Lesson 12: Student Loans & Credit Cards
Accounts Receivable &
So far we have discussed secured debt, which is debt backed by assets; like an auto loan backed by a vehicle or a mortgage loan backed by the house. If you default on those types of loans, the lender can repossess the car or foreclose on the house; both scenarios end with the lenders owning an asset of some sort if you do not pay your debt. Student loans and credit cards are examples of unsecured debt; there are nothing backing those other than the debt holders' ability to pay the debt.
We will take a look at some Balance Sheet examples for both to wrap up the liabilities portion of this course. Student loans are more straight forward so we will start there. This debt functions just like auto loans and mortgages in terms of the principal and interest mechanics, so some of this example will feel like a repeat:
Example 12-1: You apply for and receive student loan financing to pay your tuition over the next four years. The cost is $18,750 per year for a total cost of $75,000 at graduation. Repayment begins six months after graduation, in which the following terms begin to apply:
5% interest rate
25 year payment plan
monthly payment of $439
Part 1 - Accumulating the debt
Each year of college you incur tuition expenses that are paid with funds received from your lender, which grows your debt balance to $75,000 over the four years. The good thing about student loans is the deferred repayment schedule; no payments are due while you are in school. However, you carry the liability throughout college; from the moment you accept the money to pay tuition freshman year. Figure 12A shows the affects on your Balance Sheet when you start the loans freshman year:
No Asset accounts affected since the lender paid your school directly.
Liabilities: You were loaned $18,750 in student loans which results in an increase (credit entry) in the Student Loans Account.
Equity: The loan covers your tuition expense, resulting in an increase to the Tuition Expense Account. Remember, expenses are contra accounts so the debit entry increases the expense account thereby decreasing Net Worth.
Assets = Liabilities + Equity
$0 = $18,750 + ($18,750)
$0 = $0
In years 2, 3 and 4 (Figures 12B-12D), the same exact entries occur. This results in a $75,000 total student loans balance and a total $75,000 in tuition expenses at graduation:
Part 2 - Monthly Payments
Now you have graduated.. hooray! But you owe $75,000 + monthly interest. This part of the lesson covers the dark side of student loans that the lending world does not want you to know. Just like auto loans and mortgages, interest is applied on a daily basis and paid monthly. If you have been paying attention to previous lessons then you know this results in high interest in the early months/years of the repayment period.
I used an online loan scheduler to project the monthly payments over the course of the repayment period. Figure 12E shows the principal vs interest breakdown of all 12 monthly payments in year 1 and Figure 12F shows the Balance Sheet affect for the first payment:
Again, this is exactly like the repayment schedule of an auto loan or mortgage. In year 1 you make a total of $5,261 in payments but $1,547 goes to interest (almost 30%). The worst part is that most people do not realize that interest is accumulated on a daily basis on their student loans. They do not realize they can mitigate the amount of interest they pay over time by being aggressive early in the repayment period. Instead, most people opt for the "more appealing" repayment plans that lets them make cheaper monthly payments. All this does is keep the balance higher for a longer period of time resulting in more interest. To prove it, I used the same online loan scheduler and decreased the monthly payment to $341. The year 1 result is below:
As you see, almost all of year 1 payments went to Interest with the cheaper monthly payment. This route only lowered the debt balance by $345 after 12 payments. This means the principal basis for the interest remains high, keeping the interest high each month for the first several years of the repayment period. The lower monthly payment just results in more interest income for the lender over the life of the loan. Unfortunately, a lot of people fall for this trap and end up carrying a balance (and making monthly payments) for most of their adult lives. The more you can pay off in the early years, the better off you and your Net Worth will be!
This second half will cover the infamous plastic cards that less knowledgeable people mistakenly view as free money. Instead credit cards are often the most expensive debt available. All liabilities we have discussed so far have been for long term repayment periods (5 year auto loan, 30 year mortgage, 20+ year student loans), but credit cards offer short term debt that must be settled on a monthly basis. If not, there is a high interest rate attached which ends up crippling the finances of far too many. Using credit cards irresponsibly results in bankruptcy and that is the last thing I want for you. I created a course that explains all of the technical details behind credit cards. It teaches you specific measures to take to ensure that you never pay interest while taking advantage of the reward points and cash flow benefits.
For this part of the lesson, we will go over some examples in which you use a credit card to buy things. Then we will compare what happens to your Net Worth if you make your payments on time vs making late payments and incurring interest.
Example 12-2: You use your credit card for the following purchases:
Jan 1: $20 for gas
Jan 11: $100 for groceries
Jan 21: $100 for your monthly internet bill
Jan 31: $30 at happy hour with friends
Part 1 - The Purchases
Left (Asset) side:
No asset activity since the expenses were paid with a credit card instead of an asset account like cash or checkings.
Liabilities: Each transaction results in an increase (credit) in your credit card account. By the end of the month (or credit card cycle), you have a balance of $250. Note that each individual credit card you own has its own account; hence "Credit Card 1" being the title instead of just "Credit Cards."
Equity: Each transaction is an expense, thereby increasing each individual account with the proper debit entries.
Assets = Liabilities + Equity
$0 = $20 + $100 + $100 + $30 + ($20) + ($100) + ($100) + ($30)
$0 = $0
$0 = $250 + ($250)
Credit cards have a buffer period that is very beneficial to your cash flow. There is generally a 25 day lag between the last day of the credit card cycle and the payment due date. In this example, the last day of the cycle is January 31, so the payment date is February 25. This is an important date! As long as the balance due on January 31 is paid in full by February 25 you will incur no interest! Again, I have a credit card course that explains these concepts in great detail. For this reason, you see no Interest Expense recorded on Figure 12G's Balance Sheet.
As long as you pay off your balance each month, credit cards essentially loan you money for free! I know that I said people "mistakenly view [them] as free money" just a couple scrolls up. This just shows the fine line between success and failure with credit cards; they offer free money but only if you know why and how its free. If you mistakenly view it as free money then you will get burned by the lack of knowledge, preparation and attention. If you view it as strategic free money then you can take advantage of credit cards' benefits for your every day spending!
Part 2 - On-time Payment
Now that you know you must pay $250 by February 25, you put a reminder in your phone's calendar for February 24. Fast forward to February 24 and your reminder works! You make a payment of $250 to cover your previous cycle balance.
Still no entry for interest expense since you paid your debt on time! You essentially used your credit card as a holding place and did not have to lose cash until the end of February, for expenses you incurred in January. That is maximizing cash flow at its finest. Think about it - you put gas in your car on January 1 but did not have to pay for it with your own cash until February 25 (do not spend money you do not have, only use this cash-flow method if you have the cash to cover your expenses).
If you miss a payment, however, things turn sour quickly..
Part 3 - Late Payment
Late credit card payments are harmful for two main reasons - your credit report takes a hit and you pay interest. Let's say the reminder went off on February 24 but you were busy and snoozed it, forgetting to readdress the issue until February 26 (one day late) and think you may be in the clear. Then your new statement posts and you see that you still owe money. You owe interest on the previous cycle's balance since you missed your payment due date.
Your balance of $250 would result in interest of $21.13 (based on an interest rate of 15%). Figure 12-i shows the Balance Sheet affect of the interest expense being added to your credit card balance:
Making the payment one day too late resulted in $21 in interest. The credit card company simply adds that amount to your balance. Now when you login to your online portal, you see that you owe $21.13 even though you already paid them back the money you borrowed. Interest sucks huh? Well think about people with $5,000 and $10,000 worth of debt, being charged thousands $ worth of interest per month while losing points on their credit score. It can get ugly fast so it is imperative you understand how credit card works before you use them. Click here to purchase my credit card course; teaching you everything the credit card companies don't want you know.
With the detailed information given in Lessons 10, 11 and 12, you now have knowledge on the mechanics of debt that most frankly do not have. If the concepts I have explained in the past few lessons are still a little confusing then repeat them until they make complete sense. The more you understand the details of debt, the better you can use debt to help, instead of hurt, you.
Click here to continue to the next lesson on two key accounts not covered yet.