In these times of very low interest rates, consumer credit is a great product – unfortunately not for the consumers, but for the banks.
The Eurozone has been on extremely low interest rates, banks have to pay negative interest if they want to ‚park’ money with the European Central Bank. So consumer credit products are still a way to realize comparatively high margins.
It is interesting to note that in Germany people will tend to take out consumer credit with a bank rather than running up credit card debt. Credit cards with revolving credit – typically used in the US and the UK – have only been around in Germany since the millenial. The common way ‚credit’ on your card is paid back here, is by automatic debit once a month.
Attention: negative compounding!
If you want to become financially independent and you do currently have credit card debt, you need to get out of that as quickly as you can. As interest rates for revolving credit are typically extremely high in comparison to any other credit, you will be hit with the full force of ‚negative compounding’. This can lead to very serious debt – and the whole list of subsequent – problems.
What do I mean by negative compounding? Just as compounding grows the value of the money you have invested, ‚negative compounding’ grows the value of your debt. Just as the interest you earn on your principal investment ‚earns’ its own interest as time goes by, the interest you owe ‚earns’ its own interest as well, not for you, though, but for the bank. The longer you are ‘in the red’, the higher the total amount you have to pay back.
And as credit card interest rates are much higher than interest rates for any investment product with an acceptable risk, your consumer debt grows much quicker than you can reasonably expect your investments to grow.
Get rid of your consumer debt as quickly as possible
If you already have credit card debt, but your credit rating is still good enough, it would be justifiable to take up a regular consumer credit (‚Ratenkredit’) with a lower interest rate than that of the credit card, and pay off the credit card debt in one go. Then pay off the consumer credit in monthly installments and avoid to buy any product on credit again. Ever. And I include cars in my definition of consumer products.
If your credit score is too bad already to be able to swap to a consumer credit, please do get professional help by a non-for-profit debt counsellor as quickly as possible. In Germany you can get in touch with your local Verbraucherzentrale, Deutsches Rotes Kreuz, Caritas, or Arbeiterwohlfahrt among others. In any case, continue to educate yourself on personal finance and getting rid of debt with free resources on the internet. As a starting point, Rockstar Finance lists loads of personal finance blogs with different emphases.
My own experience
So how have I treated taking on consumer credit in my own life? You can probably guess: consumer credit is a product I don’t use. My understanding is that I can only buy to consume if I have the money for it. Very simple. Which means that our family saves up for bigger purchases such as furniture or vacations.
And my experience is that this habit actually provides us with a greater sense of accomplishment and a higher emotional valuation regarding those purchases. How come? I think this has to do with having effectively invested a tangible effort into the purchase by the saving process. This provides a positive emotional investment versus the quickly vanishing feeling of instant gratification.
And what about 0% loans?
Because of my financial optimization mindset I have pondered whether we should use a 0% credit offer just lately when we had to replace our dishwasher. We might have decided to go for that in a high interest environment like before the big recession where a high yield cash account (Tagesgeldkonto) would return 4-5% interest p.a.. The logic behind this is that we could have ‚earned’ a certain amount of money by leaving the savings in the high yield cash account and only paying the store (or rather the bank) back over time.
At current interest rates this is obviously not attractive. And it’s also a strategy I would only suggest if you’ve really got the purchase price saved up, are sure you’re not going to dip into those dedicated savings for something else, and are generally very disciplined about your outgoings. If the installments have to come out of your take home pay rather than out of your savings, I would strongly advise against even 0% consumer loans. The danger of running into financial problems when non-discretionary expenditures such as utilities rise, or when your income drops due to an unexpected lay-off in the next recession is just too big.
Financial Independence Rocks!