Should I use a credit card?
Credit cards have become a universal commodity in many parts of the world. In fact, there are a growing number of purchases that cannot be made without a credit card, like some cash-less restaurants. But with the proliferation of so many different types of cards and points and rewards, is it actually good to have a credit card?
In short, my argument is yes, it is helpful to have and to use a credit card, but on the condition that the credit balance does not exceed your cash balance.
How do credit cards work?
Credit cards give individuals a line of credit. For example, Average Joe decides to apply for a credit card. Company XYZ approves his application, and issues him a credit card with an $8,000 limit. This is his line of credit, and it means that he can spend up to $8,000 using Company XYZ's money for "free", provided that he pays back the balance within ~one month. The credit limits depend on the individual's credit history, income, and other factors, so it will vary from person to person. Poor college student Johnny will probably have a limit of $2,000, whereas Jeff Bezos would have a "black card" with no limit.
What are the advantages?
There are two primary advantages that I think every person should utilize through their credit card:
1) Building credit history
2) Earning rewards points
After opening my credit cards, I've consistently paid back these small "debts", and thereby solidified a great credit score. If you're looking to get a mortgage or other loan (or even rent an apartment), you'll probably need to provide your credit report. If you have no credit history (ie no proof that you've taken on debt and paid it off consistently), then it can be difficult to have confidence in loaning you money. A better credit score will also land you better terms (lower interest rates) on these loans.
As for points, I personally own a Chase Sapphire Reserve account (disclaimer: I'm not getting endorsed for this, lol), and to-date I am confident I've benefited financially more from the service than what I've paid for it. However, this is only possible because I am very intentional and careful about my spending. Which leads me to...
What are the disadvantages?
Simply put - a credit card balance that doesn't get fully paid each month will compound each month - what starts as a small pile quickly becomes a mountain of debt.
Credit card companies earn money in a few ways:
1) Annual fees / initiation fees
2) Transaction fees
3) Late payment fees
4) Interest on unpaid balances
The first two are simply a part of owning a credit card. They are usually not that expensive, and the transaction fees are typically paid by the merchant, not the customer. For example, if Sally decides to pay for her Starbucks coffee with her credit card, the transaction fees will be paid by Starbucks. However, if Sally is buying dinner at a small mom & pop restaurant, the owners may have a notice that reads, "Extra $0.50 charge for credit card unless order > $15".
However, the second two can really snowball into unmanageable fees. Different credit cards have different language surrounding the fees they charge on unpaid balances, but it's almost always difficult to parse through what you'll actually be paying. Don't let it get to this point to begin with. With APR of 20% or higher, a compounding credit card balance can absolutely demolish your ability to save. Often times, the enticing sign-up bonus is really to get that small pile of debt started. Some cards require upwards of $4000 to be spent in the first three months in order to receive the sign-up bonus. After that, if you're unable to pay it back in time, the credit card company will quickly recoup their losses from your ever-growing and compounding credit card balance. I personally had a net benefit of ~$1,500 from reaching my sign-up bonus conditions, but I did not intentionally push up my credit card spend to reach it. At the time, I also had all of the cash on-hand needed to fully pay down the credit card balance immediately.
Follow these rules to take advantage of the benefits of credits cards and avoid all of the associated pitfalls:
Pre-condition: Are you a compulsive shopper? Are you prone to making unwise purchases in the spur of the moment? Do you already have significant credit card debt?
- If yes, do not sign up for a credit card. If you already have a credit card, pay off all of your balance, hide your card somewhere safe (and inconvenient to get to), unlink your card from all of your online accounts (Amazon especially), and pay for everything by debit card or cash. Keep your credit card 'active' if there are necessary monthly expenses, like phone bill, utilities, etc. Keep those on the credit card and automate your payments.
1) Cash balance must always be greater than credit card balance
I usually pay off my credit card balance every two weeks so that the balance always remains low. Never put yourself in a position where you cannot pay off the balance, even for a few days.
2) Never increase your credit card spend just to get points or bonuses
This is a particularly dangerous trap to fall into, especially in the beginning. I paid off the $4,000 I needed to earn the sign-up bonus because I already had some major upcoming expenses (travel, hotels). I would have had to pay those expenses in cash anyway, so I charged everything onto the new card and paid it off immediately.
3) Make credit card usage inconvenient for yourself
I am much less likely to make an online purchase if I have to fill in all of my credit card information manually. Simply disconnecting our information from Google, Amazon, etc. is not only beneficial from a security standpoint, but also makes it harder to make purchases. The harder it is to make the purchase, the more likely it is that we won't follow through with the purchase to the finish. If you're going to the mall, put the credit card in a place that's inconvenient to reach in your purse or bag, or maybe don't carry it at all. Simply bring the cash needed to make the purchase that was intended.
4) Remain vigilant
There will always come a time when it becomes tempting to spend on a large-ticket item because it's within your credit limit. Or perhaps there are a bunch of smaller items that you'd like, but do not need. All of these things can start adding up. Remain vigilant, or else the credit card may end up owning you.