Often when the subject of credit is broached, people tend to think of credit cards. Credit cards are simple to understand. When you apply for one, the lending company uses your income, your credit report, and your credit score to evaluate the risk that you won’t pay them back. Depending on how trustworthy they judge you, they will give you a maximum dollar amount that you can borrow from them and will charge you an interest rate they feel is warranted. You can borrow up to the credit limit they set for you.
You can use the credit card to borrow over and over again as long as the balance you carry is less that the limit. This is called, revolving credit. For example, if Capital One gives you a card with a credit limit of $10,000 and you spend $6,000 with the card, then your remaining credit is $4,000. If you spend the remaining $4,000 using the card, then you’ve maxed out your credit card and Capital One will not lend you any additional money. However, if you make a $1,000 payment on the card then your remaining balance gets reduced to $5,000 and you will have $5,000 of additional borrowing capacity on the card. As long as you carry a balance the credit card company will charge you interest. The interest charged can vary significantly based on your credit. The worse your credit, the higher the interest rate and the more costly it is to borrow using the card.
In ShopSquawk’s opinion, credit cards should be treated like weapons; you should be respectful of them and handle them with extreme caution. Beware of the danger, because credit card companies love to market themselves to younger people and they make them so easy to get. It’s not above these companies to exploit those who lack general financial knowledge.
Back in ShopSquawk’s college days, we often had fairs at the school that would attract vendors. The majority of these vendors were credit card representatives. They know college kids are recently independent and most likely, naïve about their personal finances. They came to prey on these young adults. They all would have some sort of method to attract your attention. For example, they would offer a free t-shirt, or a gift card, or let you spin a prize wheel if you would just sign up for their credit card. Often, I would see students collecting all the loot and signing up for all credit cards. I never once say any of the credit card companies explain how credit works, or talk about interest rate, or explain what happens if you go over the credit limit or fail to make timely minimum payments. This is like handing them a gun without talking about safety or how to handle it. Credit cards companies welcome the inexperience and hope to squeeze high debt loads from them. Don’t fall into the trap, it’s not free money.
Part of the reason they are so dangerous is that credit cards are so easy to use. They are accepted at stores everywhere and take less time to use than dealing with cash. Also, there is a psychological element to using a cards instead of cash. Credit card users can become disconnected from reality with how much money they spend. Handing five $20’s to the store clerk feels less painful than swiping a credit card. By the way, have you ever wondered why casinos use chips instead of cash? Yes, it’s for the same reason.
Before signing up for or using a credit card, you should understand the damage that can be done to your credit and your financial situation if you use them irresponsibly. As we’ve discussed, credit card companies charge you a minimum amount each month based on your balance. If you always pay just the minimum, you will never pay off the credit card. As you make purchases, the debt can simply pile up and overwhelm you. Before you know it, you’ve maxed out your credit limit on your card. You’re used to having the credit card as your financial crutch, so you open up new credit cards with new limits. This can become a downward spiral and you can end up on the credit card hamster wheel, where you keep paying for items you’re your credit card, maxing out the limits, and opening new cards. This is a very dangerous situation and you can become trapped. At some point, you may not even be able to afford the minimum payments across all your credit cards.
One of the worse things you can do with credit card debt is not pay the minimum required. If you miss a payment or don’t pay the minimum required, the penalties can be severe. Lenders can charge $25 for first missed payment and $35 for additional missed payments. What’s really crazy is that you can be subject to penalty interest rates, some which go as high as 79.9%. Imagine having to pay $800/year for having borrowed $1000. (The real term for this is called ‘usury’. It’s supposed to be immoral and illegal… but most corporate, political, and religious institutions have a vested interest in it’s continued existence.)
There are 3 good reasons for using credit cards: for emergencies, to establishing credit, and to earn rewards. When you select a credit card, determine its purpose and always try to find the credit card with the lowest interest rate. Also, beware that some credit cards charge annual fees. I have not seen any worthwhile unless you spend a lot of money that earn you rewards. Try your best to avoid carrying a balance, but if you must, having a lower rate will save money.
In the case of emergencies, sometimes you just don’t have the cash available to pay for them. You may have medical issues, which is the #1 reason for bankruptcy by the way, or your car may break down, needing expensive repairs, or you lose your job. Having a credit card with a low interest rate can be very beneficial.
Credit cards can be used to establish credit if you don’t have any. As long as you keep a small balance and make at least the monthly minimum payments, you will be able to build your credit. Be careful, because if you keep a high balance or miss payments, the credit you establish will be bad credit.
Finally, if you’re very responsible, credit cards can be used to earn rewards. For example, some credit cards give you points when you use their cards. For each dollar spent, you earn a certain number of points, which can be exchanged for airfare or other rewards, such as gift cards or cash back. This is a good idea if you pay off the entire credit card balance each month.
Remember, when you use credit cards, it’s imperative that you understand how much debt you have outstanding, the interest you must pay on that debt, and the minimum payments due. Do not open new lines of credit if you’re having trouble making the minimum payments. Finally, be sure to incorporate your credit card debt and payments into your personal budget.
The take aways on credit cards are as follows:
Credit cards are like weapons – to be used with the utmost caution.
Understand the terms of the credit card and always pay at least the minimum balance, if not the full balance each month
Credit cards can be used for good, if you’re careful