Understanding how credit cards work and some of the most common debt traps will help you get the most of your plastic
I’m usually a debt agnostic on the blog. Far from preaching the debt-free lifestyle, I believe debt is a tool and can be used to build something if used responsibly.
But there is a lot not to like about credit cards and how they work. While other types of debt can be managed and paid off more easily, credit cards are more difficult and have all kinds of ways to make you overspend.
Understanding how credit cards work will help you understand some of the money traps they create. You’ll be able to spot the ways credit card companies get you to overspend and pull thousands in interest from your pocket to theirs.
How Credit Card Companies Get Rich and Make You Poor
A credit card is a revolving loan approved by a financial company. The credit companies use sophisticated computer programs to analyze your credit history, the record of your payment on other loans.
From this analysis, the company approves a limit to how much you can borrow and an interest rate on the loan. You are allowed to borrow up to that limit anywhere the card is accepted.
The credit card company will add up the balance of your loan every month on a specific day and send you a statement. You’ll be required to make a minimum payment on the loan each month, usually $15 to $35, but you can always repay more than the minimum.
You will generally have a grace period of three or four weeks during which you can repay your balance every month with no interest charge. If you only make the minimum payment on your credit card or if you do not pay the statement balance in full, you will have to pay interest on any of the unpaid balance.
Your credit card statement will show an annual percentage rate but this can be misleading. The interest you pay is calculated on your average daily balance of the amount you still owe at the end of the month. Even if you pay off much of the amount you owe, you’ll still pay interest on what you borrowed throughout the month.
- Always pay off the statement balance in full rather than making a minimum payment.
- Just because you have a credit limit of several thousand doesn’t mean you should spend that month each month. Spend only what you are able to repay.
- The statement balance is what you need to repay immediately to avoid interest while the current balance includes charges made since the statement closed.
Use this credit card interest calculator to see exactly how much you're paying on your cards and how to pay off your cards faster.
Credit Cards vs Debit Cards
A lot of people confuse debit cards with credit cards but the truth will save you a lot of headache and even more in lost money.
It’s true that you use a debit card just as you would a credit card but they work very differently.
Debit cards are like a plastic check book.
Debit cards are linked to your checking or savings account. When you use a debit card to buy something, the money comes out of your account immediately. You can only use a credit card for as long as you have money in your bank account to cover purchases.
That means you’re not actually borrowing money when you use a debit card and won’t owe any interest compared to using a credit card.
Credit Card Traps to Avoid
Credit cards are a multi-billion dollar business and the companies know exactly how to get as much as possible from you. They pay millions a year in research, marketing and rewards to do exactly that, get as much money from you as possible.
Credit card companies know that once they’ve got a card with your name on it, it’s only a matter of time before you owe them interest.
They start with low introductory rates, even as low as 0% on purchases for up to a year. This will make even people that wouldn’t think about borrowing money on a card fill out that application in a heartbeat. Why not? Borrowing at 0% is free money.
Of course, that introductory rate will eventually increase and even the most disciplined saver will have trouble paying off the entire balance before owing interest.
Credit card companies make it easy to get approved. One company will have several different types of cards, some for borrowers with high credit scores and others with scores that don’t qualify. If you’ve got a credit score, you can get a card.
Credit cards will even benefit from the psychology of money. Studies have shown that people are willing to spend more when they pay with a credit card rather than with cash. That means, not only might you owe interest on that new handbag but you might also be willing to pay more on the price without even realizing it.
How to Use Credit Cards, the right Way
There are a few times when you’ll need a credit card. My wife and I keep a few cards for different reasons but you have to be very careful to avoid the debt traps above.
Credit cards can save your financial butt in emergencies. The average car repair costs several hundreds of dollars and can be several thousands easily. Unless you have that kind of money in an emergency fund, you could be forced into cash advances or higher-rate loans to pay for it.
Using a credit card can give you an extra month to come up with the money and still avoid interest. Even if you’re not able to pay off the balance, it can still be cheaper than the alternatives.
Everyone needs credit eventually; whether for a mortgage, student loan or some other type of debt. Credit cards can help you build that credit history that convinces lenders to give you a better rate on your loans. Using a credit card regularly but paying it off before interest is owed will help you improve your credit score.
Credit card rewards programs are a tempting reason to use credit cards but are usually more trouble than they’re worth. I have rewards programs on the two cards I use but only because I am religious about paying off the cards each month.
It’s tempting to use your credit cards when you think you are getting cash back or some other reward. The problem is that if you every owe interest, you’re likely paying more that you get on the rewards.
For example, I get about a $0.02 per point on my American Airlines card when I use the points for air travel. That’s about 2% on the money I spend but the interest rate on the card is 18% so just a month or two of interest can cost a year’s worth of points.
Credit cards aren’t something you have to avoid completely and they’re not the worst type of debt. They are better than payday loans and other short-term loans in an emergency and you’ll need them to build a good credit history. Understanding how credit cards work and the common debt traps to avoid will help you get the most out of these plastic weapons of financial destruction.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.