Credit Cards 101
Credit cards are a source of great debate among financial experts.
While they have numerous benefits, the question is if the potential risks outweigh them and if the average consumer can avoid falling into the inevitable traps.
For the uninitiated, here's a quick rundown on how credit cards work.
HOW IT WORKS:
When you swipe your card, the credit card company pays the bill for you. Then, at the end of each month, you get a bill from the credit card company detailing what you spent that month. Each month, you have the option to pay off the minimum balance (usually about $40) or the statement balance (everything you spent the previous month). You can also pay your total balance, which includes your total expenditures until that day even though some of it is not yet due.
The Dangers:
Two things happen if you choose to pay less than your statement balance.
First, you'll need to pay interest on the amount you owe-and the interest rate is quite high, usually between 17 and 23 percent. Even if you only owe $100, you'll owe the bank $117 the next month. To illustrate how high this is, mortgage rates are considered really high right now, and they're hovering at around 7 percent. The average credit card charges 17% APR! Plus, the next month, if the $117 isn't paid, you'll have to pay interest on the full amount, including the interest. It becomes easy to rack up enormous debt.
Many credit card companies offer 0% APR for the first year, but this is done to trap customers. Customers fall into the habit of failing to pay their full balance, and as soon as the year is over, they're slammed with a huge bill.
The second problem is that you lose your grace period. The bank doesn't start charging interest on each purchase until between 21 and 51 days have passed, depending on the billing cycle-unless you haven't paid your full balance the previous month. Then, the bank can start charging interest on each purchase immediately. Although they aren't as common as people might think, there are plenty of horror stories of people who end up in terrible debt due to the enormous interest on their credit cards.
But what if someone is meticulous about paying off their balance each month? Is it worth it?
Paying the Costco Membership:
Credit cards have a catch. How do we know?
Imagine that instead of paying for a membership to Costco, Costco would pay you to come shop. You would obviously get suspicious- what's wrong with this store? Paying you to borrow money is a direct contradiction of the laws of economics, which dictate that one has to pay to borrow money, not the other way around.
Credit cards pay you (with points) to use their product and borrow money from them. They're not doing it out of the goodness of their hearts. It must be worth it for them. But how?
Studies show that people spend 12-18 percent more when using a credit card, partly because of the subtle incentive of cash back and partly because they're less aware of their purchases. That's a lot more money going to the credit card company. Even spending just $2 more on a $100 purchase with a credit card when your cash back is 1.5 percent cancels out the benefit. Also, since you aren't using cash, the money only comes out of your account a few weeks later, so it's hard to keep track of a budget.
Many people say, Okay, I'll view credit cards like cash. I'll imagine that I'm using the money right then, and that way, I won't spend more. If that works for you, then credit cards can be a way for you to get some free benefits. However, don't assume that this is the case. Try it out first. Personally, when I started using only debit or cash, it hurt to spend money, so I spent less.
When you use cash, you need to be much more cognizant of how much money you have available, and since you can't spend what you don't have, you end up really keeping track of your purchases. With a credit card, you receive a bill at the end of the month, but you don't get as clear an idea. It's also hard to budget how much you're spending month by month.
The Disclaimer:
Credit card offers often have a disclaimer in the fine print at the bottom: "If you have a history with credit card debt, then you should not buy a card." In my opinion, we all fall into this category. We often look at credit cards and points as a game, but credit card offers are designed by behavioral scientists to get you to spend more. You can't beat the system.
Why Have One?
After hearing all the dangers, it's easy to decide against using credit cards altogether. But that's a mistake. You need a credit card.
Why? To build up credit.
How does this mysterious "credit" work? Every credit card starts with a certain credit limit-the amount of money you can borrow or spend on the card. Over time, if you're consistent about making your payments and don't spend more than the amount you're allowed to spend, your credit limit will go up, allowing you to spend more on your card. Why is this important? Because if you have a good credit score-the amount you're allowed to borrow is high and you have a record of always paying on time-you'll have an easier time getting approved for a better mortgage.
As a rule, it's best for a person not to spend more than one third of their credit limit.
The Perks of the Card:
Some perks of having a credit card are:
You don't need to have the cash on hand or even in the bank. If you need to make a large purchase the day before your paycheck comes in, you can do it even without having the money.
You earn points with each purchase. While each credit card is different, most cards offer some sort of cash-back system, giving you rewards for every dollar you spend. If you have a 1 percent cash-back offer on your card, you'll receive $10 in points after spending $1,000. You can use these points for travel or simply to pay the credit card bill. Many credit cards also offer sign-up bonus offers, and a savvy credit card player can make a nice amount of money.
Credit cards are more secure than debit cards. If someone uses your credit card in a suspicious transaction, the credit card company is more likely to stop it than the bank would with a debit card, since it's their money.
When to Use It:
So your credit card is necessary but not for every purchase. Using credit cards for fixed expenses, like car insurance, is worth it because you're spending the money anyway, and that way you get the points. When you're worried about fraud or you're buying many items to try on for size and plan on returning most of them, that's also a good place to use a credit card. Rental cars require you to put down an enormous deposit, so that's another place to use it. But for everything else, stick with debit cards. Try going a month without using a credit card for groceries or other expenses. You may be surprised to see that your expenses go down. When you use cash and you see the money physically leaving your account, you become more cognizant of each purchase.
Credit cards are a tool-a useful and necessary one - but they can also be dangerous. Use them carefully.
