# Credit Card Debt for Dummies

You don’t have to be a genius to get a credit card, but you want to be smart when you use it!

Credit cards are pretty convenient to have, but if you’re not careful, it’s easy to get into trouble with them.  Half the battle is knowing what you’re getting into before you begin.  Hopefully, this will help.

First, a credit card is like a little loan to help you pay for things.  If you pay off the entire balance each month when you get your bill then you won’t have any problems.  If you don’t pay off the entire balance, then the credit card company will charge you interest on the amount that’s left over.  That’s how they make money.  (That and the fees they charge the store owners for using credit cards.)

Let’s say you went out and purchased some new furniture for your home and spent \$5,000 on a credit card that charges an 18% interest rate.    The first bill comes in the mail and you see the minimum payment is \$100.  Now if you pay the full \$5,000 – cool, you pay no interest.  But what if you don’t have it and you only pay the \$100?

The credit card company takes their interest payment first – remember that’s how they make their money.  So, at 18% per year, that works out to be 1.5% interest per month.

\$5000 times .015 equals \$75.

So \$75 goes to the credit card company for the privilege of using the credit card to buy your stuff.  Since you only paid \$100 towards the debt, then that only leaves \$25 to reduce the balance.  You still owe \$4,975.

If you only pay \$100 a month to reduce the debt, you will have paid \$9,400 before the account is paid up in 7 years and 9 months.  Ouch!

Now, if you were to pay \$200 a month in the same situation, you’d have only paid \$6,400 and you’d be paid off in 32 months.  You’re throwing an extra \$100 a month towards the balance so of course it gets paid off faster!   That first \$75 will still go to the credit card company to pay the interest, but you’ll have paid \$125 towards the debt so you only owe \$4,875 the next month.  And this is where it’s so sweet.  The interest you pay on \$4875 is \$73.13.  The interest you pay on \$4975 is \$74.63.  Okay, not a huge difference, right?  But every month that gap keeps getting bigger and bigger.  So you save money by making a bigger payment on your credit card.

Another way to save money is if your credit card has a lower interest rate.  For example:  let’s say the interest rate is 12% instead of 18%, and you pay \$100 a month.  You’d pay off the balance in less than 6 years and pay only \$7,000 instead of \$9,400..

So here are the three things I want you to remember about credit card debt:

Paying off your credit card charges immediately will keep you from paying interest.

If you don’t pay the full amount, the money you do pay gets applied to interest first, then the balance owed.  The more you pay, the sooner you’re paid up.  Paying down the debt saves you money!

The lower your interest rate, the less you pay towards interest.

Hopefully, by seeing how much it costs to use your credit card will help you make good spending choices.

# Time Value of Money and Taxes

Photo by Brian Mooney at Flickr.com

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.”

-Albert Einstein

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You probably have come across time value of money in one your finance classes or at least have a basic understanding of the idea.  Time value of money, as defined by Investopedia.com, is “the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity.”  Basically, money is worth more now than it is later.  This idea would not exist however, if there was no concept of “interest”.

There are two types of interest – simple and compound.  Simple interest is interest paid on a beginning principal balance only.  If you are receiving monies, the interest earned in a given period is not added back to the principal and then applied the interest rate again and appears perfectly linear on a graph.  Compound interest is interest paid on a beginning balance and any interest that has accumulated in given a period of time.  On a graph compound interest appears with a geometric (or exponential) growth pattern.

The present value of a future sum is the core formula for the time value of money.  All time value of money equations are based off this formula so it is extremely important to review.  It is expressed as such:

PV = FV / (1 + i)^n

Where

PV = Present Value
FV = Future Value
i = interest rate
n = number of periods

The future value of a present sum is expressed as FV = PV * (1 + i) ^n.  We won’t discuss perpetuities or annuities in this post nor will we execute any actual calculations with the TMV formulas.

So how can we use this time value of money concept for tax optimization and more importantly, individual wealth?

Retirement Planning:  We have all seen the example where Johnny starts an IRA at age 35 while Susie starts one at 21 and the amazing difference of the account values when they both reach age 59 and a half.  This is because Susie’s IRA endured 14 more years of compounding.  The choice between a roth and a traditional IRA has important tax implications and time value of money has some influence in the decision.  With a Roth IRA for example, the taxpayer can receive tax free distributions of earnings at age 59 and a half while with a traditional IRA, the taxpayer receives an above the line deduction on IRA contributions – given that AGI thresholds are not crossed – and is taxed on the distributions.  If your income is expected to increase as you get older and your marginal tax rate is also expected to increase, then a Roth IRA makes more sense – naturally.  Do the immediate tax savings of traditional IRA contributions outweigh Roth IRA tax free distributions?

Tax Planning: Accelerate deductions, postponing income recognition.  This concept goes hand in hand with the time value of money concept – money today is worth more than money tomorrow.  By accelerating deductions you essentially reduce your taxable income and end up with a bigger refund or smaller balance due.   Some examples include prepaying your home mortgage interest in a given year, making an alimony payment in December as opposed to January, and writing off an asset using section 179 expensing or bonus depreciation as opposed to depreciating it over several years.  The amount of tax savings probably doesn’t have enough compounding power for individuals to make a huge substantial presence but for well established businesses it most definitely does.  Examples of postponing income are increasing your retirement plan contributions to a 401(k) plan, legally deferring compensation, and delaying the collection of any debts you are owed.

Investment Planning:  Younger people can be more aggressive because they have more time to make up for their losses.  A younger person’s portfolio can afford more risky securities such as stocks.  As one gets older, the switch to dividend producing stocks and bonds usually happens because the “interest rate” is more stable.

With time value of money, the uncertainty of the interest variable is the most difficult to tame.  Those who can predict its patterns the best, tend to make the most money.

# How Long Should I Hold My Tax Returns? Forever If You Live in Missouri!

Photo by Jimmy Emerson at Flickr.com

Forever!  That’s what I said.  I realize that I’ve made posts about keeping your tax returns before and I’ve said ten years, or even less, but I’ve changed my mind.  Keep your tax returns forever!  Keep your W-2s also.

Why am I going all crazy about this?  Because it seems the state of Missouri doesn’t care how old your old tax issues are.  If they think you owe back taxes, there is no statute of limitations.  Let me repeat that—NO STATUTE OF LIMITATIONS!

Over the past few months I’ve seen them go after people for back taxes from 2000, 1999, 1995, and my favorite:  1987.  Yes, 1987, that’s 26 years ago.  If you were asked to produce your tax returns from 26 years ago, could you?  I couldn’t.

Here’s the thing—if Missouri believes that you have not filed, or that you perhaps filed but still owe, you’re going to need to provide some sort of proof of payment or filing.  If you didn’t keep your tax returns, how can you prove it?