OPM — Other People’s Money. What we’re talking about here is debt. Debt is incurred when you use money that is not your own — it might be a loan from the bank, a credit card balance, a loan for a car or a house, or any other kind of borrowed money.
While debt, or borrowed money, can seem like a positive as it may help you achieve something you really want, like home ownership, it is important to recognize that money has a cost. And that cost is known as “interest.” Interest is the rent paid on money that you borrow from other people and institutions, usually expressed as a percentage of the total amount borrowed.
The idea that money has a cost is a foundational concept in finance. It underlies critical financial concepts like compound interest, which is in turn related to important consumer products like credit cards and investments. Understanding the power of compound interest and using it to your advantage can help a consumer avoid credit card debt, and build wealth through investing.
Compound interest is so powerful that we made it the topic of Week 4 of our Summer$Fun boot camp for teenaged girls on our Facebook page. This week’s activity is focused on figuring out how long it will take to pay off a credit card in eight different scenarios, as well as how much extra will be paid, when a minimum payment is made and interest is accumulating. We do this with a Credit Card Pay-Off Worksheet. We even include an answer key for the activity!
In some cases when the balance and interest rates are high, when a minimum payment is made each month, more than twice the original balance is paid back. This shows the power of compound interest as the interest paid is equal to or higher than the original balance borrowed.
Next week we are going to take a look at how time and compound interest can work to a person’s benefit, by focusing on investing. But we wanted to start with compound interest on credit cards, as they are such a handy — and sometimes overused — consumer financial tool. And the power of compounding can mean that interest piles up much more quickly than borrowers expect, possibly creating its own financial crisis.
Compound interest is a famously difficult concept to grasp, according to financial researchers, so on Wednesday on our Facebook page we will have another idea for how to aid comprehension of that important topic. As usual, we welcome all comments and questions throughout the week!