Credit Cards: A Useful Tool that Should Not Be Misused

Credit cards have grown in cultural significance over the last fifty years. Commercials highlight the glitz and glamour of using a plastic, shiny card when checking out at a restaurant or hotel. Credit card issuers are nimble enough to highlight the perks of owning their card. Credit card designs are evolving to imbue elegant features, such as a heavier weight or majestic color, to signal to others that you are ahead of the game with your credit card.

I could keep going on with this diatribe about the evolution of credit cards. I don’t want to come off as the pessimistic person who views credit cards as a sin. They’re useful tools when used appropriately. And that’s the keyword: appropriately. Our culture views credit cards as a free-spending tool for frivolous purchases that often leave us unhappier than we were before the purchase.

Simply put, credit cards are not an extension of money. They are a revolving line of credit issued to creditworthy borrowers. When you swipe a credit card to complete a transaction, you are borrowing money to finance the transaction today. At the end of the month, you either need to pay the issuer back in full or make a monthly payment on the credit balance to avoid entering a delinquent status. When you fail to pay off a credit balance at the end of the month, you carry the balance forward to the next month, which means interest compounds on the outstanding purchase. The eloquent dinner that was originally worth $350 is now costing you each month in interest.

Each credit card has an upper credit limit. Credit card issuers determine this upper limit by looking at an individual’s credit score and other characteristics to determine whether a large credit limit makes sense for this borrower. Income and credit history are the key determinants of a large credit limit.

Each month, credit card issuers tally your expenses to determine your statement balance. You will then have a period to decide whether to pay the balance in full or make only a minimal account payment. When you pay the balance in full each month, you avoid interest in future billing cycles, which prevents minor purchases from turning into a financial headache. If you cannot make the full payment, you can make a minimum payment. This minimal payment keeps your account in positive standing. It leaves you on the hook for a balance due in future billing periods. Accruing interest on this revolving balance has a devastating impact on your ability to manage future debt loads.

Despite all the risks credit cards entail, several benefits of them can transform your financial life. First, credit cards allow you to build credit. Building credit now makes it easier to access credit in the future for larger purchases, such as a home or a personal car. Some credit card issuers offer reward programs in a variety of formats: cash back, airline miles, or points for every dollar spent. It is always important to scrutinize the structure of a rewards program to ensure you fully understand it.

Unlike debit cards, credit cards offer fraud protection through zero-liability protection. You are not liable for unauthorized credit card swipes if someone fraudulently uses your credit card.

Credit cards entail three risks that are deadly to an uninformed consumer. Interest, often referred to as the annual percentage rate, is much higher on credit cards than on other forms of credit. Credit card interest rates are typically higher because there is no collateral for the credit card company in the event a credit card user defaults on their obligations. Some credit card issuers charge an annual fee for premium perks. Other fees a credit card user may experience include late fees, cash advance fees, and foreign transaction fees. Credit cards are a classic example of a debt trap that can create financial havoc. As debt capitalizes each month due to compounding interest, a meager credit balance can easily snowball into unmanageable debt. When this happens, credit card users often find themselves on the precipice of bankruptcy, which is ruinous to a person’s credit score.

Like any other tool, credit cards work best when used appropriately. The most important takeaway is this one: credit cards are not money. They are an extension of credit from an issuer to you. This credit is not free. It requires repayment. Those who fail to understand this simple aphorism are bound to fall into a debt trap that ensnares too many people each year.