Thursday, February 26, 2009

Credit Card Payments: Expensive, but NOT an Expense.

When I first started using MS Money to track my finances, I was single and my accounting needs were very basic; I wanted to pay down my credit card debt and make sure my bills were paid on time.  Despite the simplicity of my needs, I had never taken accounting and there were some things I didn't understand.

For instance, I faithfully setup my checking account and credit card account in MS Money and proceeded to enter every transaction as an expense until, finally, I got my first statement from the bank.  Everything looked great - all my expenses were there.  But when I went to make my first credit card payment, I didn't understand how to properly enter the transaction.

From my naive perspective, paying money to the credit card company was just like any other expense -- an expense I was NOT happy to incur.  So I went looking through the built-in list of expense categories looking for something appropriately named; there wasn't anything called "Credit Card Payment," so I did what seemed natural to me -- I created a new expense category. I'm betting you can guess what it was called!

With my paper-check in hand, I navigated to my electronic register and updated the electronic register utilizing my newly created expense category "Credit Card Payment."  Then I navigated to the credit card account and waved my magic wand to make everything come out right.
My numbers seemed right, but months later I realized that my approach was based on a flawed understanding of what I was actually doing. My mistake was thinking that my credit card payment was an expense.  The reality is that, whenever you pay down debt, it's like paying yourself -- like moving $10 from one hand to the other.  It's a transfer from one account to another, and consequently, there was no detectable change in my net wealth as an immediate result of the transfer. In other words, I shouldn't have registered an expense!
My incorrect utilization of the "Credit Card Payment" expense resulted in double-counting expenses; I can't remember exactly how I was "fixing" everything with my magic wand, but whatever I was doing, it was wrong. To the best of my recollection, I was doing something along the lines of:
As a result of my discovery, I built the new model of my financial workings as seen below.  It was still simple, but it met my needs. Paychecks were recorded as net income; everything I spent money on was recorded as an expense; and most importantly, every credit card payment was recorded as a transfer (I had to go back and correct several months worth of transactions). I don't know why, but once I started thinking about my credit card payments as the rough equivalent of saving money in my account, it wasn't nearly so painful to write out that check every two weeks. In fact, the realization motivated me to the point where I was "saving" $1000 a month.  It took me 12 months to pay off my credit card debt, but it felt great to see my net worth going up every two weeks.
If you are just beginning a personal accounting process, here's the most basic model that you should consider using.  The boundary line represents your accounting system.  Any transaction that crosses the boundary should be recorded as an income or an expense.  If you decide to allocate some portion of your income to debt reduction or savings, record it as a transfer.