Credit Cards 101
Let’s talk about credit cards. Seemingly essential in the wallet of the American consumer, credit cards can be used to get ahead financially by earning points on purchases you make and providing certain purchase protections that would not be available if you used cash, as well as helping to build your credit score. However, the flip side of these nifty plastic rectangles is that Americans carry approximately $986 billion in credit card debt, according to Federal Reserve data from the 4th quarter of 2022. This debt often comes with extremely high interest rates and can potentially hurt your long term financial goals. Therefore, if you choose to use credit cards after doing your research, I encourage you to do so responsibly.
What is a credit card?
Most people know credit cards are plastic (or metal) rectangles that you can use to pay for things. But how does the system actually work, and what distinguishes a credit card from a debit card? When you swipe your debit card, the money is immediately deducted from your bank account to pay the merchant. A credit card is essentially a form of short-term loan from the credit card issuer (Visa, Mastercard, American Express, etc.) to the cardholder (John Smith). When John swipes his credit card, no money comes out of his bank account at that moment. Visa puts up the money for the purchase and in return, John agrees to repay Visa the money he has spent on his credit card during the billing period (usually a month). If John does not repay the issuer the money that he owes, Visa will begin to charge interest (usually at very high rates) and other fees, which can add up very quickly to take a lot of money out of John’s pocket. Additionally, not paying each month or running up an excessively high balance can quickly start to hurt John’s credit score, which will affect his ability to buy a house, car, etc. Therefore, if you choose to use a credit card, it is essential that you pay the entire balance each month if at all possible, to avoid paying additional interest, fees, and hurting your credit and financial future. If it’s not possible for you to pay the whole balance, you should seriously consider getting rid of your credit card or rethink your spending habits.
Credit Card Pros
Credit cards can bring open a number of benefits to the cardholder. The most obvious benefit is the convenience of being able to carry a single piece of plastic, instead of lots of cash, in order to pay for daily transactions. Additionally, credit cards are an easy way to start to build or rebuild your credit score. They help with a number of credit score factors, including credit limit, utilization, and average credit age. Many credit cards give you a certain percentage of your transaction costs back as points or other rewards. These rewards can also be given in the form of a sign-up bonus, usually after you sign up for the card and spend at least a specified amount. They want to incentivize cardholders to spend on their cards instead of other cards, because they take a percentage of every transaction that goes on a credit card. These points can be used as cash back, or for travel, dining, gift cards, etc., depending on the card. Some credit card users are able to optimize their spending on certain cards to get free or almost free vacations, a practice known as travel hacking. I’ll talk more about travel hacking in another post dedicated to that topic.
Credit Card Cons
Psychologically, it is easier for most people to spend money from a credit card than by counting out cash for a purchase. This means that some people may accidentally spend more than they intended to or budgeted for, especially since your bank account balance does not immediately reflect the purchase. Spending more than you planned for can lead to carrying a balance, otherwise known as credit card debt, if you are unable to pay off your credit card bill at the end of your billing period.
As I stated before, Americans carry an incredible amount of credit card debt. This debt can hurt consumers in a number of ways. It normally carries high interest rates, meaning cardholders will end up paying much more for their purchases than the sticker price, as they could be paying interest for months or years after if they choose to carry a balance. Additionally, carrying this balance can hurt your credit score by driving up your credit utilization, and potentially hurting your payment history as well, should you choose to not even make the minimum payment. Additionally, many credit cards come with fees, either for late payments or simply for the privilege of having the card. This means it costs consumers money to use their own money. For military members, this impact may be lessened as many issuers waive their fees for those on active duty and their spouses.
Are Credit Cards Right for You?
Some people are good at using cards for their benefit. They always pay off their balance and never pay any interest to card issuers. They spend in the right categories on the right cards, so they can build up lots of points, miles, or cash back. They are able to take advantage of many of the benefits their cards offer, ensuring that the benefits they get out of their cards outweigh any fees or other costs of having the card. We’ll call these people “credit card people” a term used by Caleb Hammer, a great personal finance YouTuber.
There are also people who are NOT credit card people. If you spend on your credit card without knowing you have the ability to pay for every purchase you make, or if you allow a balance to accrue because you forget to pay your bill, you’re probably not a credit card person. If you are constantly doing balance transfers to new credit cards to stay ahead of rising interest, you’re probably not a credit card person. If having credit card bills constantly hanging over your head stresses you out, you’re probably not a credit card person.
It’s okay to not be a credit card person! There is nothing wrong with it, but it is good to recognize financial practices that aren’t good for you in your current life situation. Also, just because you may not be a credit card person now doesn’t mean you never will be. If you are able to heal your relationship with spending and recognize the harm that credit card debt can cause to your financial future, you may be able to become a credit card person and use credit cards in a healthy way in the future.
Wrapping things up
Credit cards can be an amazing tool for building credit and getting great perks for travel and other rewards in the right circumstances. However, they can also present a great deal of risk for people who are unable to use them properly. Before you decide to get a credit card, or even if you already have one, consider the following questions:
Are you able and motivated to pay off the whole balance every month?
Are you able to feel a psychological impact from spending on a credit card as you are with cash, instead of just swiping away?
Are you able to justify any fees charged by your credit card issuer with benefits offered by the card?
Are you getting a card that is appropriate for your financial situation, and that will not cause you to get into financial trouble down the road (reasonable limit, etc.)?
If you can confidently answer yes to these questions, getting a credit card may be the right decision. If not, don’t panic! As I mentioned before, credit cards are not for everyone. If you are not a credit card person, either allow yourself to be okay with that, or ask yourself what steps you need to take to get to where you can confidently answer yes to the questions listed above and become a credit card person.
Read More:
https://www.nerdwallet.com/article/credit-cards/credit-cards-101
https://www.youtube.com/@CalebHammer
