By: Douglas J Utberg

Reading the headline for this article will probably make you think that I am referring to a drink that is served to the ultra wealthy at a luxurious resort.  Most of us think of the cost for an item as the amount that we pay at the time of purchase.  However, if the purchase is made with credit we must also account for the impact of compounded interest over time.

In this case, I am referring to a $3.50 cup of coffee purchased on a credit card at 20% interest, and the balance being kept on the card for 20 years.  (The actual amount comes to $1,341.82)  If this seems far fetched, consider how many people carry a balance on their credit card every month while only paying the minimum amount.  As if this weren’t a bad enough situation, many of these people will add to the balance on their credit cards month after month . . . resulting in continually compounding interest that will need to pay at some point.

The other point to emphasize is that the overwhelming majority of most people’s credit card purchases are very small.  (Coffee, meals out, snacks at the store, etc)  These small transactions can add up very quickly . . . and when they do you may end up with insufficient cash flow to pay your entire balance this month.  And insufficient cash flow to pay your balance next month.  And so on and so on, until the $3.50 cup of coffee you purchased on the way home from work has compounded to $1,300 of interest payments.

In order to avoid exhausting all of our financial resources on interest payments for money that has already been spent, each of us needs to be disciplined in how we budget and spend.  This discipline should compel us to decide which of our expenditures are reasonable (given our income) and which are unnecessary.  By gaining control over our finances, we will only have to pay $3.50 for that cup of coffee and can leverage that discipline to build wealth over time by making smart investments.

Read Once, Think Twice

If you read the prior article entitled “A $1,300 cup of coffee” and thought that something was fishy with my math, you were correct.  When I wrote the article, I intentionally inflated the impact of paying for a cup of coffee on credit by a factor of 10.  (The ‘real’ amount you will pay by holding a $3.50 cup of coffee on a 20% credit card for 20 years is $134 . . . still a ridiculous amount of money for a cup of coffee)  The reason why I did this was not to be deceptive, but to demonstrate how easy it is to believe distorted information once it is in writing.

While we are on the subject, consider how many people have an incentive to communicate distorted information.  People like journalists, research scientists, business executives, and politicians have tremendous incentives to manipulate, distort, and outright ‘create’ information.  When these incentives are compounded with the persuasive power of the printed word, it can be quite possible for highly slanted information to be distributed to the public over a long period of time, without the distortions ever being brought to light.  This can create very large problems when public and private investment decisions are based on distorted information.

Because of this, I strongly urge readers of “The Business of Life” to approach everything that is in print or presented on television with a very critical eye.  (Including these newsletters)  This is especially important in the current era of media bombardment, since news agencies need to try much harder than in previous years to attract viewers and readers.  Unfortunately, the way that most news agencies accomplish this goal is by communicating highly sensational stories that can tend to be . . . ‘misleading.’