Among credit card advertising aimed at millennials, there appears to be two main camps: 1) the Dave Ramsey camp where all debt is bad so get out of it ASAP and 2) listings and rankings of all these great credit cards with cashback, airplane miles, or some other reward. If you get stuck in a never ending credit card cycle with a high balance, you need to lean toward Dave Ramsey and snowball your debt. If you love the idea of rewards from your credit card, you need to manage the spending on that card so that you do not force yourself to have join the Dave Ramsey camp, spending years getting out of expensive debt. With a credit card offering so much temptation, it is terribly easy to buy anything you want.
“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – attributed to Albert Einstein
First, let’s actually take a look at the formula for compound interest that we all learned back in high school; because knowledge is power. The compound interest formula written out below is what makes a best friend or a worst enemy of your credit card.
This is to say, that the amount of money you will end up owing depends on how much you spent on the card (of course), the interest rate, how often the interest compounds, and the holding time frame. The two variables r and n are incredibly important and you need to understand the implications so you don’t find yourself in a financial contract you dislike. So consider an annual percentage rate of 16% with a daily compounding. Your daily rate would be 0.16/365=.00043836=0.04%. If a company were to advertise only the daily rate, that would confuse a great many people because it looks so appealing. Most credit cards are upfront about the APR, but when I went to buy my car, they told me the quarterly rate rather than the yearly rate. I had my own financial calculator with me so I could call them on any deceitfulness. Don’t get me wrong: the APR was still a great rate, but I did not appreciate them using other numbers to inform me about the major contract in which I was about to enter. Knowledge is power, people.
Understanding all of these different values present in your life is essential to taking financial ownership of your life. Knowing how your credit cards function is definitely something you want to know, this way you can become best friends with your card. But first, I am going to walk you through how your card can quickly become your worst enemy.
Credit cards can quickly become your worst enemy
My highest interest rate on any card is 23% and like most cards, the interest compounds daily. Let’s look at the math of how a credit card can be a source of evil, or at least a source of pain. According to a 2017 study by NerdWallet, the average credit card debt is over $15,600, among those households that carry a balance. I am someone who does not carry a balance because I pay off my credit card (or cards) each month in full.
This analysis was a simple example explaining how compound interest works. Many people will still continue to use their credit card, even if the balance is getting too high. The point is to avoid paying money for no reason. Don’t live beyond your means just because you have a tool that lets you do so. Once you are clear and comfortable about how to avoid making enemies with your credit cards, you need to become best friends with it!
3 Reasons Your Credit Card Should Be Your Best Friend
Build Credit: A credit card can help you build a strong credit score, so long as you are treating it responsibly, mainly paying it off on time and not carrying a balance. I opened my first credit card when I was 19 years old. My mom co-signed, meaning she would have had to pay the bill if I failed to do so. It had a limit of $500 which is perfect for someone just starting off. The main reason my mom wanted me to obtain the credit card was in case of emergency. My first emergency came in the spring of 2010, when I sustained a concussion. Two ER visits later, I felt lucky to have the credit card since I didn’t have the cash to pay the hospital. But the secondary purpose of the card was to build credit. At least once a month I bought something small, like a tank of gas, or some food, and paid it off immediately.
Your credit score won’t mean much to you when you are just starting out, but it will matter when you go to buy your first car or your first home. The credit score influences the rate you get for those major purchases. As your credit develops more, you’ll have other opportunities. Cards will start to compete for your business. I have three traditional credit cards, and they all compete for my business. One approach to getting your credit limit raised is to just apply for an increase though the bank or company. But another approach is waiting for one card to try to match or beat the limit of another card you own. My credit card from my hometown credit union, just upped my limit last month to $5000 from $2500. I presume that they made this change for me because I was only using another credit card which has a limit of $6500. Higher limits are important because you never want to actually reach the spending limit they give you. Using up the entire capacity of the credit card doesn’t demonstrate responsibility or financial discipline. The rule of thumb is not to exceed 30% of your limit. For my card with the $6500 limit, I could charge $1950 and still maintain an excellent score. Spend more than that, and I start to look bad.
Security: If someone steals your credit card information and charges several expenses, it’s much easier to fix your balance than if they had stolen a debit card or a checkbook. Credit companies allow you to dispute charges and to report fraudulent activity. It may be perfectly possible to get your money back if your debit card information was stolen, but while you’re waiting for a new card to come and any kind of investigation to happen, your money is gone. If my debit card was swiped and wiped out I would be screwed. Three years ago, on Christmas Eve, my credit card number was used at a place named Pasadena Platinum Gas out in California. I wasn’t missing $300 from my bank account, rather I just waited until the credit card company sorted it all out then called me back to say “we’ve erased those charges and we are sending you a new card.” I only ever use my credit card on vacation for this reason. I also use my card for big purchases, like the appraisal on my house and service on my car.
Rewards. Most credit cards these days offer some sort of incentive to spend money on their card. This is, of course, an attempt by the company to make more money. It works because they count on someone to develop a large balance and take many months to pay it off (see the tables at the top of the post). But if you are being responsible with your card, you could reap the benefits of cash back, statement credits, airline miles, and prizes that you can find online. I personally use the Huntington VOICE credit card, because it was offered to me when I opened a new checking account in Cleveland. There were two choices: a lower interest rate or earn 3% cash back on a particular category of expenses. Currently, I have the triple rewards to grocery stores. I buy my groceries on my VOICE card and immediately pay back the card from my checking account, right from my phone. In the summer, when I knew I’d go on vacation, I selected travel as the triple category. All other spending gives 1% cash back. Credit cards are very tempting to use on anything your heart desires. Use the card to purchase or pay for the items already in your budget, then immediately pay yourself back.
If we circle back slightly to point 1, we can determine how to obtain better reward opportunities. My favorite type of rewards cards are the ones with travel miles. I don’t currently have one but plan to get one eventually. If you have a higher credit score, you will be offered better deals. That would be the card itself or the interest rate established for you.
5 ways to keep your best friend
Psychology. Know the psychology of spending. When I taught a unit on Financial Literacy my first year as a teacher, psychology was an essential part of our studies. One research study that took place at McDonald’s concluded that people will spend about 12% more if using a card than if they’d use cash. I’ve made this mistake time after time. It’s really easy to fall in this thought trap that goes: “I make $2500 a month, of course I can afford this $40 spiralizer at Bed, Bath, and Beyond. “ But do that every time you want something, you end up spending $320 on random junk. OF COURSE you can afford to spend $40 from a paycheck. But can you afford to spend $40 eight times in a month and still have some left over to save or invest? Not if you make what I make. Know whether you have the personality of a spender or a saver. Work for balance in your life. If you’re looking for a thrill in your financial house, try investing the money in equities and look at it about every 4 months. You’ll get the same pang of happiness that you get when you buy new clothes or an expensive meal. Saving money or building up your assets provides comfort and happiness that paying down debt will never give.
30% rule. I mentioned this briefly above, but it is so important to follow. You shouldn’t buy more than 30% of your limit on any one credit card. This is called “credit utilization.” Just because I could spend $6500 in a single month, doesn’t mean I have to. Being sure you don’t go over this 30% credit utilization limit can save you much heartache and money. Because let’s face it: the majority of us don’t have $6500 to pay back to the credit company 3-6 weeks later. You’ll end up paying interest on it, which wastes your own hard earned money and it can hurt your credit score.
Don’t pay interest. This is a fee for borrowing money from the lender. It’s good for them, bad for you. And credit card debt is bad. The interest rates are at least 3 times other types of loans: my auto loan has a rate of 3.49%, my mortgage has a rate of 3.785%, and my student loan has an interest rate of 6.5%. I already have so many items to pay interest on major purchases, I can’t imagine paying interest just for some gizmos or gadgets I thought were cool at the time. One of my cards has an interest rate of 10.99%, Huntington has a rate of 15.99%, and my Barclays card has a rate of 22.99%. By making big purchases and paying them off slowly over time, all I would end up doing is paying extra for my purchases.
Make a plan for your card. You will get the most reward and do the least useless spending if you make room for the credit card in your budget. As I mentioned above, my VOICE credit card has the purpose of buying groceries this quarter so I can get triple rewards points. In fact, I just filed for some statement credit this week. Next month, I’ll be buying items for my new house, meaning I’ll be at Home Depot or Lowe’s often. I switched my VOICE triple rewards category to “home improvement.” My point is, I use my credit card for things I need to buy or I am intentional about how it fits into flexible spending. Your credit card should not be this extra tool outside of your planned spending. That’s how people end up in debt. With all the perks available to us, we millennials should be the masters of credit card usage. It requires careful planning and discipline and if I can do it, so can you.
Pay every two weeks. I am assuming that most people get paid how I do: every other week or twice per month. Rather than waiting until the credit card due date, I pay half or all of the balance the day I get paid. This keeps me looking at my statements so I can reduce frivolous spending. It also creates a healthy habit of not letting debt – no matter how small – build up. Since I started this habit 7-8 months ago, I have regained complete control of my credit card spending and have gone back to a higher savings rate. I will never go back to once a month payments on my credit card.
The bottom line…
- Know the mathematics behind interest
- Live below your means
- Take advantage of the card, but don’t let it take advantage of you
- Know if you are a spender or a saver & find balance
- Don’t pay extra for your purchases