What are credit cards?
Credit cards are ubiquitous nowadays. What are credit cards? You may ask, if you are new to the financial world. 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, so credit card companies charge you a fairly high interest (generally around 20%) just so you can 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, 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 up 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 them for everything – grocery shopping, restaurants, flights, you name it.
Deep dive into the good and the bad of credit cards
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.
Advantages of credit cards
- 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, the global presence of major credit card companies means that they 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 usage. With a click of a button, you can purchase items from around the globe, with just the strings of numbers on your credit card. You definitely can’t do that with cash.
2. Using credit cards to make purchases allows you to build up your credit score, which 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 (e.g., banks, credit card companies, etc) 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 bills on time. 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 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. Credit cards offer rewards for everyday purchase, making everything a slightly better deal
- Nowadays, to attract consumers to use credit cards, the companies have devised various incentives. 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 can make everything slightly cheaper. 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 offer sign up bonuses that can be super lucrative
In addition to the regular rebates, many credit cards also 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.
Now, after talking about all the advantages of credit cards, let’s talk about some disadvantages.
1. The interest credit card charges it hefty
- We have to realize that credit card companies are in the business to make money, and they are 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 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 are unable to pay it until a year after, 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.
2. Credit card fraud is rampant
- Unfortunately, with the advance of credit cards, there comes the dark side of the industry – fraud. Fraud happens when someone uses your credit cards 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 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.
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.
Bella Wanana is a freelance writer. She is the owner of 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 has been featured on sites like MSN.com, Reader’s Digest, The Financial Diet, Yahoo Finance, and GOBankingRates.