that needs to be asked is whether that price is worth it.
Is debt bad?
Like most things, there is no clear-cut answer.
In fact, debt should be looked at as a tool. As such, it is capable of helping someone improve their life greatly, or be at the core of a string of financial troubles.
In the Euro Area alone, household debt levels were at 58.3% in relation to GDP (check page 4). This is an impressive number, although it doesn’t tell the complete story, namely how debt is being used.
For instance, it is very common to resort to debt for acquiring a home. The vast majority of people simply don’t have that kind of money available, so debt is an enabler of sorts, making it possible for families to build a better life.
Other large and necessary purchases can also qualify, such as buying a car.
Necessary debt also carries a price, but add it to systematic and unnecessary use of this tool, it can become a real problem.
To see how much it can really cost, let’s look at this example: imagine that you charge €1,600 to a credit card, at a 15.7% rate. Considering a minimum 4% monthly payment, it would take 83 months to pay it off. And in the end, you end up paying a total €2,277.59 (you can check for yourself here).
That’s €677.59 right out of your pocket.
But the potential losses can go even further. Split those €2,277.59 by 83 months and you get around €27.44. At a projected 2.5% interest rate, you could end up with €2,485.72 for yourself.
That is a €4,763.31 difference in net worth.
How’s that for opportunity cost?
Should you use debt to invest?
While the decision ultimately lies with each investor, for the vast majority of people the answer is likely to be “no”.
Yes, there are operations that use borrowed funds to maximise results (a practice called leveraging), but those are technical and complex, requiring experience and specialized knowledge, as well as a clear understanding of the risks involved.
Enjoy the Holidays!
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