Credit, overdrafts and the dangers of compound interest

road-to-good-credit-1

Essentially, credit is the availability of borrowing money from a lender, be it a bank or a car dealership and the credit industry is built around lending people money and more general services. A typical example would be me going to a bank and asking to borrow £1,000 for five years to pay for a car, since I do not have the total sum in my account. If the bank accepts and gives me the money with a yearly interest, I will have been extended credit by the bank. I might therefore end up spending £1,200 total on the car rather than the £1,000 if I had the money straight up. It is clear that having to borrow money is more costly than already having the money but the borrowing scenario is much more common at a university where many students have credit cards with pre-agreed overdraft limits.

Creditworthiness is a “valuation performed by lenders that determines the possibility a borrower may default on their debt obligations”. Someone who has a house, a job, a profession and some savings will probably be deemed credit worthy because there is evidence and experience of their ability to control debts, loans and income. The paradox is that someone, such as a student, who wants to get credit, perhaps through a loan, is much more unlikely to get it because they aren’t credit worthy, having had little experience with loans. On the other hand, someone who is credit worthy is less likely to want credit yet more likely to be given it due to their credit worthiness. Graduates, therefore, looking for a loan for a first flat outside university are in a much worse situation for being accepted than a wealthy family looking to buy a second home! Over the summer, my dad and brother got into a disagreement about students having credit cards. My dad posed that it is safer for students to avoid credit cards at all at uni to avoid the pitfalls of compound interest, mentioned later, and spending money that they cannot pay back in reasonable time. My brother on the other hand came from the angle of creditworthiness and said that it would be harder to rent a flat, get a mortgage or buy a car without a credit card because the bank has no past record of how well you manage credit. Therein lies another dilemma; namely that it is safer to avoid credit cards at an early age but it is harder to become creditworthy.

If you walk into any bank you will be bombarded with financial products for overdrafts, mortgages, car loans etc.  In addition, living in a flat this year I get a fair amount of spam post from banks including student account discounts from many different banks trying to persuade me to switch to their scheme. Offers online include free railcards, an interest free overdraft up to £1,500 in the first three years, Amazon gift cards and more student exclusive discounts. It all sounds lovely and inviting but to me it feels similar to throwing drugs over the playground fence. It is very important then, to take a step back and realise that the banks are not offering these tantalising prizes as generosities or pure gifts; they are doing it to flash short term rewards in front of your nose in the hope that you do indeed use their bank. This is advantageous for them because people rarely switch bank accounts and as such, if they can grab you as a student it is very likely that they will have you until your death. My family all use one bank and my parents have used the same one for all of their lives as well so it is very much in the bank’s interest to sign you up for their services because of the longevity of your relationship with them. It is therefore vital to look at the long-term offers and conditions of a bank before deciding which one to go with.

One of the great pitfalls of having a credit card is the interest that racks up on your monthly payments, or if you go into your agreed overdraft, and it is here that compound interest can be a real killer. If I borrowed £100 with 10% interest every year and didn’t spend it or add to it, it seemed (at least to me, when my dad posed this question) that the £100 would double in 10 years with the interest given. This is perhaps what many people would give as an answer yet it is wrong. The amount to be paid would double after just over 7 years. This is all because of compound interest and the way in which interest can become greater over the years. The example is quite simplified but it gets across the point well. After the first year the £100 would have increased to £110 due to the 10% interest. After the second year you have paid 10% interest on £110, not the original £100 so the money increases to £121, at the end of the third year you have paid 10% on £121 and as the graph shows the amount to pay soon spirals out of control if the compound interest is not monitored. This is more likely to happen to students due to our youth and inexperience with the financing and credit worlds. For example, it might seem like a good idea to spend £399 and go into your overdraft to pay for that plasma TV in time for the FA cup final, but in a year’s time, when the price of the TV has dropped and you have only been able to pay off the minimum monthly payment meaning that the interest is still growing, you realise it may have been a mistake! It is mistakes like these that can send students into further financial troubles.

It is important however to stress that there is both good and bad credit; credit should not be universally criticised. An example of good credit would be a young couple with two children who work and save money, borrowing £20,000 for an extension to build a second bedroom for the kids. This couple is very likely to be able to pay back the loan in a reasonable time period with the given interest rate. This is good credit because at the outcome, the couple now have a two-bedroom house which may bump up the price by £40,000 when it comes to selling the house, so even after the interest on the original loan the couple may have made money through the investment. Another example would be lending money to a businessman to buy stocks that he knows can sell for more than he bought them for. Bad credit would be lending money to someone who goes down to the bookmakers and puts it all on a horse in the grand national. Good credit is therefore determined by credit worthiness and here one of the paradoxes of credit and loans is introduced.

What can we draw from this then? Most importantly, banks are there to make money off you, so don’t be naïve about the multiplicity of offers you receive from banks to draw you in and purchase their products and services. Secondly, don’t think that you can get away with paying the minimum monthly fee for outstanding payments because at best you may only be paying off the interest and still have the actual payment to get rid of, a situation you don’t want to find yourself in.

 

 

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