I’ve heard it said there are two types of people who use credit cards, those who benefit from the service without paying for it and those who carry high interest balances and foolishly provide all the corporate profits. Regular use of credit cards could be compared to swimming in shark infested water. If you know what you’re doing and understand the situation around you, you’ll likely come out with all your limbs intact. However, if you don’t understand the risks of your surroundings, things might not end on a high note. Whether swimming with sharks or using credit cards, it’s crucial that we all know when to get out of the water.
At their core, credit cards share a similar history to cash. Long ago, people would barter with each other by exchanging the goods they owned for the ones they wanted. That wasn’t always an easy process, so money was created to give us a common unit of value. Since money was accepted by everyone, it simplified business.
Retail credit started with merchants allowing some of their preferred customers to build a tab and then settle their accounts at the end of the month. As time went on, banks capitalized on the opportunity to provide a service so individuals could consolidate their store credit accounts into one single account that was widely accepted. Just like cash, credit cards simplified and facilitated business.
Here is a brief video from Visual Capitalist providing a visual history of credit cards:
It’s important to remember that credit cards, like money, are simply tools that we can use wisely to serve us or that we can use foolishly to our own detriment. Before using any tool, we need to understand the benefits and the risks associated with it.
Benefits of Credit Cards
Despite all the negative aspects of credit cards, there are some benefits they offer.
1. Convenience – We enjoy freedom and flexibility and it’s not always easy to have enough cash in our wallet or be up to date on our checking account balance. So, it’s nice to know that if you find yourself in an unexpected situation, you have almost universally accepted funds at your disposal.
2. Protection – Credit cards offer some protections that debit cards don’t. For example, if you discover an unauthorized charge, credit cards allow you to dispute the charge before paying it. Debit cards will deduct the amount from your account first, which could wreak havoc and potentially cause you to be overdrawn while you work to get your money back. You also have a longer period of time to contest credit card charges and potentially less personal liability.
3. Rewards – Some cards offer cash back for purchases, while others offer points or miles that can be exchanged for cash, airline tickets, etc. While it may seem like these benefits are free, I have to mention that merchants are paying a fee every time you swipe your card and then adding that anticipated cost into their prices. However, with credit card usage being so prevalent, short of a cash revival, retailers are going to charge those higher prices anyway, so you could argue your decision doesn’t really affect prices.
Risks of Credit Cards
If not handled with extreme caution, credit cards can have a devastating effect on the financial life of the user. Here are a couple of risks to keep in mind as you navigate these potentially dangerous waters.
1. Increased Spending – Research has shown that when we swipe a piece of plastic (debit or credit), we don’t mentally process our spending the same way we do when we pay cash. We lose the connection to what we’re giving up that was originally very real in a barter economy. Due to cash’s universal value, it still registers in our minds as giving up something of value.
Our mind doesn’t equate swiping a card (debit or credit) to giving something up, so now we only get the emotion of gaining what we want when we go shopping. This disconnect causes the average person to spend more money when they use a card. Statistics can vary, but one report calculated the average credit card user will spend 26% more than the person using cash. So beware, even if you never carry a balance, you are potentially still hurting your budget by spending money you wouldn’t have spent otherwise.
2. High Interest Rates – Interest is a huge profit center for credit card companies and an enormous burden to the individual carrying a balance. According to Bankrate.com, variable rate credit cards are currently charging around 16% interest on outstanding balances with that rate being much higher if it goes into default. Credit cards are not a good source of borrowed money.
Steps to Wisely Manage Credit Cards
Some people shouldn’t even consider using credit cards. Please know your weaknesses and your spending patterns and only use cash or debit cards if credit cards are a stumbling block for you. If you still decide to swim with the credit card sharks, here are some fundamentals I would highly recommend:
1. Keep your credit limit reasonable – Credit card companies like to raise credit limits. When they do, give them a call and request a lower limit. You should have a good idea of how much you need available at any point in time and there’s no reason to have a $40,000 limit if you only need $5,000. Some will argue that it’s good for your credit score to have large amounts of available credit, but I would argue that if you’re doing everything else right, that benefit isn’t worth the danger.
2. Beware of fees – If all things are equal, pick a credit card with no annual fees. There can be exceptions, so evaluate whether the benefit is worth the cost and close any account that is no longer worth the fee.
3. Never buy things not in your budget – Since we spend more money when we use plastic, commit to only buying what’s in your budget and avoid justifying purchases because it’s on sale. I commonly see people carrying balances on store cards because they offered discounts if you used it. The stores want you to spend beyond your budget and then you’re at risk of not paying off the balance at the end of the month. By the time you pay the interest, that sale price wasn’t such a great deal.
4. Pay off your balance every month – If you’re going to use credit cards, this is a non-negotiable rule. You absolutely must pay off your entire balance at the end of every month. If you ever can’t pay it off in full, you need to instantly chop up the card and stop using it. Following this single rule will prevent you from ever having a problem with credit card debt.
Credit cards have gotten a bad reputation and they probably deserve it. The odds are stacked against us when we play with credit cards and the consequences of being on the losing side can be severe. As we read in 1 Corinthians 10:23, “All things are lawful, but not all things are helpful”. However, for the informed and disciplined few, they can be a tool with benefits that outweigh the costs.
Brad Graber, CFP® has been working with clients on personal financial planning and investment issues since 1996. He invests his time mentoring and educating individuals on ways to be better stewards of the resources God has entrusted to them.