As taxpayers, we seem exceptionally interested in what our marginal and effective tax rates are. We take pride in our ability to reduce effective tax rate (how much we ultimately pay in taxes) and will even spend money to do so. In some ways, we could say that we are obsessive about reducing tax rates!
The reason we care about reducing tax rates so much is that we see the amount that we are left with as ""our"" money. If we earn $25.00 per hour and have $20.00 left over after we pay our taxes, we believe that this $20.00 is ours to spend how ever we would like.
This is not the case. While reducing tax rates is a taxation strategy, reducing our cash dilution rate is a money strategy.
<b>What is a Cash Dilution Rate?</b>
to put it concisely, in the example above, our cash dilution rate tells us how much money we have left after paying interest on our credit debt. In the case above, by reducing tax rates (legally of course) on the $25.00 we have $20.00 left over ""after-tax.""
With this after-tax $20.00 we must pay for our living expenses and other necessities. These are tangible items from which we really like the full benefit.
But also, from this $20.00, we've got to pay interest on credit products. This interest is not a benefit to us, no matter how you cut it. By taking a cut of our after-tax dollars, these interest costs dilute our cash value. If we pay $2.00 to interest from the $20.00 we earn, then our cash dilution rate is 10%. In other words, there's only $18.00 available to us to love the tangible benefits of life.
<b>Calculating The Cash Dilution Rate</b>
to be sure to calculate our cash dilution rate, we need to understand how much we pay in interest charges. This will involve a couple of complicated calculations if we are aiming for one hundred% accuracy (including compounding periods and multiple time-value of money calculations). But if we want a more generic value, we simply need to know what our debt balance is and how much we pay in interest every year.
So, to get started we will take our most typical credit statement and highlight the balance owing along with the rate charged. If our statement shows $10,000 and we carry this same amount from month to month, then we will use that. However, if we are steadily repaying this amount, we should use the ""average"" balance.
Next, we multiply the annual interest rate by the balance. If we pay 19.9% interest, then our total annual interest cost is $1,990.
Lastly, we divide this $1,990 into our total annual after-tax income. Assuming we earn $20.00 after-tax for forty hours of work each every week, our cash dilution rate is 4.6%.
This may not seem like a very significant amount, but bear in mind two things -- we are assuming a 20% effectual tax rate, an annual pre-tax earnings of $52,000 with debt of just $10,000 (the average North American owes quite a bit more).
<b>Importance of money Dilution Rate</b>
Just as taxpayers believe that reducing tax rates are an important included in getting ahead, we need to know our cash dilution rate before we can start boosting our finances.
Even a 4.6% for example will result in substantial income loss over the course of, say, five years may be only $1,990 per year, but compounded for identical period, for the credit provider at a rate of 19.9% works out to $14,779.69. This clearly explains why the credit card industry is so lucrative for the credit enteprise outfits.
Understanding our cash dilution rate allows us to turn a 4.6% dilution rate into a surplus by first repaying all debt and investing the same amount we pay to our creditors in interest. In the example above, the $1,990 in interest (this is not identical as the minimum payment) could result in savings of $10,996 if compounded at a rate of 5%. In that sixth year, those savings could return almost $550 in additional income (if not compounded) meaning that the $20.00 in after-tax dollars could increase by a small more than 1%.
Not much, right? Of course not, and that is the point. While we are so busy reducing tax rates, we sometimes forget the true inequality we suffer when repaying credit debt. If the credit card company gets 4.6% of our after-tax dollars and we would only see 1% after being debt-free for five years, who is really losing?
We are, by a large factor, too!
For this reason, understanding our cash dilution rate is clearly a little more important from a personal finance vantage point than reducing tax rates.
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