The credit card is one of the most divisive products among all the financial tools available. Ask around and you’re sure to find people who pay all their expenses using credit cards as well as others who swear the products are the embodiment of pure evil. Opinions among financial experts and thought leaders are just as mixed. Dave Ramsey won’t even let customers pay for his products using credit cards, and his large following is adamant about the destructive powers of credit and the virtues of debt abstinence.
A credit card is nothing but a tool. Whether its effects are helpful or harmful depends on the skills and knowledge of the user, a person with the power to choose how to use the tool. Here is everything you need to know in order to make the most out of this particular financial tool, taking advantage of its benefits without falling into any traps. Here are some of the common traps for dealing with credit card rewards.
Credit cards are not for everyone. Like tools, in the wrong hands, they can be dangerous. If you have personality traits like a tendency to lack self control, if you’re in the process of repairing your finances, or if you’re not ready for personal responsibility, avoid credit cards until you are mentally and emotionally prepared.
What is a credit card?
Physically, a modern credit card is a rectangular piece of plastic, graphite, or a metallic alloy, that identifies a financial account. All contain a magnetic strip on the back, and some contain an RFID chip. An account number and the owner’s name or business name may be imprinted on the front.
Behind the scenes, the credit card represents a type of financial account. By using credit cards, customers can offers a bank’s money instead of their own to pay for a product or service today, and over time, they repay the bank. For the benefit of using someone else’s money, customers will often need to pay interest, as expected with other types of loans. This is where problems can arise. Using other people’s money is often preferable than using your own because it lets you keep your own money available for other purposes, but if you buy something with someone else’s money while not being able to repay that type of loan, the results can destroy your own financial future.
Credit cards are like DVRs for money. Digital video recorders allow users to “time-shift.” Television channels, at least for now, have regular schedules during which they air programs, but if you’re not free at 8:00 PM to watch The Big Bang Theory, your DVR allows you to watch the program from the beginning at your convenience.
When this is the philosophy behind the use of credit cards, users avoid financial problems.
How does a credit card work?
When you choose to pay with a credit card and you hand the card to a cashier or submit your card number over a secure internet connection, the merchant you’re dealing with validates your account and whether the bank will allow the purchase to go through. If everything looks good, your purchase is added to your credit account. Many companies are involved with each swipe of a credit card, and money exchanges hands between all these companies each time a card is used. Merchants pay fees to accept credit cards, and eventually the card-issuing banks receive part of this as revenue.
Once a month, the bank accumulates your credit card purchases and sends you a bill. The best option, and only option I recommend, for dealing with that bill is to pay in full by the due date. If not, you have to pay a minimum amount, determined by the bank, to avoid extra fees.
Even if you avoid extra fees, an interest fee will be added to what you owe the following month. Interest adds up quickly, and could make a $100 purchase cost $200 in total or more rather quickly. When this happens, it’s more than just time-shifting; it’s as if waiting to watch your 30-minute recorded show would require 60 minutes of your life.
When you pay on time and in full, the bank considers you a well-behaved customer, and will report this behavior to other companies that evaluate whether you’re a good borrower. You want these companies to consider you a good borrower, because it could have financial consequences in the future.
Banks, in their roles as credit card issuers, don’t want all users to be well-behaved customers. The companies profit from these customers, but the most profitable customers are those who don’t pay bills in full but are rarely late. Because of all this profit, some taken from merchants, stores often have no choice but to raise prices for everyone as a result of the increased popularity of credit cards.
Why do people hate credit cards?
Using a credit card makes it easier to spend money. Scientific studies have shown that people are more likely to complete a purchase if they intend to pay with a credit card than if they intend to pay with cash. Cash just seems more scarce, so people are more likely to try to conserve it. Credit cards don’t produce the same kind of psychological barrier.
Also, with cash only, you can never spend more money than you have. With credit cards, that’s easy. The bank doesn’t check your savings account before approving your purchase, they just check to make sure you’re under your credit limit — a total amount the bank determines you’ll be allowed to borrow at any one time — and the transaction doesn’t appear to be fraudulent. In fact, even if the transaction would put you above your credit limit, the bank will likely approve the transaction anyway just so they can charge you a fee for being over the limit.
As a result, people spend more money with credit cards than they would otherwise. This just creates more profit for the banks while making it possible for users to destroy their financial future. In practice, many people do let credit cards harm their financial future, and they do so without even realizing the mess they’ve made for themselves until it’s very difficult to clean up.
Credit cards are like hammers. Hammers can be a very useful tool. You can drive in more nails with a hammer than you can without, but you can also hurt yourself if you aren’t paying attention and smash your finger. Other see credit cards more like guns. Guns have only one purpose — to kill or maim — and likewise, the real purpose of credit cards is to create significant profit centers for banks.
What are the benefits of using credit cards?
With the potential for harm, why even use credit cards at all? First, the concept of using other people’s money for a short period of time. Time-shifting your money can come in handy if you need to buy food for your family today, a day before your pay check arrives (though this can create a dangerous precedent). Credit cards can also help you organize your expenses, but that’s only a minor benefit.
There are three major benefits to credit cards, without which, it wouldn’t be worth the hassle to use these products instead of debit cards or cash.
Credit cards create a barrier between merchants and your own money. If nothing else, credit card companies are good at handling fraud, and they create a line of defense between fraudsters and your money. You should always check the rules when you open a credit card, but in almost all cases, you are not liable for any unauthorized use of your credit card account. And unlike a debit card, unauthorized use doesn’t affect your bank account, so you’ll still have your money if you happen to need it for something else on the same day someone uses your credit card account.