Compounding Is a Double-Edged Sword[Fool on the Hill] May 5, 2000

An Investment Opinion

Compounding Is a Double-Edged Sword

By Bill Mann (TMF Otter)
May 5, 2000

We spend an inordinate amount of time here at the Fool looking at equities, dissecting companies for potential investment, discussing our portfolios, and such things. For millions of Americans (if the Fool Credit Card Discussion Board is any indication) this focus on investing is woefully premature.

We admittedly get pretty excited about ownership in great companies. The stock market is the greatest legal producer of wealth in existence, something that can be backed up by the fact that no other activity has historically returned on average 11% per year (the average return of the S&P 500 index over its lifetime).

That 11% may not seem very high, and given the frothy 86% return on the Nasdaq Composite last year, it may seem downright dowdy. But if you recognize that, even if you never add another red cent to a portfolio, every dollar you add in year one will be worth $7.26 in year 20, you will do yourself all sorts of favors by parking your money an S&P 500 index fund.

Such is the beauty of compounding growth -- the 11% doesn't remain based upon the beginning investment, but rather on the total capital value at the beginning of the particular year. So in the 23rd year, you gain as much in growth as the amount you originally invested. And in year 24 you gain 11% more than that!

But there's an old saying, one that most everyone is familiar with: "First things first."

Notice above that I said your money. Because I've got news for you: If you've got consumer debt, then the money that is sitting in your savings or checking account is not really yours. You owe it to some other entity and just have not paid it yet. You are holding money that you have earmarked as spent. And the thing is, you spent it. (I know, I know, some people out there have mean ex-spouses who maliciously ran up their credit cards, some had emergencies that could not be avoided. I'm no priggish Dr. Laura type, and particularly in such cases, I am not assessing blame, just reality as it stands.)

Average credit card debt is being carried on your books at 16.6% per year. And this number does not include the myriad fees and other incidental charges related to credit card debt. But just viewing the percentage above, there is one thing that jumps off the page to me � the rate of interest is higher than the average returns for equities. And unlike equity returns, debt interest appreciation is guaranteed. You got debt, you get charged a fixed rate of interest. The same cannot be said for equities, which return very well some years, and not at all for others.

As unglamorous as it sounds, using the law of averages, your best investment is to pay down your debt before you ever invest a dime in the market. Equity markets are not like the fictional town in A Prairie Home Companion, where every child is above average. Some people will fail to make 11% average returns, some will make more, and some years almost everyone invested will end up with negative returns. But if you have credit card balances and invest at the same time, by and large you have to earn better than average returns just to break even with the interest payments on your debt.

I doubt you will find anyone at The Motley Fool who will come right out and say that credit cards are evil. Credit cards are tools, and mighty useful ones when used responsibly. Credit cards give the consumer liquidity in situations where he or she does not have cash on hand to pay for a good or service.

But the danger of credit cards, just like the danger of margin debt, comes from wretched excess. People who use consumer credit to spend money they have not yet earned are pouring money into the coffers of the companies providing the cards. This debt will make the power of compounding interest work against you. Rather than building your nest egg, this is a tool that is helping you hand your future prosperity to someone else.

So, while the Fool tends to focus elsewhere, we would be wise, all of us, to revisit this portion of our financial health every once in a while. Only when Americans lower their overall credit levels will this message cease to be important.

Statistics provided by the Nilson Report suggest that there is no danger of this happening anytime soon. In 1999 there were $1.3 trillion in credit card transactions in the U.S. and unpaid balances reached $653 billion by year-end. This means that in December 1999 after one of the best years in stock market history, in which more individual wealth was created than in any year in our history, there was an average credit card balance of $2514 for every man, woman, and child in the U.S.

Let's do some fudging here. Let's assume using the CWG method (Complete Wild Guess) that 40% represented current balances that were paid in full. This still leaves us with $391 billion in interest bearing credit card balances. Apply a 16.6% average rate, and Americans are paying $5.4 billion in credit card interest each month, or $64.8 billion for this year. $249 per American, in interest expenses alone!

Add to this the 5.8% of all credit card balances that are overdue. That's a total of $37 billion that is not only subject to interest, but whatever myriad penalties applied by the banks as well. That, for those of you playing the home game, is $145 per American that is subject to the banks highest rates and other associated charges and collections fees.

I've seen credit card rates as high as 23.9%, and it does not stretch credibility that a fair percentage of this money is subject to the highest interest rates. Let me be very specific. If you have overdue credit balances, and you have stocks, you should liquidate whatever equity it takes to pay down that debt, because you are playing a loser's game.

For those of you caught in the middle, those who have consumer debt that is not overdue but is accruing interest charges, here's some more specific advice: Ignore the stock market until your outstanding balances are gone. You are doing yourself no favors by rushing into the market before you have taken care of your debts. In fact, you are putting yourself mathematically on the wrong side of the averages. You are making yourself into the underdog. And although it is possible for the underdog to win, it's not the way to bet.

I'm going to close with a chart showing the top 10 credit card issuers in the U.S., which account for some $387 billion of all credit card debt. For those of you out there who are holding no consumer debt, these are some of your best investment options available to take advantage of the financial folly of others. With credit card debt growing at some 15% per year, you'd be hard pressed to find companies with a larger revenue base with faster growing rates of growth.

 Company             Outstanding Bal (Blns) Change from 1998
 Citigroup (NYSE: C)             $74.2              6.6%
 Bank One(NYSE: ONE)              69.4             -1.0%
 MBNA (NYSE: KRB)                 58.8             20.2%
 American Express (NYSE: AXP)     43.2             27.2%
 Morgan Stanley(NYSE: MWD)        38.6             17.7%
 Chase (NYSE: CMB)                33.6              4.3%
 Bank of America (NYSE: BAC)      20.9             -0.1%
 Providian (NYSE: PVN)            18.7             66.4%
 Capital One (NYSE: COF)          15.7              9.9% 
 Fleet (NYSE: FBF)                14.3              0.0%
For those of you holding credit card debt, The Motley Fool has a whole section designed to help you get out of debt, including one of the most supportive discussion board communities in all Fooldom. Remember, we do not aim to judge here, but to educate, amuse, and enrich. Your first step to all three may well be your determination to eradicate both your debt and the spending habits that got you there. For that first, important and painful step, I salute you.

Fiat Fool!

Bill Mann, TMFOtter on the Fool Discussion Boards

Editor's Note: You can win $4500 in our Get Out of Debt Contest. Check out our new Fun & Folly area for details.

Related Link:
  • Credit Card Discussion Board