Still reading? Good.
Here's the idea: Pay down your credit cards instead of putting money into savings or keeping it in your checking account, then use those cards for your purchases instead of debit/checks/cash.
This seems to go against most advice to only use credit when you have to. It can work to reduce your debt, or at least lower the interest you pay each month. Since credit card debt is likely your highest interest debt the more you can pay towards it the better. If you budget your expenditures, especially basics like food, and pay that money to your credit card as soon as you get your paycheck then you will lower your average daily balance, and possibly your period ending balance as well.
This uses the Average Daily Balance in your favor. To understand this let's look at an example. Say that I have $1000 in credit card debt at 10% yearly interest. My monthly interest rate will be 0.83%, and that will likely be calculated against the average daily balance on my card. If I pay nothing that month (let's not count any late fees) I would be charged $8.30 in interest. If I do pay something, but I wait until the last day of the billing cycle, my interest will barely change. For instance, if I pay $100 on the last day then my average balance is still $996.67 and my interest will be $8.27. Not much savings this month, it would help the next, though.
To calculate your average daily balance you need need to multiply what your balance was by how many days it was at that balance, then add it to every other balance over the period, and divide the final number by the days in the period. If I bought nothing on that $1000 balance card during a 30 day period, but I paid that same $100 on the 15th day of the period then my avg. daily balance would be calculated as such:
((1000 * 15) + (900 * 15)) / 30 = $950
With the earlier payment I would save almost 50 cents. Now that you see how it works, perhaps you can imagine what it would look like with bigger numbers. Unfortunately, that is about as easy as it gets to conceptualize because normal use will cause fluctuations in the balance that make calculating your average a chore. The important thing to walk away with is that the earlier you pay a credit card the less interest you will pay at the end of the period.
Now we need to apply this to budgeting and savings. The idea here is that if you have money budgeted then you should immediately pay that money to your credit card, lowering your balance immediately, then use that card to buy the things you've budgeted for. During the time between the payment and the purchase your balance will be lower, positively affecting your average.
This works great for groceries. We can continue to use our $1000 debt card to show this. Assume that you budget $50 for groceries each week and you're paid every other week. You use $100 of every paycheck on groceries, but you pay with debit each time. Your money isn't working for you. Instead, pay the $100 immediately to your card (above any normal payment you would make) and use the card for those purchases. Here's how it would look if you were paid on the 1st and 14th day of the period and you bought groceries on the 7th, 14th, 21st, and 28th days:
Now we need to apply this to budgeting and savings. The idea here is that if you have money budgeted then you should immediately pay that money to your credit card, lowering your balance immediately, then use that card to buy the things you've budgeted for. During the time between the payment and the purchase your balance will be lower, positively affecting your average.
This works great for groceries. We can continue to use our $1000 debt card to show this. Assume that you budget $50 for groceries each week and you're paid every other week. You use $100 of every paycheck on groceries, but you pay with debit each time. Your money isn't working for you. Instead, pay the $100 immediately to your card (above any normal payment you would make) and use the card for those purchases. Here's how it would look if you were paid on the 1st and 14th day of the period and you bought groceries on the 7th, 14th, 21st, and 28th days:
((900 * 6) + (950 * 7) + (900 * 7) + (950 * 7) + (1000 * 3) ) / 30 = 933.33
Notice how even though our ending balance is the same as it was at the beginning of the month our average daily balance is far lower. In fact, it's actually lower than if we paid $100 on the 15th and never used the card. The interest for that period would be slightly less than if we made a substantial payment in the middle of the month. What happens if we combine the two and make a $200 payment on the 15th ($100 for each, the groceries and to pay down the debt)?
((900 * 6) + (950 * 7) + (800 * 7) + (850 * 7) + (900 * 3) ) / 30 = 876.67
Notice how even though our ending balance is the same as it was at the beginning of the month our average daily balance is far lower. In fact, it's actually lower than if we paid $100 on the 15th and never used the card. The interest for that period would be slightly less than if we made a substantial payment in the middle of the month. What happens if we combine the two and make a $200 payment on the 15th ($100 for each, the groceries and to pay down the debt)?
((900 * 6) + (950 * 7) + (800 * 7) + (850 * 7) + (900 * 3) ) / 30 = 876.67
By rolling your budget for monthly expenses into the money you pay upfront to credit cards you dramatically lower your average balance. Think about how much of a difference that could make if you applied it to your food budget (which is likely more than $50 per week, especially if you have a family), your gas budget, and anything else you can pay using your card. If your interest rate is higher then you get more benefit as well, and 10% is a fairly low rate. The other aspect that is hard to quantify is just how much you will save over future periods, because the interest charged this period will accumulate more interest every period until you pay it off.
It works for savings, too. Actually, it works better for savings. If what you are saving to buy can be purchased via credit then you should consider this method. Think about the difference in interest rates between your savings account and your credit cards. I can imagine that the difference is stark. I should note that the better savings accounts compound interest on a daily basis, which will generate more interest than the same rate compounded once a month. That isn't enough to overcome the difference between most savings and credit rates. So, financially you may be better served by paying off your debt instead of saving for purchases.
Even if your savings interest rate is fairly high and compounds daily you should save more money by paying off higher interest debt. In our previous examples we used a 10% interest credit card, which is on the low end, so let's go to the high end of savings and compare a 5% savings account (you can't get these right now, but it will prove the point). Using those accounts if you saved $50 per month, at the beginning of the period, towards a $300 TV you would double your return by paying off the credit card. I'm going to spare you the math, but my calculations showed a credit interest savings (money you don't owe in interest) of $8.84 and a savings interest return (money you earn in interest) of $4.32.
Obligatory warnings and clarifications: If you do this you must be careful about it. Monitor your spending carefully to be sure that you stay within, or at least reasonably close to, your budget. That may limit the usefulness of this plan, because if you are deep in credit card debt you may have issues with monitoring.
This should not replace your emergency fund. The last thing you want in case of an emergency is to run up tons of debt. You may run into problems with that debt down the road. If nothing else, cash is infinitely more useful in emergency situations.
The idea should be that you use this in place of saving to spend or use already budgeted money that you will spend during the course of the month. Don't use this to replace other savings such as retirement, emergency funds, or college funds. Obviously, if you're in debt you should think about discretionary spending carefully. I like to think that this makes such thought easy, because you don't have money burning a hole in your pocket, it's working for you to dwindle your debt.
Lastly, I'd like to apologize for the ugly equations. I tried to keep the math simple and clear. I realize that there are better ways to express the equations I included, but they would be less clear and probably more confusing.
That's it. I'd like to know what you think or if you've done something like this before. Let me know in the comments.
It works for savings, too. Actually, it works better for savings. If what you are saving to buy can be purchased via credit then you should consider this method. Think about the difference in interest rates between your savings account and your credit cards. I can imagine that the difference is stark. I should note that the better savings accounts compound interest on a daily basis, which will generate more interest than the same rate compounded once a month. That isn't enough to overcome the difference between most savings and credit rates. So, financially you may be better served by paying off your debt instead of saving for purchases.
Even if your savings interest rate is fairly high and compounds daily you should save more money by paying off higher interest debt. In our previous examples we used a 10% interest credit card, which is on the low end, so let's go to the high end of savings and compare a 5% savings account (you can't get these right now, but it will prove the point). Using those accounts if you saved $50 per month, at the beginning of the period, towards a $300 TV you would double your return by paying off the credit card. I'm going to spare you the math, but my calculations showed a credit interest savings (money you don't owe in interest) of $8.84 and a savings interest return (money you earn in interest) of $4.32.
Obligatory warnings and clarifications: If you do this you must be careful about it. Monitor your spending carefully to be sure that you stay within, or at least reasonably close to, your budget. That may limit the usefulness of this plan, because if you are deep in credit card debt you may have issues with monitoring.
This should not replace your emergency fund. The last thing you want in case of an emergency is to run up tons of debt. You may run into problems with that debt down the road. If nothing else, cash is infinitely more useful in emergency situations.
The idea should be that you use this in place of saving to spend or use already budgeted money that you will spend during the course of the month. Don't use this to replace other savings such as retirement, emergency funds, or college funds. Obviously, if you're in debt you should think about discretionary spending carefully. I like to think that this makes such thought easy, because you don't have money burning a hole in your pocket, it's working for you to dwindle your debt.
Lastly, I'd like to apologize for the ugly equations. I tried to keep the math simple and clear. I realize that there are better ways to express the equations I included, but they would be less clear and probably more confusing.
That's it. I'd like to know what you think or if you've done something like this before. Let me know in the comments.
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