It Simply Costs too Much

Roger Schlesinger
Posted: Mar 28, 2007 4:06 PM

When people tell me that they aren't interested in paying off their credit cards by refinancing and taking the cash out of their house I just shake my head. They have a million reasons and aren't particularly interested in what I have to say about it. It used to bother me that I couldn't get through but now I just tell them straight out, "it simply costs too much." If they take time out to understand what I am saying, that is terrific; if not, they are the ones that are paying too much. Not I, and hopefully not you.

Although we have many brackets to determine the income tax we owe on our earnings I will demonstrate my proposition using the 15%, 25% and 35% brackets. These three brackets will give you an idea of why it costs too much to use credit cards to finance your purchases if you don't pay them in full right after the first bill comes in.

Let's examine the rules of the credit card companies and begin to uncover the problem. Today you are supposed to pay one percent (1%) of the outstanding balance of your credit card each month. On a $10,000 balance that's $100 that is due. Now the interest rate. Although I can choose from the many interest rates (they range from 0 to 33 1/3%), I will use 9% interest for the example.

On $10,000 the interest payment at 9% is $75 a month. That gives us a payment of $175 a month on $10,000. At 33%, the payment would be almost $400 a month. Credit card payments are paid with after tax dollars meaning you first earn the money, pay the tax and then with the left over money you can pay your credit card payment above of $175. So how much do you need to earn to make the payment? It depends on the bracket you are in.

15% bracket - must earn $205.88 to pay $175 on the credit card. ($30.88 tax)

25% bracket - must earn $233.33 to pay $175 on the credit card. ($58.33 tax)

35% bracket - must earn $269.23 to pay $175 on the credit card. ($94.23 tax)

Without going any further you can see that you must earn more than you have to pay so you can pay the tax and use the remaining money to make the credit card payment. But you have only seen half of the story.

When you borrow money from your house, the interest you pay on the loan is tax deductible in most cases. So how much does it cost you in payments to pay off the loan of $10,000 you took out of your house to get rid of the credit cards. It depends on the loan and the tax bracket of the borrower. To simplify this discussion I will use the 25% tax bracket. I will give examples of 10 year fixed, 15year fixed and a 7 year arm paid as a 7 year fixed.

7 year arm (fixed) $145.46 payment $48.92 interest $12.23 tax savings $133.23 net payment ($145.46 minus $12.23)

10 year fixed $108.53 payment $45.83 interest $11.45 tax savings $ 97.08 net payment

15 year fixed $ 82.37 payment $46.88 interest $12.55 tax savings $ 69.82 net payment

To find the answer of which is the better way to pay, either the after tax paying of the credit cards or borrowing the money from your house and reducing the payment by the interest savings for your tax bracket, it would take many assumptions and a very detailed analysis. What you readily can see from this exercise is that in the first case you must make more than the payment and in the second case the net payment is less than the actual payment.

This gets me to the real point of the exercise: credit cards keep people from affording a quicker amortization of their house. A $250,000 thirty year fixed mortgage @ 6.125% with $25,000 in credit cards would have a monthly payment of $1519 for the mortgage and $525 for the credit cards (in the 25% bracket actually $700). A 15 year loan for $275,00 @ 5.625% would be $2265 a month. This is $221 more a month than the $250,000 loan and the $25,000 in credit card payments but with taxes included it is a mere $46 a month more and it saves 15 years in payments.

That is the Real Story behind the problem with credit cards. It costs too much in dollars and in lost opportunity. The lost opportunity is the ability to pay your house off 15 years earlier than you ever dreamed you could and actually find yourself on the road to financial freedom. It is something you need to consider.