Americans tend to have mixed feelings about credit cards. They appreciate having easy access to funds, but largely resent the tendency created by credit cards to overspend. Credit Card issuers pollute the problem by pushing the use of credit on consumers and tangling a web of fees and interest charges along the way. However, having access to credit is an extremely important part of today’s financial world and helps to validate the consumer. It allows one to conveniently buy things located anywhere, and creates the ability to make reservations for services such as car rentals, hotels and restaurants. I would say that credit cards are already an item of necessity rather than luxury. It’s difficult to make it through a year as an active person without having some sort of access to credit. The convenient record-keeping and surveillance aspects of using credit over cash have made it an appealing choice for consumers and vendors alike. As this dependence on credit cards continues to spread, it’s important that one understand the benefits and drawbacks to credit cards, why they cost consumers so much money, and how one can avoid falling into credit card traps.
Before I embark on a rant about why credit cards are dangerous, I’d like to emphasize that responsible usage can provide you will all types of rewards- and I don’t just mean free flights and gift cards. One of the most important benefits is purchase protection. When you buy something for cash and it gets damaged, it’s very unlikely it can be returned, even if you believe it wasn’t your fault. When you pay with a credit card, you can challenge a transaction if a legitimate problem exists. Let’s say a vendor sells you a damaged product and you can prove it. You very well may be able to challenge that purchase because you paid for it with a credit card. Purchase protection is a huge advantage provided by credit cards. Establishing credit history is also an important benefit. By acting responsibly with your access to credit, you help shape the way future lenders will view your eligibility for loans. Credit analysis is tricky in that you must exhibit good financial habits when you don’t need a loan to establish good credit for when you do need one. If a bank is considering giving you a loan and they see you rarely make late payment or go over your spending limit, they’ll be more likely to extend credit to you. Finally, as we mentioned above, credit cards are great for organized record-keeping. Since all the activity can be viewed electronically, one can track what they buy, when it was purchased, how often payments are made, etc. from the convenience of any computer.
So let’s talk about why I refer to credit cards as dangerous. For me, and I’m sure for many others, spending a hundred dollars on the credit card is a very easy thing to do. I also find that it takes on a different meaning than pulling a crisp hundred out of my wallet. The simplicity of spending on cards, whether $50 or $500, encourages increased frequency, and larger amounts of spending. A good analogy is playing casino games with chips rather than cash. The reason casinos require the use of chips is to induce a game-like atmosphere where players focus on building up chips rather than thinking about the potential saving or spending opportunities for the money on the table. Perhaps we should put a disclaimer on credit card receipts which is similar to a pack of cigarettes: “Please be aware that you are about to spent $260. Please take out thirteen $20 bills, look at them, and think this through. Are you positive you can afford to do this?” Maybe that would curb some spending?
Most of the other drawbacks related to credit card spending involve the potential interest charges and fees. When we leave unpaid balances on credit cards, finance charges build up. The longer we wait to pay down those balances, the more we’ll pay in interest. For many consumers, the balance builds up quicker than anticipated and can take months or even years to be paid down. At points like this, when you stare at your dining room table and just wish it could be returned for something less expensive, you start to understand why that credit card is so evil. The table which cost you $1,000 quickly becomes $1,200 as your interest charges accrue and you get hit with a fee for paying the minimum amount due three days late. Situations like this either need to be avoided altogether, or carefully managed.
The Truth in Lending Act is a federal law created to promote the responsible use of consumer credit by requiring disclosures about its terms and costs. While I’d speculate that credit providers didn’t love this piece of legislation, I don’t think it has made a shred of difference in the care taken by consumers prior to obtaining and using credit. These companies don’t need to hide information about their terms and costs. They can spell out how they get paid in plain English and remain confident that the use of credit cards will either remain steady or increase.
At this point I’d like to break down the financial jargon often attached to credit cards so that it makes better sense. Interest charges are often quoted as APR (annual percentage rate) on statements and other mail you receive from credit card companies. When you first apply for a card, many promotions offer an introductory rate APR. This percentage is generally good for only the promotional period, typically six months or a year, and then defers back to your standard APR tables for purchases, balance transfers, and cash advances. You might not notice when and if rate changes occur if you don’t view your statement in detail. Many consumers look only at their total balance due each month and then figure out how much they feel like paying. The better thing to do is go over your statement for a few minutes each month, make sure the purchases look familiar, and the interest charges (if any) make sense based on stated APRs. Other terms besides APRs can change at the end of promotional periods. One should really try to take note of when those changes may happen. Also, an advertised APR for a credit card may appear to be low- say 12%. However, that percentage can often vary depending on a number of factors. First, if you transfer over a balance from a different credit card, the APR is usually higher. If you take out a cash advance, this often triggers the highest APR. And while you may not track the different interest rates you pay on purchases, balance transfers, and cash advances, the credit card company does. Ask them for a breakdown of your interest rate charges if you get confused.
Finance charges will also vary based on the calculation methods used to determine how much you owe. One part of that equation will be the APR discussed above. A lower rate will be better in almost all circumstances. Another big factor is whether or not new purchases are being included in your outstanding balance. If you carry a balance sometimes, you should look for a card which does not include new purchases. This will allow you a period of time, usually until the end of your billing cycle, in which you can pay off new purchases without them incurring any finance charges. Also, the computation of your balance, from which interest charges are based, can be calculated in different ways. The two most common methods are “average daily balance” and “adjusted balance.” The adjusted balance method is simply calculated by adding up your purchases and other charges each billing cycle and subtracting out payments and other credits. The average daily balance method differs in that your average balance is recalculated daily based on new purchases, payments, and other activity. When using this method, one needs to take note of the time between when charges are made and when they are paid down. While I tend to prefer the adjusted balance method, this should really not be the determining factor when evaluating credit cards. I would encourage you to focus more on making large, on-time payments and maintaining a reasonable APR.
Another important aspect of using credit cards is the fee schedule. For starters, I’m not a big fan of the annual fee. If you are paying it, there should be a good reason to do so. This could be a low APR, a card with special privileges, or a card issued to someone with less than perfect credit. In the latter example, the issuing organization is taking on more risk and the annual fee serves to compensate them for that additional risk. If your card doesn’t fall into any of those categories, ask your provider to remove the annual fee. In the world of credit, if you don’t ask questions, you probably won’t get answers. The two most common penalty fees on credit cards are for paying late and going over your spending limit. When dealing with responsible consumers, the credit card company will often waive a first late fee or over-the-limit fee. Don’t be shy, just call up and ask nicely for them to remove it. If they really appreciate your business, they’ll work with you.
Your credit limits are based on how responsible you are with your cards. If a consumer regularly charges up their credit card near the spending limits, it will more than likely to get any credit line increases. This is because credit card companies want the reassurance that you’re able to make large payments when and if necessary. Keeping a balance which is 20% or less of your available credit is generally considered within the responsible range of most lenders. Now, I’d like to share an interesting story regarding spending limits which illustrates how credit card companies look to make money. My original impression was that paying my balance in full each month would demonstrate good habits and lead to the most rapid increases in my credit lines. I learned this isn’t always the case because not as much money is generated off consumers who never carry balances. I spent a period of my life carrying balances from month to month, amounting to about 10% of my available credit. I noticed that my credit line increased faster when I left a small balance than when I paid the balance in full. My guess is that by demonstrating responsibility with payments, while, at the same time, allowing credit card companies to make some money off me, I became the ideal consumer.
A great way to start making changes in your financial life is evaluating the cards you currently use and getting new ones if your current ones aren’t fitting your needs. Before you apply for a new card or take advantage of a balance transfer offer, consider which credit card features appeal the most to you. For instance, if you are like the many other Americans who don’t pay their balance in full each month, try to get a credit card with low interest rates. However, if you charge everything to your card but always pay the balance in full, you might care less about interest rates but want a good rewards program. I have a friend who buys everything on his credit card, pays his balance in full, and at the end of each year cashes in his points for a plane ticket to Hawaii. Each person has a different style when it comes to how they spend on credit cards. Try to evaluate your spending so you can find benefits which truly coincide with your card usage. Card Web (www.cardweb.com) is a great site for locating the credit card which is right for you. They break down credit card offers into categories which help you better understand their benefits. They also have helpful payment calculators you can use to estimate how long it will take to pay down your balance, a question and answer section, and access to free newsletters.
If you don’t feel like applying for a new card, you can try negotiating the APR on your current cards. Because credit is a competitive industry, and issuing companies understand that you have the choice of either canceling your account or transferring it to a different credit provider, you constantly maintain some degree of bargaining power. If you call up and demand a lower interest rate, they are put to a decision of either granting your wish, or rejecting your request. Many consumers actually do not follow through with threats of closing their cards because they have anxiety about making changes. If this sounds familiar, try to overcome fears of financial change and make decisions which increase your bottom line. If you are having financial problems, credit providers actually will listen to you as well. If they reasonably believe that someone might not be capable of making payments, they might lower your interest rates and impart some undesired financial planning advice. I find it highly unlikely that they actually want you to be debt-free, but they’ll be mildly accommodating if a reasonable possibility exists that you will stop making payments.
So, from now on, don’t immediately throw away those credit card offers. Some of them may actually offer great terms, including a zero percent interest rate for the first year, if you stay within your spending limits and never pay late. You could even jump from card to card each year taking advantage of deals like this. I know people who do it. Be careful if you become too obsessed with capitalizing on credit card deals as this may impact your credit score or become an organizational issue. The best thing to do is find a card or two which work for your individual situation and make you happy. As a general piece of advice, try not to carry more cards than you can handle. I find that two or three is often plenty and usually recommend against taking on retail cards. These are the kind that gives you 10% off when you apply for them at the cash register. They tend to have very high interest rates so only apply for one if you pay your balances in full each month and spend often with that particular retailer.
If you want to surf the web for more education on credit cards, I can recommend a few more useful websites. Bankrate is a personal favorite of mine, for both credit cards and other personal finance advice. They have a very broad base of information including material which is appealing for beginners looking to improve their understanding of credit cards and experienced users who want specific offers or articles. In the blogosphere, check out Five Cent Nickel and AllThingsFinancial. Both of these bloggers post great financial planning articles including a bunch that talk about credit card issues. Keep that plastic under control!
Russell Bailyn
Premier Financial Advisors
(212)752-4343 *31