We recently wrote about 5 things to know about paying off a credit card. While we coach people to pay off their debts and live more on a cash basis, we recognize that credit cards also have some very important benefits. There are, however, some risks that can be a serious threat to your personal finances. Being informed and responsible is always the best policy when using credit.
5 Dangers of Credit Card Use
It’s no secret that credit cards are designed to never be paid off. Not making your monthly credit card payments on time is the worst thing you can do—but making only the minimum required monthly payment is a close second. If you only pay the minimum, your debt will take much, much longer to pay off, and you’ll incur more interest charges along the way.
Check out this post on our blog “The Dangers of Paying the Minimum on Your Credit Cards”; in the scenario described in the article, paying the minimum payment of $28 toward a $1,424 debt means 12 years to pay off the debt, and $1,238 in interest paid—that almost doubles the cost of the debt. And if you are late with a monthly payment, the late fee is typically $35, which is more than the $28 minimum required. These kinds of repayment structures make even relatively small debts take decades to repay.
These kinds of articles that talk about the dangers of making minimum payments always assume that you aren’t using the card at all while paying down the balance. That’s rarely the reality; most people continue to use their credit card, and if you’re making only minimum payments, your overall debt is growing rather than shrinking.
In our recent article, Top 5 Things to Know About Paying Off a Credit Card, we covered some of the benefits of credit card use, and building good credit was key. We talked in that article about how important your credit is to your financial life in general. The opposite therefore is always true, misusing them can have negative consequences on your credit rating.
If you miss payments or pay past the stated due date, even by a day or two, your credit score can take a serious hit. And even credit behavior that is not negative can have an impact; getting a balance transfer, opening new accounts—these things can be a red flag to lenders, employers, landlords, and others who might access your credit report.
There are even some actions, like closing an open credit card account that might seem very responsible. However, closing unused accounts can lower your credit score and, depending on the drop in your score, could impact your ability to get the best terms and rates on loans like mortgages or auto loans.
Credit cards aren’t a free product by design. It might be possible to get by without paying anything extra, but only if you get a card with no annual fees and you pay off the balance in full before the grace period ends every month. That’s very difficult for most people.
First off, there are annual fees, which are more common these days, and you’ll pay that fee no matter how much you use the card. Credit cards with extra benefits and perks are much more likely to carry such fees.
Then there’s interest. Any time you don’t pay off the balance in full before the grace period ends, you’ll be charged interest, and if your interest rate and balance are high enough, your payment might be paying as much or more in interest than in principal.
To calculate an example using our Credit Card Payoff calculator, we take $2,500 in debt with a 19% interest rate and pay the minimum monthly payment of $50. This debt takes 9 years to repay and costs $2,493 in interest. So the $2,500 spent initially is nearly doubled by the time the balance is paid off.
Finally, there are other fees, like late payment fees, or balance transfer fees, and cash advance fees. Most of these fees are charged for things you shouldn’t be doing in the first place (like paying late or getting a cash advance), and they can significantly add to the cost of credit over time.
Credit cards are convenient, and that’s a good reason to have them. But they can be too convenient, and lead people to spend more than they would or should. If you’re faced with an impulse purchase that you really want, but don’t have the money in the bank, it can be very easy to swipe the card and buy the item today. We rationalize that we will pay off these purchases soon, but the truth is, we shouldn’t be buying things we can’t afford. And just because credit cards make it possible for us to make a purchase, that doesn’t mean we can truly afford it.
People also have a psychological tendency to compare a purchase to their available credit card balance rather than the cash in their pocket. If you have $100 in cash and you want to purchase something for $50, it’s painful to spend cash because that would take 50% of the money you have on hand. But if you have a credit card with a $5,000 limit, the $50 is only 1% of the total balance available. We forget that we don’t have $5,000, it’s an illusion created by the credit card’s available balance. So people will tend to buy things with credit that they wouldn’t buy if they were required to spend cash on them.
This is something our clients on a Debt Management Plan learn; they must live on a cash basis while on the plan, so they are far less prone to overspend while we help them eliminate their debts.
Credit card agreements are notorious for their fine print, and the terms often give the creditor the right to close the account or change terms (with proper notice given to the consumer). The Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act) reduced penalty fees and made the cost of credit cards clearer to consumers.
Some cards come with 0% introductory rates, but the fine print will specify when that rate expires, and how much you’ll pay if you don’t have the initial balance paid off before that time.
Other tricks include changing the category of purchases that will generate a reward. One month, you might get rewards for grocery spending, while the next you get rewards for spending at restaurants. But even these rotating benefits might be riddled with exceptions—is the café in your grocery store considered a restaurant or grocery purchase? What about buying groceries at a big-box retailer?
Finally, read the fine print to make sure you know how to redeem your credit card rewards—some cards will let them sit there waiting, and you’ll never get the bonus unless you proactively redeem them. And if that redemption method is buried in fine print, you might never claim the rewards you’ve earned.
Credit cards can be a good thing, and most people should strive to have a credit card and use it responsibly. But they are fraught with dangers and each of us has to be careful to use credit cards the right way.
Anyone who has struggled with credit cards can reach out today for confidential debt coaching. We’ll help you create a budget designed to eliminate your debts and get you on the road to financial freedom.