Credit, Interest, and Cash
The first visual that comes to mind when someone says “Credit” for an average person is probably an image of a “credit card”. We are so used to credit cards in our everyday lives. They serve a major purpose. They also come with a cost. That cost is interest. Interest is the price we pay for being able to use credit cards and, as a matter of fact, any type of credit. Then there is also an interest that can be earned on interest – compound interest. In the words of Albert Einstein, “Compound interest is the eighth wonder of the world. He who understands it…earns it. He who doesn’t…pays it.”
In essence, Einstein meant that if you understand what interest is, how interest works, the purpose it serves and how inevitable its nature is [whether you like it or not] – you can build a fortune over time and use interest and credit to your advantage (i.e. leverage). That’s one of the main reasons why people with money continue to make more money: they are able to lend money and earn interest on it [plus interest on that interest]. But if you don’t understand what interest is or for some reason choose to ignore it [or disagree with it as some people do], you’ll likely end up overpaying pretty much for everything in your life: your food and groceries, your clothes and other essentials, your rent, your insurance(s), your education, your car payment, your mortgage, your retirement, etc.
There may be some of you that will claim that you’d rather pay cash for everything and not have to pay any interest. That’s admirable and kudos to you if you have a lot of cash. That’s a dream for many of us – to have a lot of cash. But if you are an average consumer, like millions of other people in the U.S. and globally, you don’t have a lot of cash sitting around. In that case, you’ll be using credit that comes with an interest rate that you have to pay (whether you like it or not).
“Why should I have to pay interest?” you may ask. Great question. Here is my answer: TIME VALUE OF MONEY (TVM). TVM is one of the common and widely accepted economic principles that states that “money you have now is worth more than the identical sum of money in the future due to its potential earning capacity.”
Let me explain. Ask yourself a question: would you rather have a $100 bill in your hands right now or two weeks from today? Be honest. $100 bucks now or later? Why now? Probably because you can do something with that money right now versus hoping to get it later. Right? Perhaps, you’ll take this $100 and invest it into your health and fitness and it will make you feel better. Perhaps you’ll just spend $100 on things you wanted to buy and that also makes you feel good. Perhaps you’ll take $100 and reinvest it and make $110 by the time you would have gotten $100 in two weeks. That’s $10 extra bucks and a 10% return on your investment of $100. And that’s exactly the point of Time Value of Money. You can “do things” with your money today and you can’t do anything today with money that you don’t have. So, money today will always be greater than the same money in the future. Therefore, in order for Person A to lend money to Person B, Person B must compensate Person A. It’s compensation for the lost ability to do something with their money. And that’s why interest exists. It’s the cost of borrowing money TODAY.
Furthermore, according to the Business Insider, there is about $1.5 Trillion of physical currency in circulation in the U.S. In contrast, the U.S. economy as measured by nominal GDP (Gross Domestic Product) was $21.43 Trillion in 2019, according to the U.S. Bureau of Economic Analysis. That’s right, the actual physical cash and the amount on money out there represented by the goods and services sold/exchanged in the economy are no match for each other (14X difference, multiplier effect). Remember the “FIAT MONEY” concept explained in my last article when in 1971 President Nixon decoupled the U.S. dollar from gold reserves? … And that’s part of the reason why buying everything for cash is not a feasible option for all of us. Even if we all had that much money, there is simply not enough cash to cover all of our needs at the same time. That’s why banks let us borrow money. That’s why a Federal Reserve Note exists (aka “the Dollar”). That’s why credit exists. That’s why interest exists. It’s the cost of borrowing money TODAY.
Hope you find this knowledge useful. I will be talking more about practical ways to use this knowledge in my future articles and podcasts. Let me know if there is a particular topic you’d like for me to cover next.
With much gratitude,
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