This is the first post in our Fundamentals Series. I wanted to take some time to talk about some of the most important aspects of our financial lives, starting with credit cards. Many financial tips that are available assume a basic understanding of certain terms and principles. Not everybody has received an overview of the information, so I’m going to go through that now.
Stay with me through the entire series so you can make the first steps on your journey.
Purpose of Credit Cards
Credit cards were designed as a way to temporarily fund expenses at times when cash flow is low. The key term to pay attention to is “Temporary”. Credit cards were never designed to hold balances for months or years.
To really understand credit or charge cards, you have to go back to the 50’s with the advent of the Diner’s Club charge card. Before then, if you wanted to make a large purchase, your option was to carry around all the cash you needed, which was dangerous. You could write a travelers check for the item you wanted to buy. Lastly, you could use a charge card, which was a much more convenient option.
The charge card was a convenient way of carrying around a lot of purchasing power. You had no issue paying off the balance every month, because you never had the option to carry a balance forward. The option to carry a balance forward was not invented until 1987.
Higher interest rates are common on credit cards because of the risk that comes with collateral free debt. The cards are most useful and cheapest when you can pay them off every month.
Types of Cards
Reward Cards – Rewards Credit Cards are cards that offer some type of incentive to make purchases on the card. Those incentives are usually points, that can be used towards rewards, or miles, used towards flights or vacations.
Other rewards that are offered with reward cards are cash back programs. Usually once a quarter, they issue checks to their cardholders based on the spending from the prior quarter. These programs typically offer higher cash back percentages to certain types of merchants
Store Cards – With store credit cards you can only use them with the issuing merchant. These cards are designed to encourage continued sales to the store. This encouragement comes in the form of increased purchasing power of cardholders. Additional benefits usually come in the form of special discounts and sales that are only available to cardholders.
Standard Cards – These are your typical credit cards that do not have any special reward program. Your standard issue credit card may be directly from the credit card companies, like Visa or Amex. However, they may also be issued by the large banks, like Chase of Citi.
Pricing of Cards
The Reward programs that come with Reward Cards obviously have a cost. As with any cost, there is a winner and usually a loser. Fortunately for you, the loser is the merchant in this case. When a merchant agrees to accept credit cards, they agree to pay the credit card transaction fees. Your credit card issuer receives these fees, which are usually 1.7% per transaction. The more money you spend on the card, the more merchant fees are collected so the more points you earn.
The costs in a number of these reward programs cannot be absorbed by the merchant fees. You will have to pay an annual fee for a number of these cards. If you use the card regularly enough to accrue a substantial amount of points, then the cost is worth it. If the benefit of the rewards you earned for a year does not exceed the annual fee, this card may not be for you.
Store Credit Cards and Standard Credit Cards do not have a rewards program to support and do not usually have fees associated with them.
Credit Cards are nothing more than short term loans. In any situation where you borrow money for more than a month, you are charged interest. There are some exceptions to keep in mind however.
To entice people to get a credit card, many cards offer an introductory rate. For these cards, you are charged very little or 0% interest for a set period of time. That time frame is typically from 6-15 months. These interest free periods are designed to encourage you to spend more on the card, ensuring you are more likely to keep the card after the introductory period.
Another exception to being charged interest is if you have a Charge card. When you are required to pay your balance in full each month, you are not charged interest because you are not borrowing money for more than 1 month. However, to help pay for these cards, Charge cards usually have an annual fee associated with them.
The Interest rate that is charged on credit cards is known as an APR (Annual Percentage Rate). This is the rate that would be applicable if you were to hold the outstanding debt on your credit card for one year. Each month, you are only charged 1/12th of this rate.
Anybody who has been in debt or has had problems with their credit understands that managing your debt payments is a very important part of using credit cards. The trend in the personal finance community of becoming totally debt free can be misleading about the use of credit cards. You may have heard the advice and decided to forgo credit cards altogether. However, this is a mistake.
You should continue to use credit cards, but use them responsibly. What we all should focused on is using credit cards as if they were charge cards. Our credit card spending should be paid off every month. Not only does this limit the risk of accumulating a dangerous amount of debt, but it makes the use of credit much cheaper.
Credit cards only charge interest on the balance that carries over. You can continue using credit cards and your only cost would be if there is an annual fee. If you are using a reward card, you also continue to accumulate points. However, the greatest benefit to using credit cards is the establishment of credit.
You need to have established credit for a number of reasons. Not only is it required if you want to purchase a house or car, but you may need to get a job or an apartment. I go into greater detail in my post 5 Ways to Increase Your Credit Score.
It is very important for you to understand credit cards, how they work, and how to use them to your advantage. Your understanding of credit is key to improving your financial situation.
Subscribe to receive updates for new posts so you don’t miss the next post in the Fundamental series.