Credit Cards
Credit cards are a double edged sword. They can be a great tool for building credit and points or it can be a blood sucking parasite siphoning away your earnings. The easiest way to know if you should have a credit card, is if you have ever not paid your credit card off in full in the last year, then you should not have a credit card. It's that simple. You should immediately take all your credit cards and cut them up then begin to use your debit card for all your purchases. You cannot go into debt with a debit card, you will simply be denied which will be a wake up call to you that you are spending too much. Credit cards allow you to live beyond your means which is fun in the short term but will always be at the detriment to your long term saving potential.
If you do not have an emergency fund to cover unexpected expenses you should not have a credit card. Credit cards are a luxury for those who are financially stable. They should not be used as an emergency fund or for purchases you cannot buy outright.
Credit cards are designed to be a trap for those with less discipline and financial knowledge. 22% interest on a $6 drink from Starbucks doesn't sound like a lot, but when the numbers start getting into the hundreds or thousands it really starts to add up. $1000 of debt on a credit card at 22% is only $18.33 a month. But just like compound interest on investments, interest on debt also compounds. $1000 of credit card debt a year turns into $1220 which can then snowballs out of control ignoring minimum payments of $10 a month (see graph below).
Interest
Interest is always stated at a yearly rate. If you only collect interest for 6 months a $1000 would be calculated as such: $1000 x 0.22 = 220 ($220 being the yearly interest on $1000). 220/2 (divided by 2 to get interest on 6 months from 12 months) = $110 the cost of interest on 6 months of a $1000 purchase. 0% is low and anything higher than 10% interest is high. Rates ebb and flow based on the prime rate decided by the central bank, but generally unless its interest from a mortgage you should not be paying any % of interest. Debt passively costs you money and unless that debt is making you more money than the cost of the debt it is not financially responsible.
It is thinking that one can simply pay off the debt at a later time which ensnares a victim an a vicious credit card debt cycle. Eventually the debt becomes so great that the debt cannot ever be paid off without debt consolidation intervention.
But for most everyday users of credit cards who pay off their balance mostly or in full most months it is important to know how high 22% truly is (some credit cards are as high as 28%). Credit card interest is calculated daily from the time of purchase and even though there is a grace period of 21 days if you pay off the debt a day after the grace period on the 22nd day the interest would be multiple days not just 1 day of interest. If $1000 were spent on January 1st then the credit card statement was delivered on February 1st with a due date of February 27th. If the bill is paid February 28th then the interest for the $1000 would be $35.56 for the 59 days since the purchase.
Credit cards also just make everyday life more expensive. If you buy a $10 sandwich for lunch and delay paying the bill by just a single 30 days from the purchase date, that $10 sandwich turns into a $12.2 sandwich. Plus that is just if you delay a single month for just one single purchase. If you delay for multiple months with multiple purchases the financial bleed starts to really add up.
Pay Debt or Invest
If you have extra money or investments that you can access it is almost always better to pull your investments to prevent the interest payment on a credit card. The only time it wouldn't be better to pull your investments is if you have a low interest credit card that is lower than your investments are making (which most likely not the case), extremely high earning investments (higher than 22% interest) which is also most likely not happening and RRSP accounts as you'll permanently lose RRSP contribution room. Even though it is best to leave your investments alone to benefit from compound interest, it is important to note debt can also compound but at a much higher rate (see graph above).
Credit cards should always be paid in full each month as it is never worth the benefit of extra time to pay. Whether you pull investments or borrow from friends or family or even take from your loans with less interest such as student loans or line of credit it will greatly reduce your overall costs. It is important to note how the credit card debt was accumulated in the first place. If you move your credit card debt to a lower interest rate it won't make much of a difference if you just fill up the credit cards again.
Benefits of Credit Cards
Credit cards are not purely negative, there are lots of benefits to them which make them quite enticing to use over debit card or cash.
Cashback
There are cashback and points cards that give you 1% to 3% back which can add up to be quite a bit over the course of a year. The average American spends $1,506 per month on credit cards or 18,072 per year which is $542.16 at 3%, $361.44 at 2% and $180.72 at 1% of potential cash back. This may not seem like a lot but it is money you are leaving on the table if you don't use a credit card. You can look at a purchase made with a credit card as getting 1% - 3% off the purchase price compared to someone using a debit card. Now the rewards from credit cards are not always worth it. Only 48% of credit card users do not pay down their entire monthly balance meaning the cashback or points rewards are completely not worth it for those users. Not paying down the entire balance can negate a significant amount of rewards if not all the rewards earned over the course of the year.
Annual Fees
Not all credit cards are free. Besides all the interest they will charge you if you are late on a payment they will also charge you an annual fee for the privilege of using their card. These can range from $50 to $800 per year. I would recommend steering away from credit cards with annual fees but for some that spend a lot per year it may be worth it given they can handle a credit card. For example, say you make $200,000 a year and you spend $50,000 on your credit card per year due to personal spend or even business expenses. At only 1% back it would be $500. Annual fee credit cards normally come with much better rewards and perks like 4% back which would lead to much higher point or cashback rewards that would more than make up for the annual fee. Its just a matter of doing some math and making sure to cancel the premium card as soon as it is no longer financially logical.
Other Perks
There are protections on purchases from unauthorized charges, thief and lost merchandise. Perks like free car insurance for car rentals, discounts with certain stores, travel flexibly, airport lounge access and more. The other benefit of a credit card is the fact that it's not your money. It's the credit card money. So when your credit card gets stolen or compromised, if anything is taken, it's taken from them and not you. It's much easier to dispute a charge on a credit card vs a debit card. This can help with identity theft as well.
Building Credit
One of the reasons I got a credit card when I was 18 was to build credit, as lenders want to see a long history of paying back debts. Credit card debt is short term and is normally paid off each month (ideally) contributes to your credit score even though it is such a small amount of time. You may not even be thinking of buying a house or getting an auto loan but with years of paying off a credit card your credit score will be well in the Good to Excellent range.
Overall credit cards are a tool and just like physical tools they can be abused and mistreated causing undue harm to your credit score but more importantly costing hundreds or thousands in interest fees. You need to use a credit card like a debit card or cash. Only spend what you have and pay it off in full each month no matter what. Set an alarm to remind you on the date your statement comes out so you don't forget. Used correctly you will have some fun perks and save a few hundred per year.
If you found this helpful and would like help budgeting or investing please email me at TaylorMckeeCoaching@gmail.com
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