The Debt Latency Trap

When getting paid with physical checks and purchasing with cash, it's fairly easy to determine how your finances are doing. As long as you successfully anticipate when bills will arrive, and you have enough money set aside to cover expenses, it's not that hard to stay out of debt.

However, with credit cards, things can get a lot more complicated. Here's an example; assume you have the following:

• A credit card that closes at the end of each month. The December statement just arrived, and shows an $800 balance.
  
• A job which pays you $500 on the 15th of each month.
  
• A bank account with a $800 balance.

You start off the new year by paying off your December statement completely. You then make a $500 purchase on January 3, a $300 purchase on January 20, and a $400 purchase on February 10. Your bill closes on January 31, and you receive a statement showing $800 owed. You receive your paycheck on February 15, and immediately pay off the January statement. On February 25, you spend $200, and on March 5, spend $600. Your February statement arrives showing $600 owed, and on March 15, you pay it off. What is your current financial status?

Answer: You are $500 in debt; more specifically, your debt is leading your income by a little over a month. Even though you show a $100 bank balance, and you were able to make your payment without fees in January, February, and March, you're still running a $500 deficit, since the total amount of purchases made since January 1 ($2000) exceeds your income since January 1 ($1500).

This issue is due to what I call debt latency. When purchasing on credit, it's very easy to let purchases get slightly ahead of income. Over time, the gap between expenses and income can extend for as much as 45 days without problems, and unless you're consistent about when you pay your bill, you may not even notice. But if something unexpected occurs (Car repairs? Plane tickets to a funeral?), you may quickly find yourself unable to pay your full credit card balance, and suddenly face significant credit card fees.

Here's a step-by-step analysis of what happened. When you made your initial purchase on January 3, you were spending money which was not yet earned. Even though you got paid on January 15, the additional expenditure on January 20 still meant that you spent more money ($800) than you made ($500). The same thing happened in March: only $500 of income was taken in, but $600 of new expenses occurred. The result is that as of the end of February, almost all income through the end of March has been consumed. The March 5th purchase puts you in an even worse position, as it consumed the remainders of March's income, as well as all of April's income. As of March 15, you still have sixteen days until the end of the month: any purchases made during this time will push you over the amount you will be able to pay without fees in April, and even if you arrive at April 1 with no new expenses, any purchases made during that month will still be drawing against May's paycheck. Even worse, the $100 balance remaining in your checking account on March 16 may create the illusion of financial stability. Where did this $100 come from?

Here's where part of the trap lies: Over the course of the example, the date on which credit card bills were paid changed. The December statement was paid using money already in the bank, including December's income. The January statement, however, was paid using January's income, and part of February's. The February statement was paid using the rest of February's income, and most of March's. The expenditures at the beginning of March will use up the rest of March's income, and all of April's income, and if you're not careful, you could find yourself spending into May's income as well (which will result in credit card fees).

One of the biggest advantages credit cards can offer is the 45 day buffer between the time when a purchase is made and the time when payment is due. This buffer gives you more time to earn interest on the money by keeping it in your savings account, and can also make it much easier to handle unexpected emergencies. But remember: credit cards make most of their revenue not from fees charged to merchants, but from interest charged to cardholders. A simple miscalculation, such as paying a bill before receiving a paycheck one month, and paying the bill after receiving the same paycheck the next month, can result in an inability to make a complete payment in the long run.

What's the best way to deal with this? Treat your credit card as a debit card, and never spend money that you haven't already earned. If you do spend more than your income allows for in a given month, reduce expenses in subsequent months to compensate, until your cumulative income matches your cumulative expenses again. Prepare a rudimentary budget so that infrequent expenses (such as car insurance, taxes, doctors appointments) won't catch you off-guard. And finally, track your expenses religiously using appropriate software.

Given the risk, why use credit cards? I'll discuss this issue in my next article. Stay tuned.