Now that you’re an adult, you have two basic ways to pay for the things you buy:
- Pay with cash
- Pay with some form of credit
When you pay with cash, you dig the money out of your wallet or swipe your debit card and that’s it! The transaction is done and you own the item for the exact price you paid. When you borrow money, it’s going to cost you more—how much more depends on the type of credit you use, the interest rate you’re charged, and how long it takes you to pay the money back.
Common Types of Credit You Might Encounter
Most people get their first taste of credit soon after leaving home. All of a sudden, you start receiving credit card offers in the mail or getting pushed by clerks to sign up for store cards.
And it isn’t just cards. There are plenty of other forms of credit that allow you to buy something you can’t afford or get access to cash you don’t have:
- "Interest-free” loan from a retailer, such as a furniture store
- Cash advance from your credit card
- Payday loan from a lender
- A loan for a specific purpose (school, home, car, opening a small business)
All of these scenarios have their own perks and drawbacks, but the one thing they have in common is interest.
How Interest Adds Up
Lenders give you money to buy things you want, because they’re going to charge you, via interest rates, for the privilege of accessing money you don’t have.
If you put on your blinders and only look at the low monthly payment the lender requires, any purchase can seem affordable. You might not be able to pay for that new outfit, couch, or game system right away, but you can easily pay it off over time, right?
But when you include interest rates in the scenario, you’ll see how much more it’s going to cost you over time.
Total Cost of TV: Cash vs. Credit
*Assumes $1,854 balance on credit card with 20% APR and 3% minimum payment, which is paid off in 109 monthly payments of $25.
A Real-Life Example
Let’s say you want to buy a 55-inch high-definition TV for your new apartment, and it costs $1,854. You don’t have the money now, but you have a credit card that only requires a $25 per month minimum payment, and you think you can fit that into your budget.
The credit card also has a 20 percent interest rate—and that is the important part. Because if you only pay the minimum payment, the rest of the TV cost will accrue interest. Each month, 20 percent of the leftover TV cost will be added to your balance, making the balance more than what you started with. And, it will keep happening each month until you’ve paid everything off.
At that rate, it will take you 109 months, or nine years of your life, to pay for that TV in full. Plus, you’ll be spending an additional $1,669 in interest, making the total cost of the TV $3,523.
Consider Borrowing Carefully
If you decide borrowing is the only or best option for your situation, consider the following carefully before you swipe the card or sign on the dotted line:
- Understand what the item will cost you over time. Not sure how to figure that out? Use an online calculator, consult your credit card statement, or ask a loan officer.
- Look for your least expensive option for borrowing. Compare the interest rates, minimum payments, and penalties of credit options available to you before taking them up.
- Think about whether the purchase is worth it to you. If it’s something small that you don’t need, you might consider saving up. If it’s something big, like taking out a loan to go back to school, it might be worth it to you because it will help you in the long run.
[Any reference to a specific company, commercial product, process, or service does not constitute or imply an endorsement or recommendation by the National Endowment for Financial Education.]