The dark side of compounding

Well after the last couple of posts (here and here), I hope you are truly in love with compounding.

But I’ll let you in on a little secret…compounding has a dark side too.

It can work against you.

Just as it can be a friend of those that learn to master it, compounding can be an incredible foe for those that fall victim to it.

Compounding can work against you, and it happens to many people everyday.

You may not even realise it’s happening.

Compounding works against you when you borrow to buy anything other than an asset.

It works against you when you buy consumer goods that have little or no value, or need to be replaced quickly.

When you buy a new car on loan or put your holiday on your credit card, you’re essentially putting your hands in the air and saying “I can’t afford this! But I want it so bad that I will allow you to charge me interest because I can’t help but buy something I can’t afford.”

When you spend frivolously, you are taking away from both your current and future wealth.

If you’re using a credit card to fund your lifestyle, you’re effectively paying an extra 20% on your purchases.

When you only make the minimum repayment on your credit card, your repayments don’t even cover all the interest you’ve been charged. Yep, that’s interest charged on interest.

That’s wealth destruction, not wealth creation.

Borrowing to fund lifestyle expenses or lifestyle assets that go down in value (TVs, furniture, cars) keeps you poorer for longer and makes it harder to get ahead.

If a dollar invested today is worth 10 times that amount in 30 years, every dollar you waste is not just making your current financial situation worse, but your future financial circumstances worse as well.

Whenever you spend frivolously, pay interest or generally waste money, you are not only losing money now, but disproportionately making your future financial self less wealthy.

One of the reasons why it is so important to work towards financial security is the overwhelmingly positive impact it can have on your life.

It frees you up to invest, to not have to trade your time for money, to make bigger and better decisions.

Conversely, consider the massively negative psychological impact that can be at play when you are lacking funds.

Being in a constant state of financial flux or in excessive debt weighs heavy on the mind.

It makes you scared to take chances.

It makes you feel stuck in your job.

Over time, there’s a good chance that working a job that you don’t like but need is going to wear you down and lower your self-esteem. You drag your feet to work, you don’t want to be there.

Is this the kind of person that sounds like they will be in line to get a promotion?

You miss out of your promotion, which makes you feel even worse about yourself and your financial situation.

It’s a horrible situation to be in and a cycle that’s hard to break. But it needs to be broken.

If you currently have credit card debt that you aren’t paying off in full at the end of the month, consider this your financial wake up call.

If you don’t have enough money to meet your living expenses, or your loan repayments, you are officially in financial strife.

Credit card debt and a lack of funds is a symptom of an underlying problem, and the problem is that you’re spending more than you earn, that your lifestyle exceeds your means.

The good news is that this problem is able to be fixed. Just stop spending more than you earn!

Live more frugally, skip the overseas holiday, cook more of your own meals, do everything you can to boost your income, and please, please, please, stop trying to keep up with the Jones’s.

Only when you start doing this, will surplus cash eventuate.

If you are on the journey to financial freedom and have credit card debt or personal loans, the first step must be to pay these off as soon as possible.

The interest you save and the habits you form will almost certainly offset any financial return you are likely to obtain by investing.

I have credit card debt or consumer debt - what should I do?

If you’re currently looking to build your wealth but have consumer loans, personal loans or happen forbid credit card debt, the single best thing you can do is pay these debts off as soon as possible.

There are a few approaches here, as follows:

• Start paying off the loan with the highest interest rate first. This makes the biggest financial saving, as by reducing the loan outstanding, you are saving the most amount of interest.
  

• Others recommend paying off the smallest loan first, so that you receive a psychological boost by retiring a debt. Personally for me, it has always made sense to pay off the loan with the highest interest rate first. Get your dopamine hit by saving the most amount of interest possible.
  

• Consider consolidating your debt into a single loan with a lower interest rate. This can be an excellent way to save overall interest, especially if your loans are made up of predominately credit cards and you can obtain a personal loan with a lower rate.
  

• Consider organising a balance transfer. This is where a credit card balance/debt is transferred to a new credit card to take advantage of an interest free period. This can be an excellent way to save interest. PS remember to cancel the old credit card (and stop using it!)

It’s important to remember though that whichever option you select, you need to fix the underlying problem - that you are spending more than you earn.

Only by solving this problem, can you progress your financial journey.