Credit cards can be your greatest ally or worst enemy.
Some use credit card rewards to travel for free.
Others use credit irresponsibly–digging themselves into an insurmountable financial hole.
As we move towards a more cashless society, it’s important to understand how credit cards work.
The fact is more people use credit cards irresponsibly, then do so responsibly.
And this is often the difference between living in a constant state of financial stress vs. financial abundance.
So, I wanted to put together a post that will have you looking at credit cards in a different way. A way that can benefit you financially for the rest of your life.
Because when you understand how credit cards really work–you’ll never look at them the same.
Let’s dive in…
How Credit Cards Work
How Do Payments Work On A Credit Card?
You walk into a store, see that new grill you’ve been eyeing, make your purchase using your credit card, and go home to toss some steaks on your new purchase. But what happens then?
From there, one of two things can happen when your next credit card statement arrives and it’s time to pay the piper.
- You can pay the minimum payment or just some of the amount your credit card charges you: If you do this, you’re going to owe on that grill for months. And your purchase will end up costing you more than the sticker price at the store because of the interest you’ll pay.
- You can pay the whole amount: This is the best choice because you won’t have to pay back any interest. The amount you were charged at the store is exactly how much this grill will cost you. In fact, you could even defray the cost a bit if you use a cash back credit card to make the purchase.
Let’s look at how much of a difference paying the full amount of a credit card purchase can make to your bottom line.
Pretend you buy a $500 television at 18 percent interest. And say you’re making minimum payments of $30 each month.
That might sound pretty good on the surface – getting a nice television for only having to fork over a small amount every month. But let’s shine a bright light on that purchase if you’re only making the minimum payment.
At that rate, it’s going to take you two years to pay off that $500. And by the time you’re done, you’ll have paid $80 in interest. That means that $500 purchase will end up costing you $580. You’ve managed to turn your purchase into a much costlier one.
How Credit Card Companies Make Money
Credit card companies don’t put their eggs all in one basket. They make money in a variety of ways.
They earn a portion of the purchase price, which is usually a 1 to 4 percent fee from merchants.
They also make money off of you. That’s their real treasure trove. They can get you to part with your hard-earned money in the form of interest payments, late fees, balance transfer fees, and cash-advance fees. There are a ton of fees, even ones you don’t realize are there.
Now, if you’re the type who pays their bill in full every month, these fees and interest aren’t going to affect you. But they can be a debt trap for those who make late payments or only make the minimum payment.
Credit Cards vs. Debit Cards
Debit cards come with less risk, but they also don’t carry the rewards that some responsibly used credit cards do.
Debit cards might be a good choice if you feel you’ll be out of control with your spending if you have a credit card.
With debit cards, the money is taken directly out of your bank account. You’ll be paying it instantly instead of later like you would with credit cards.
One word of caution about using debit cards though – it can be harder to recover your money if you’re a victim of fraud.
Instead of merely fighting the charges as you would with a credit card, you also have to wait for that money to be reimbursed if it has already been taken out of your account through your debit card. That can be a scary proposition if you’re on a tight budget.
Credit Card Pros
- Build good credit. Building credit can save you thousands throughout your lifetime. If you have a high credit score, you can get lower interest rates on big-ticket items like your mortgage and car loans.
- Rewards. If you get a cash back credit card, you can watch the rewards grow. You can get a 1 percent cash back card, or even up to a 5 percent cash back card. If you spend $10,000 a year on your credit card charging your gas and groceries just with the 1 percent cash back card, you’ll get back $100.
- Convenience. Credit cards are one of the easiest ways to pay for things, whether you’re home or traveling. They are widely accepted, and you don’t risk losing a wad of cash.
- Get to pay later. You can delay payment by weeks simply by paying with a credit card. If you have the money in the bank for a big-ticket item and you charge it, you can let your money continue to earn interest for you until your credit card statement arrives.
- Get perks like warranties and purchase protection. Here’s a story to illustrate this point. I got married in 2009 right after the Great Recession. After paying the photographer in full upfront, he showed up on our wedding day, but a couple of weeks later, we got a notice saying he was going out of business and wouldn’t fulfill his obligations. I contacted the credit card company and they refunded us the full cost. So there is a lot of purchase protection there with a credit card.
- Can carry lower emergency fund. It’s nice to have access to credit for this reason. If there’s a zero percent interest card you can carry, you don’t need to have as much of an emergency fund because you can use that and pay it off in a pinch. That frees up more money for you to invest.
Credit Card Cons
- Interest payments. If you don’t pay off your bill in full each month, your purchase can come back to haunt you. You might be paying that purchase amount twice in some cases.
- Fees. If you make a late payment or you choose a card with an annual fee, this can be a definite con. The only time an annual fee on a credit card may be worth it is if it has great rewards you’ll use fully.
- Studies show people spend more. It can be easy to overspend when using a credit card. If you spend from a debit card linked to a checking account, you’ll pay attention to how much you’re spending because you’ll be subtracting it from your account as you make your purchases. But with a credit card, you can be stunned at the total when you get your monthly bill.
- It can just as well hurt your credit. If you carry too high of a revolving credit card balance, your credit score will take a hit. You can also damage your credit by missing payments if you fall upon hard times and can’t meet those minimum payments.
Is Dave Ramsey Right About Credit Cards?
Dave Ramsey is one of the most popular financial gurus in the world right now. He says to close your credit card accounts and live off debit cards and cash.
But should you?
It’s not a bad option when you consider how much of a burden credit card debt can be. Of those who carry credit card balances, the average household carries $15,482 just in credit card debt. That’s a huge weight to be saddled with.
So, yes. In a way, Dave Ramsey is right. You’ll be far ahead of others sticking to debit cards and cash. You will be forced to live within your means, which is what your grandparents and other older relatives used to do.
But there is a role for credit cards for people who understand how to work the system. Credit cards can be used to your advantage, but only if they are handled strategically.
The question is whether you can control your spending. You know yourself better than anyone else does.
If you are the type with great self-control, there’s no reason not to take advantage of credit cards. They can offer great rewards and perks you won’t get with a debit card.
But if you’re not capable of handling them responsibly, Dave’s advice is good. And there’s no shame in admitting you have issues with your spending. At least you’re smart enough not to put yourself in that position.
So what do you do if you’re not sure if you can handle the responsibility? This would apply to younger people who are just starting out or those who have never had a credit card before.
If that sounds like you, go conservative and get a card with a low minimum credit limit or secured card.
You can see how you respond and adjust your strategy accordingly.
How Do Secured Credit Cards Work?
Secured credit cards are different than a regular credit card. With these, you have to pay a deposit upfront before you can use the card. That cash is then your card limit. This is done to lessen the risk to the credit card company.
You can use a secured card just as you would a normal credit card – it will be accepted wherever other credit cards are.
If you don’t pay your bill when it arrives, they can use the money from the deposit you’ve made.
These types of cards can make sense for beginners wanting to build their credit or for those who have bad credit and want to repair it enough to eventually take out a regular credit card.
How To Use Credit Cards To Your Advantage
- Don’t use them if you can’t pay. There’s no way to win in this situation. If you can’t pay the full balance, it’s best to simply avoid using them at all.
- Fees and interest rates add up. Know these fees and make sure you’re not hit with any. Pay off your full balance each month.
- Have a low (but not zero) credit utilization ratio. One of the things that helps build your credit score is having credit available to you – but the key is to not use too much of this available credit. You want to keep it fairly low, like under 25 percent.
- Understand what goes into your credit score. Payment history is important, such as timely payments. Automating your payments also factors in. But you have to fully understand how your credit score is calculated so you can do everything to nudge your score as high as possible.
- Use balance transfers responsibly. Balance transfers can be a godsend when you have a troubling amount of credit card debt. It can give you a leg up you’ll need to knock that balance out. But it only works if you avoid racking up more debt on the card you just freed up.
- Understand that there’s no best card for everyone. You need to tailor your card choice to how you spend your money. Where do you spend more – traveling or groceries? Look for a traveling rewards card or a cash back card that will maximize your points total.
- Get a minimum of 1.5 percent on every purchase. There’s no reason you can’t get at least this much cash back on your credit card. Some even carry 5 percent cash back in certain categories, such as one of my favorite cards the Chase Freedom Card. Shoot for as high of a percentage as possible.
- Have a way to track your credit card spending. You can do this easily with software, such as Personal Capital or Mint, or even a plain old notepad where you write down every charge you make.
- Immediately shred cash advance offers. Your credit card company will be handing out these cash advance offers like candy is handed out in a parade. You’re going to get them frequently because they are a huge money maker for the credit card companies. Never use them because they’re a big money drain for you. If you ever find yourself in an emergency situation, try one of these cash advance apps instead (they’re either free or close to free).
- Have a minimum sign-up bonus in mind, to avoid signing up for store cards. Before signing up for a card, look at the sign-up bonus – it should be worth hundreds of dollars. Store cards are a poor choice because they don’t offer that wow factor when it comes to a sign-up bonus. They also carry some of the highest interest rates out there.
With these tips in mind, you’ll be one of the few who understand how credit cards work and use them responsibility.