When Warren Buffett gives you financial advice, you listen. Currently the third richest person in the world, the chairman and CEO of Berkshire Hathaway has been giving us sage advice on topics like investing, saving, and credit cards for decades.
During a speech he gave to high school students in Omaha, he offers up one piece of financial advice: “Avoid credit cards,” he advised, “just forget about them.”
If you’re someone who uses credit cards for necessities and always pays off your bill in full each month, you might be questioning his advice. If you’re a credit card rewards junkie who earns free vacations and never pays interest, you probably disagree with him completely.
The truth is, what Warren Buffett actually meant to say was this: avoid credit card debt.
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Warren Buffett’s take on compound interest
In this speech, Buffett goes on to explain his reasoning by saying that credit card interest rates are extremely high — often 18% or 20%.
Compound interest, he explains, can either be a beautiful thing or a terrible thing, depending on which side of the equation you’re on. If you’re earning 18% or 20% in compound interest on your investments, expect to retire early. If you’re paying 18% or 20% in compound interest on your credit card debt, he states, you’ll end up on the side of the equation that’s always behind in life.
Compounding interest means that on day one, your balance accrues interest. On day two, your balance, plus the interest you accrued on day one, accrue interest. On day three, your balance, plus the interest you accrued on day one, plus the interest you accrued on day two, accrue interest. Put simply, you’re paying interest on your own interest.
This is why people who find themselves deep in high interest debt often feel like they’re in a never-ending cycle. The table below shows how long it would take three people with different balances to pay off their debt at a 20% interest rate, and how much they’d pay in interest if they only made the minimum payment.
Source: Author calculations
Each person ends up paying more than double what they borrowed, and they spend over a decade, sometimes two, trying to get out of the hole. The first step when you find yourself in a hole? Stop digging. If you’re someone who carries a balance regularly, then Warren Buffett would probably tell you to stay away from credit cards entirely.
Credit cards aren’t all bad
Does this mean that everyone should avoid credit cards? Not necessarily. If you’re honestly good at managing your finances, credit cards can actually be a tool to help you get ahead.
If you have poor credit, credit cards are one of the most powerful credit-building tools you have at your disposal, especially when you can’t qualify for loans. A good secured credit card from a trustworthy issuer will help you gradually increase your credit score, as long as you pay off your balance in full each month.
Credit cards can even help you pay off debt, but if you’re trigger-happy with the plastic, this isn’t the best solution. For those who swear to stop swiping, a generous balance transfer offer can save you hundreds on interest fees and get you to debt-free status more quickly. Just make sure you pay off the balance in full before the promotional period ends or you’ll get hit with even higher interest rates.
Finally, if you have an excellent credit score and are financially stable, the best rewards credit cards can save you hundreds each year.
The best tool for avoiding credit card debt
Right after explaining why students should avoid credit card debt at all costs, Warren Buffett goes on to mention that he saved $10,000 by the time he got out of school. This savings cushion, he tells students, was worth millions he might have earned later, because it helped him stay ahead of the game.
Building up an emergency savings fund in a high-yield online savings account will put you on the right side of the interest equation, but it will also protect you from falling into debt when unforeseen expenses arise. When you have something other than a credit card to fall back on, it’s easy to avoid falling behind.
View more information: https://www.fool.com/the-ascent/credit-cards/articles/warren-buffetts-credit-card-advice-isnt-what-you-think/