Personal finance writers love to preach fire and brimstone about using credit cards. But credit cards are a powerful tool that can make managing your money easier…if you use them wisely.
This blog was born of stupidity. Between the ages of 18 and 25 I racked up nearly $80,000 of debt — much of it on credit cards.
I wrote this article in 2007 when I was still digging out of debt and struggling with how to quit my bad money habits, and I’ve since updated to include some things I’ve learned in six plus years of blogging about money.
Using a credit card responsibly isn’t a difficult concept. What’s important to remember, however, is that how you use credit cards is a habit. During your first few years of using credit cards, you will either develop good habits or bad ones. And you can take it from me, being reckless with credit cards is not only a hard habit to break — it can cost you thousands and thousands of dollars.
How credit cards work
Understanding a bit more about how credit cards work can help you use them responsibly.
When you swipe your credit card, your bank loans you the money to make that purchase. The credit card then gives you a grace period — typically between 20 and 30 days — during which you can pay off that purchase before interest begins to accrue.
Grace periods are powerful because they give you the opportunity to use your credit card as a short but interest-free loan.
As long as you pay every penny you charged last month before the due date, you won’t pay interest.
Sooner or later, however, many people do not pay their credit card balance in full each month, turning their credit card into a revolving credit line. Finance charges (interest) then accumulate on the unpaid credit card balance each month.
Now the credit card companies make a little bit of money every time you use your card because they charge stores 1 or 2 percent of your purchase (called an interchange fee) to accept the card.
But the real money comes in charge you interest when you carry a balance — in other words, you don’t pay off your purchases in full at the end of the month. Credit cards typically charge interest rates between 10 and 20 percent. So, with interest at a 15 percent annual percentage rate (APR), if you charge $500 to your card that you don’t pay off for a year, you’ll end up paying the bank $75 in interest. If you owe $5,000 that’s $750 a year in interest, $50,000 is $7,500 a year!
The worst part is that credit card companies make it easy to get into this situation by only requiring you pay a small minimum payment each month, usually between 2 and 5 percent of your balance. So until you hit your card’s credit limit — the most the bank will let you borrow — it’s very easy to charge a large balance that’s difficult or impossible for you to pay off. And, once you have it, the interest meter keeps running.
If you’re in this situation, you may be able to do a balance transfer in which you transfer your balances to new credit card that has a 0 percent APR for the first few months. This is a tool credit card companies use to get you to switch from one card to another — of course they hope that you will continue to pay them interest after the promotional 0 percent aPR expires.
Whatever you do, if you get stuck with a credit card balance you can’t immediately pay off, you need to make and follow a plan for getting out of debt like I did.
Developing the habit of paying in full
To use your credit card responsibly, you must develop the habit of paying your balance in full each month. That means keeping track of how much you’re spending on your credit card each month and ensuring you will have enough cash the following month to cover your purchases.
I find that using one credit card for nearly all of my monthly purchases not only makes this fairly easy, but has made it easier to manage my money, keep my checking account balanced, and track my spending.
With a very simple spending plan in place, you should know how much discretionary income you have left after required monthly expenses.
Let’s say your monthly spending allocation is $1,000. Now assume you’ll need $100 in cash for various transactions where using a credit card isn’t feasible. You know that you have $900 to spend for the month and can easily track how much you left to spend by checking your credit card balance, which most cards allow you to do easily and for free online.
At the end of your credit card billing cycle, simply pay the balance and start again.
Why use credit cards at all?
With the ease of using debit cards these days, why add a credit card to the mix if you’re not planning on paying over time? There are several reasons:
Most credit cards offer some kind of rewards program, giving you back about one percent of every dollar spend in the form of cash, gift certificates, or travel. Although I don’t recommend using credit cards just to earn rewards, they are a feature you don’t get with cash or debit cards.
With growing concern over the ease of credit and debt card theft and fraudulent charges, having your credit card lost or stolen is a simpler fix than if the same happens to your debit card. In both cases you won’t have to pay for fraudulent charges, the difference is if a thief snags your credit card no money actually leaves your bank account.
Every month you pay your credit card bill on time, you’re building your credit history and improving your credit score, which will save you money in interest rates on every big purchase you make down the road, from your next ride to your first house. If you never use a credit card you could find yourself in your thirties and unable to buy a home!
Using a credit card for your monthly purchases eliminates the need to balance your checkbook more than once a month. As long as you track your credit card spending (and don’t touch your checking account), your checking balance will always be where it should be.