Risks and Benefits of Credit Cards

In this topic, we cover:

  • Reasons why some people may have trouble with credit cards.
  • When to use and when not to use a credit card.
  • How to avoid the minimum payment trap.


 

Credit cards can be a major source of financial hardship for many Americans. Whether credit card debt was acquired as the result of unplanned spending or a major financial crisis, high-interest credit card debt can be a long-term financial burden - imagine not being able to afford a car or a home, just because of a credit card payment! It happens to more people than you may expect.

So if credit cards are so bad, why not just use cash for everything? To a certain extent, using cash - especially for everyday expenses - is an option you may want to consider. Studies have shown that people spend less overall when using cash as opposed to credit. But at other times, you may not have the cash you need for an emergency situation or you may need to buy an airline ticket or rent a car - each of which is more convenient with a credit card as opposed to a debit card.

Like anything, credit cards can be used for sound and unsound reasons. Using credit for a financial emergency like a car repair far away from home would be a responsible use of credit. But using credit cards for dinners out, gadgets, and entertainment can be risky. As a general rule, if you can eat, drink or wear an item, it's usually not a good use of credit.

Minimum Payment Trap
One of the most common problems people have with credit cards is that they fall into the minimum payment trap - confusing their ability to make the minimum monthly payment with actually repaying their debt. Believe it or not, making just the minimum payment means you may end up paying 3 times more than the amount you originally charged!

Say you've charged a total of $2,000 and then stop making new charges. If your card has an interest rate of 19% and a typical minimum repayment policy of 2% of your balance per month, it will take you more than 22 years to pay off the card.

How is that possible? Even though you pay off 2% per month, the amount you owe grows each and every day because of interest - your 2% really just pays the interest and a tiny fraction of the principal. And not only does it take a very long time to pay off the debt, but it gets expensive - the interest charged will be nearly $5,000, making the original $2,000 actually cost you $7,000!

Thanks to the Credit Card Act of 2009, credit card companies must now disclose more information on credit card statements, including late payment fees, repayment scenarios, the length of time it would take to repay the debt under each scenario, and how much interest would be charged. Some companies are even modifying their minimum repayment policies to cut the repayment period using minimum payments as short as seven years - still among the most expensive types of debt available.

Coupled with much higher interest rates than education loans and the risk to your credit score from even occasional missed payments, it's easy to see how credit cards could become a serious problem.

The Benefits of Credit Cards
Since abusing credit cards can lead to serious financial trouble, should you cut yours up and avoid them entirely? Not necessarily. There are many benefits associated with credit card use.

  • Emergencies. None of us can predict the future, and unanticipated bills are a part of life.
  • Building a good credit history. While not the only way to build credit, credit cards can help to establish a positive credit record, which you'll need for future loans.
  • Consumer protection. They allow you to order products by phone or on the Internet and offer protections that some debit cards may not.
  • Convenience. Car rentals and hotel stays are more convenient with a credit card since a "hold" is not placed on funds in your bank account. Some banks also have daily spending limits on debit cards that could be a problem, especially if traveling overseas.

We recommend that most people have one card to be used for emergencies and for Internet or mail order purchases in which the consumer protection provided by credit cards would be useful. Daily purchases should be made with cash, a check, or a debit card.

And before getting an additional credit card - ask yourself if it's really necessary. If you're getting a new card because you've maxed out another one, that's a sign of serious trouble. Some people also get a new credit card because they have been offered a lower interest rate. While taking advantage of these teaser interest rates can save money for those with large balances, it's a strategy that does involve risk. For example, getting a new card increases your total available credit, which gives you the potential to increase your total debt more easily.

If you are planning to acquire a new card for a lower interest rate, it is often easiest just to call your current credit card company and tell them you are considering switching to a lower rate card - they may lower your rate on the spot.

Finally, if you do choose to carry a credit card balance, please remember that you are the only one qualified to set your personal credit limit, which may be very different than the credit limit on your card. Even if your card's limit is $2,000 or more, you can set a personal limit of less - once you reach a $500 balance, for example, you simply stop making new charges until the balance is reduced. Remember that your credit score can actually go down if you use a lot of your card’s limit.

Credit card companies will also raise the credit limits of those who pay their bill on time, leading some to feel that they can obviously handle more debt because their credit card company says so. That reasoning is a great way to get in over your head with debt. The educational materials provided by credit card companies often refer to "safe" levels of credit card debt - like 10% of your income. In fact, there is no appropriate or normal level of credit card debt other than zero. As a financially responsible adult, you are the one who must say "no thanks" to excess debt, no matter what anyone else says.