Visualising Credit Card Misuse and the Debt Cycle

Used correctly, credit can be a financial tool of yours, rather than a source of long-term stress / debt

• Your "credit limit" is how much you are allowed to borrow, whereas debt is the result of that borrowing.
• A credit card allows you to repeatedly borrow up to your credit limit, as long as you have paid the previous borrowings on time.
• Credit cards can be a great financial tool if used correctly; however, the ability to continuously borrow even if within your credit limit can lead to a vicious debt cycle.

Getting Out of Debt

Credit cards can be a great financial tool if used correctly. However, the ability to continuously borrow, even if within your credit limit can lead to a vicious "debt cycle". This is where spending on a credit card (i.e. borrowing) without consistently paying it all off leads to increasing levels of debt, with interest costs becoming an increasingly bigger monthly expense. Those interest charges get added onto the existing debt, making it increase even more quickly and even more impossible to pay off! You can see how it all can end in default, where you can't pay off your debts or even your minimum sums, and then bankruptcy. (This would be very bad!) 

But let's wind back a bit from that miserable scenario and understand how different credit card interest rates and different repayment plans can affect the total interest you pay and, therefore, your overall level of debt.

Example 

Denise, Brandon and Wen Qian are desperate to go on a last-minute holiday, but cash is tight right now, and they can’t afford to pay for a holiday out of their current account. 

However, they come up with a plan. They decide to treat themselves to a holiday anyway, by using their credit cards at the cost of $5,000pp, because #yolo! 

They arrive back home, only to be greeted by the reality that they have now incurred debt of $5,000. So, they set about working out how to pay it back…

• Denise decides to set aside $150 per month towards paying off the $5,000. Her credit card APR is 25%

• Brandon decides to use $150 per month towards paying off the $5,000. His credit card APR is 21%

• Wen Qian decides to go for it and put $250 per month towards paying off the $5,000. Her credit card APR is 25%

(All of their credit cards have a minimum monthly payment of $100)

The damage:

Denise

• It will take Denise 58 months to pay off the $5,000 loan based on paying the proposed $150 monthly payment @ 25% APR

• The total interest based on the proposed monthly payment = $3,625

Brandon

• It will take Brandon 51 months to pay off the $5,000 loan based on paying the proposed $150 monthly payment @ 21% APR

• The total interest based on the proposed monthly payment = $2,569

Wen Qian

• It will take Wen Qian 27 months to pay off the $5,000 loan based on paying the proposed $250 monthly payment @ 25% APR

• The total interest based on the proposed monthly payment = $1,535

The difference in payback time and total interest between Denise, Brandon and Wen Qian demonstrates how damaging compound interest is when you don’t get on top of tackling your debt. What’s more, the difference in payback time and total interest between Denise and Brandon really emphasises the need to pay attention to the APR credit card providers offer you. Four per cent difference may not sound like much, but it cost Denise $1,056!

This example was just for a $5,000 debt. Imagine the debt was $10,000. At Denise's rate, the periodic (monthly) interest rate would be 2.08%. Paying back $150 per month as she wanted to do would be just 1.5% of the principal, so it wouldn’t even cover the original interest charges, let alone pay back the principal. Yikes. You want to have your assets going to the moon, not your liabilities! That's why the debt cycle is also known as the debt trap.

We recommend you do not go into debt unless it is essential, for example, to own your home. Only making minimum payments or constantly adding to debt allows little opportunity to increase your net worth and achieve your financial goals. It's crucial to understand the difference between an asset and a liability when trying to understand how you’ve ended up in such a hole. 

Assets – resources that you own and have the potential to supply you with future economic benefits. They can increase your net worth and help you achieve your financial goals. Examples include cash, property, land, shares, and intellectual property. 

Liabilities – debts or obligations which you need to pay off now or in the future. Can come in the form of money owed, goods needed to provide, or services required. They come to light out of past transactions and are settled with assets. 

If you find yourself in a position of constantly rising debt and are worried about your finances, you’re not alone. No judgment: The past is the past - what's important now is to get yourself out of this mess before it's too late.

Did you know? According to the OCBC Financial Wellness Index, 49% of Millennials in Singapore found themselves worrying about money over the last week.

To get out of debt, you should focus on establishing a debt repayment plan and reducing your liabilities. One way to do so is to increase your use of debit cards over credit cards. Unlike credit cards, debit cards use current account funds, meaning you won't find yourself purchasing goods you do not have the money for. 

If you aren't confident about how to address your credit situation, then professional guidance is a good option.

Credit counsellors are available at Credit Bureau Singapore (CBS), who can assist with personal debt management. 

Contact information:

Phone 6565 6363

Email consumer_services@creditbureau.com.sg

CREDIT AND THE DEBT CYCLE. COMPLETED. ✅

Sources: 

1. https://www.moneysense.gov.sg/articles/2018/11/credit-reports-and-creditworthiness
2. https://www.nibusinessinfo.co.uk/content/difference-between-assets-and-liabilities
3. Header photo from Pexels
4. https://www.exus.co.uk/blog/the-shifting-demographics-of-debt-millennials-and-money