If you are interested in learning about the pros and cons of using a credit card, you have come to the right place. Knowing how to use a credit card is an important step towards financial literacy.
What are credit cards?
Credit cards are ubiquitous nowadays. What are credit cards?
Simply put, credit cards are cards that allow you to borrow money to buy things. This is in contrary to debit cards, which you can only use if your bank account actually has money. Well, technically speaking, nowadays, you can still use your debit card even if your balance dips below zero, but your bank will charge you a hefty overdraft fee for it every time you use your debit card on a below-zero balance.
Of course, there is no free lunch in this world. An average credit card has a fairly high interest rate of at least 20%, which is the price you pay to spend the money you don’t have. They typically give you a grace period within which you get charged no interest if you pay your balance in full before the due date, but all the remaining balance is subject to the interest, compounded usually on a daily basis.
My journey with credit cards
Credit cards are the way of living nowadays. I remember when I first got my own credit card when I was in high school, I was very confused. Borrowing money to spend was a very foreign concept to me, and I didn’t understand why my dad insisted that I have to spend a little bit on my credit card to build credit, when I was fortunate enough to have a small sum of pocket money in the form of cash to spend on things I liked. I remember asking myself, what is credit and why is it important? The credit you get when you pass your course, or the acknowledgement you get when people say that your work belongs to you?
Of course, nowadays, after years of routine uses of credit cards and a deeper understanding of how they work, I have integrated credit card usage into my life as well. I use credit cards for everything – grocery shopping, restaurants, flights, you name it.
Credit card pros and cons
Why is this particular piece of financial instrument so well-loved? What are the pros and cons associated with this financial instrument? Below is a list that I believe can shed some light on this topic.
Credit card pros and cons: pros
Let’s admit it. Credit cards are so convenient! They are these light little plastic rectangles that barely take up any space in your wallet. Using credit cards means that you don’t have to carry heavy cash anymore, and you don’t have to stand in front of a cashier counting bills and coins and feeling embarrassed for the long line of people waiting behind you. All you need to do is swipe swipe, and that’s it!
In addition to the above, credit cards are accepted in many countries around the world. That means that by having just one Visa card or MasterCard, you can travel from US to Canada to England without worrying too much about not having enough local currency on hand to pay for things. Although it is true that most credit cards charge foreign exchange fees on top of currency conversion, the fees are quite often worth it compared to the hassle of exchanging a large sum of foreign cash, carrying it around and worrying about losing it.
The growth of e-commerce has also propelled the expansion of credit card use. With a click of a button, you can purchase items from around the globe, with just the strings of numbers on your credit card. Your credit card allows for so much convenience that you simply cannot get with cash.
Having the credit card statement at the end of the month can also make budgeting easier, because the company helps you keep track of all your expenses.
2. Credit cards allow you to build good credit. A good credit score is crucial if you are ever interested in any level of borrowing (including mortgages)
First of all, let’s define credit score. A credit score is a numerical expression based on the analysis of a person’s credit files. It helps lenders understand how creditworthy you are and evaluate the potential risk they may have to bear if they have to lend money to you. Ultimately, they are letting you borrow money from them, so if by any chance you cannot afford to pay them back, then they will have to suffer a loss (bad debt). This is much the same reason why you may have heard the philosophy that if you ever decide to lend people money, you should treat it as charity and don’t expect them to return it back to you.
Credit scores are very important if you are ever interested in borrowing money, which many of us do since we typically at least need mortgages to help purchase our homes. Business owners may also want to borrow small business loans from the banks to help with start-up costs and ongoing development. Therefore, it is critical that we have good credit scores, and the most important way to have that is by using you credit cards and paying your credit card balance on time in full every month. All of your credit card payment history is stored in credit bureaus, which are used to calculate your credit score. Typically, you should aim for a credit report showing a score of at least 690.
For Canadian residents, Young & Thrifty has an excellent post on credit score and how it is calculated in Canada. You can find it here.
US residents may find this post by Dollar Roller helpful. The concept is similar as the above, but there are some small technical differences between US and Canada.
3. A rewards credit card can help you make everything a slightly better deal
Credit card rewards are key advantages that they offer. Nowadays, many credit cards offer incentives to attract consumers. Typically you can see two types of credit cards on the market, the ones that offer cash rebates, and the ones that offer points (e.g., travel points, points to specific stores, etc). By using your credit cards regularly for everyday purchase, you can get rebates on purchases you need to buy anyway, which will reduce your credit card bill. You can also even funnel as many recurring bills as you can through credit cards, and pay them off with one payment from your regular checking account when the monthly payment is due.
Some credit cards charge an annual fee in exchange for better rate of return for the rebates. I have created a spreadsheet that helps you calculate whether the annual fees are worth it. You can find it in the link here.
4. Credit cards’ sign up bonuses can be super lucrative
In addition to the regular rebates, credit cards often offer sign-up bonuses that are extra juicy. The sign-up bonuses could be in the form of cash, a fixed amount of reward points that can be redeemed for items ranging from grocery to flights, and/or a much bigger cash rebate (e.g., 5-6%) for the first few thousand dollars you spend, or for the first few months that you use the credit card. This means that if you are smart about it and time your big purchases (e.g., your tuition or furniture) around it, you can save a lot more than you typically do.
5. Cash advances
Cash advances can be a handy feature if you need cash in a pinch. However, please keep in mind that the interest rate can be even higher than that on normal credit card use.
Credit card pros and cons: cons
1. High interest charges
Your credit card issuer is counting on garnering a significant amount of interest from people who do not pay their monthly credit card bills on time. You do not want to take on more credit card debt that what you can afford.
Take a simple example of a credit card that charges interest of 20% annually.
If you use the card for a sofa that cost $1,000 but carry a balance for a year, then by the time you pay it off, you will have spent an additional $200 on the purchase ($1000 x 20% = $200).
Additionally, note that the interest is typically compounded, which means that you will have to pay interest on top of the interest. For example, if you can’t pay the $1,000 bill off till two years later, you will have to spend $1000 x 20% x 2 = $400 on the interest of the principal, plus $200 x 20% = $40 for the interest of the interest accumulated in the first year, for a total of $440.
That is a lot of extra money you have to spend for the sofa that originally cost $1,000! Let’s say a fancy latte costs $5. You can buy almost 90 cups of fancy latte during the two-year period.
Of course, you can find 0% APR credit cards on the market, especially during the introductory period. Make sure you don’t overspend though, because eventually, you will still have to return the money.
2. Identity theft and unauthorized use of credit cards
Unfortunately, with the advance of credit cards, there comes the dark side of the industry – fraud. Fraud happens when someone uses your credit card number or credit amounts to make a purchase that you do not authorize. The most dangerous thing is that the fraudsters can sometimes steal your credit card account information and use it without ever touching your physical credit cards.
The bright side is that if you are proactive about contacting your credit card company once you notice that something fishy is going on, they can help you freeze your credit card so no more charges can go on it, and they typically won’t require you to pay back the purchases you didn’t authorize. However, because the companies most likely will have to bear the cost themselves, they can be very strict about the timeline. For example, you may need to report back the purchases within 30 days, so please make sure that you check your credit card statements diligently, and report any unusual charges right away. I’d also recommend that you pause your credit card if you are going to be away for a long period of time.
3. They will entice you to spend more, even beyond your means
There seems to be a general belief that people are less sensitive to purchases if they are using plastic cards instead of cash, because you lose that physical sensation of parting with your money, and don’t have to worry about payments until at least 21 days in the future.
I personally have never felt that way because I only make purchases when I have enough money in the bank to cover them (I know that it may not be the smartest when it comes to cash flow optimization, but I think it’s worth it for my peace of mind).
However, I do know some of my friends who easily fall into this trap even if they vow to never do it again.
I notice that this happens most often around Christmas time, when it is holiday season and people expect a big bonus coming, and therefore they spend according to their expected earnings, instead of their actual earnings. Well, they have just created a big trouble for themselves when the bonus they receive the following year isn’t as generous as what they thought it would be.
I should make a note that the various incentives, such as cash back and reward points mentioned in the “pros” section above, can actually be a double-edged sword, because some people, in the pursuit of that 2% cash rebate, or other extra incentives that companies create “for a limited time”, could end up losing sight of the 20% interest that they would have to pay on purchases they cannot afford. Do not fall into the traps set up by the credit card companies. Know what you can afford, and spend within your means.
Credit card pros and cons: alternatives
If you don’t trust yourself with a credit card, here are some alternatives:
Use debit card
Credit cards provide convenience. A debit card is also pretty convenient. It also forces you to only spend the money you have.
Apply for a secured credit card
If you don’t have a great credit score or only have limited credit history, chances are you may not be eligible for a credit card. A secured card is a great alternative. It does have a higher interest rate because the risk is higher, and you have to put down a cash deposit, but it is a great way to build up your credit.
Things to check before signing up for a credit card
Here are the things you need to check when you are looking for a credit card
- Interest rate
- Grace period (usually 21 days)
- Interest charges on cash advances and balance transfers
- Your credit limit
- What rewards are offered, and how you can earn rewards
- If the credit card offers fraud protection
Last but not least, always remember to read the fine print!
Above are some of the most prominent pros and cons of credit cards in my opinion. Although the cons could be pretty scary sometimes, I personally believe that if you are careful with them, credit cards can be a very important and useful tool for your daily lives. The best credit cards are the ones that you can afford and that meet your needs and give you some rewards. When used responsibly, a credit card may be a blessing. Before you go ahead and apply for a new credit card, I recommend that you carefully think through all the pros and cons, and only make a decision after you have done your research.
Bella Wanana is the blogger behind bellawanana.com, a personal finance and lifestyle blog. She loves sharing with her readers the best tips and tricks on personal finance and how to live a balanced but fulfilling life. She is also a freelance writer, and she has been featured on sites like MSN.com, Reader’s Digest, The Financial Diet, Yahoo Finance, and GOBankingRates.