Most people have heard the horror stories of credit card debt or gotten themselves into their own nightmare. But credit cards are not inherently evil. Like any tool, it’s all about how you use it.
In this post, we will discover why credit cards are so different and how you can use them for good.
Why Credit Cards are Different
The average US credit card holder has four or more cards and carries over $8,000 in revolving debt (Debt.org). While this may seem like quite a chunk of money, credit card use accounts for a relatively small portion of overall consumer debt. The costliest offenders are mortgages, auto loans, and student loans.
But there are several reasons credit card debt has a reputation as a more significant issue than other types of debt:
- It is strictly personal debt.
- It is subject to variable interest rates with an average of around 19%.
- The principal owed is not a fixed amount.
Higher interest rates are usually associated with higher risk. The likelihood the borrowed money will be repaid determines the “risk” for credit card companies and lending institutions.
Mortgages are considered low-risk because the loan is taken against a piece of property for a specified principal amount. This type of loan is a “secured” loan. Should the borrower fail to repay their debt, the lending institution has the right to take the property and sell it to recoup their losses.
Auto loans are also single-use secured loans but with a slightly higher risk factor. If you’ve ever been car shopping, you know older cars are far less expensive than newer vehicles. Similarly, more miles on a vehicle can negatively affect the value. This loss in value makes it less likely a lender would fully recoup their money should the borrower fail to make payments. As a result, automobile loans usually have higher interest rates than home loans.
Student loan interest rates are affected by the standards placed by the federal government. As such, they do not follow the usual rules regarding secured and unsecured loans. The US government has set interest rates and maximum amounts for student loans provided through specific lenders. Because these loans are subsidized, average interest rates sit at around 5.8% (Debt.org). While there are un-subsidized and un-secured private loan options, the majority of student loans (92%) are owned by the US Department of Education (NerdWallet).
Credit Cards are 100% un-secured, unsubsidized credit. The only guarantee an issuing company has is the card owner’s payment history and credit score. While the average interest rate sits around 19%, it is not uncommon to see rates of 21% or higher. Apart from interest, the most significant differentiator between credit cards and other debt is how it is used. Loans provide a one-time payout for large purchases such as homes, cars, and education. Credit cards, on the other hand, payout multiple times up to a specified amount. This amount is your line of credit. Paying off any of the accumulated debt re-opens that portion of your credit line.
How to Make it Work to Your Benefit
The detriment of using credit cards is high-interest rates. But those rates are only applied to balances that are not paid off within 30 days. This is why the first rule of making credit cards work for you is:
- Pay off your balance every month.
To do this, you will need to use your credit card as a tool in your budget arsenal rather than a way to make extra purchases. Whether this means paying toward your bill every pay period or immediately after using your card, it is the only way to stay out of debt. Don’t worry; it really is worth it. The trade-off is free stuff.
- Take advantage of cashback and rewards.
Credit cards offer a range of sign-on bonuses, cashback, and rewards. These rewards are linked to how much you spend on the card within the last statement period. You could rack up points to use on gift cards for your favorite retailers, post credit back to your current statement, or increase your frequent flyer miles. The company relies on the interest paid by their cardholders on revolving debt to fund these rewards. But they are real bonuses for those who keep their balance paid.
If you have a great deal of control, it is possible to use a credit card for the majority of your spending to rack up the maximum rewards. Using your credit card for the majority of purchases also allows you to:
- Take advantage of federally mandated protection against fraud.
If your credit card information is stolen and a purchase is made, federal law protects you from liability. The most you may be responsible for is $50 unless you report loss of your card or stolen information before the thieves make a purchase. However, many credit cards have a zero-liability fraud policy so that you would be completely refunded.
- Credit cards build credit.
Finally, the proper use of a credit card will help you get better rates on other common debts. People with a better credit score can get better interest rates on mortgages, car loans, and other credit cards. So, even beyond the rewards and fraud protection, proper use of credit cards can place you in a better financial position for the future.
Despite their bad reputation, credit cards can be a useful tool in your budget arsenal. If you use them wisely and pay them off monthly, they can provide a wealth of benefits for you and your household.