Rules of the Game
Credit Cards bring great value. They are why I created this site. Credit cards:
Offer great convenience. Cardholders can:
Pay on-line
Use them almost anywhere
Use your phone to pay with them
Provide safety – you can carry cards instead of cash
Give us a 30 day float to pay, enabling investments to grow
Offer a wide array of benefits
Sign up bonuses
Points
Cash back
Special credits / discounts
While they bring great benefits, they also bring risk. Cardholders can quickly find themselves in significant debt if they’re not careful.
As a result, I encourage two rules for responsible use of credit cards to reap the benefits they offer while avoiding the risks cards carry:
Pay card balances, in full, every month.
Don’t buy things to get benefits. Buy what you need and let the benefits happen!
Why is it important to pay card balances, in full, every month?
Banks have three primary sources of income from credit cards:
Transactional fees – these are usually around 3%, and usually borne by the vendor, though some vendors add this charge to the transaction, meaning the cardholder is paying it.
Interest and penalties
Annual fees
I haven’t verified this with any banks offering credit cards, but I’m fairly certain the income generated is in the order I have listed above. If I am wrong it is because interest and penalties are first.
The banks are able to reliably project the income they will generate from each of these sources, and they factor that in when considering operational costs, advertising, point and cash back redemptions and other expenses to ensure the card business remains profitable.
Simply put, if you are paying interest and penalties on your credit card, you are not only making the banks more profitable, you are also subsidizing those of us who aren’t.
Credit cards charge interest rates of 20%-30% in most cases. That rate is far higher than could be sustainably expected for any kind of investment any of us may have, so carrying debt on credit cards just doesn’t make sense. It is why I will never consider interest rates or introductory rates in any card review I post on this website. Paying credit card interest is a fool’s game!
Let’s look at an example to show how quickly this can spin out of control:
Let ‘s assume you have a modest credit card spend of $300/month. Let’s also assume an interest rate of 25%, which is a standard rate. Finally, let’s assume that you avoid penalties by paying the minimum allowable each month, $25.
Starting with $0 debt and paying the minimum due each month, at the end of the year we will have $275 unpaid per month X 12 months = $3,300.
Average debt over that span is $1,650, on which 25% interest is charged. That’s $412.50 in interest. Total debt at year end is $3,300 +$412.50 = $3,712.50.
Extending the same habit for another year, the base debt of $3,712.50 is untouched, and we’ve spent another $3,300 more than we paid. Interest is again $412.50 on the unpaid spend over the course of the year. This is in addition to 25% interest on the base debt of $3,712,50, or $928.13.
Total debt at year end is:
$3,712.50 + $928.13 + $3,300 + $412.50 = $8,353.13
If you extend the same behavior for 3 more years, debt would grow to $30,468.61. Your actual spend during this time was only $18,000, so over $12,000 is accumulated interest!
If you get to this point, you would have to pay $7,600 per year just to keep the debt from growing further. This does not address reducing the debt, nor does it account for the continued spend of $3,600 per year!
It becomes readily apparent that credit card interest can quickly spin out of control. It can be debilitating, so it should be avoided altogether.
If you have the discipline to pay your credit card debt in full every month you’ll be able to fully enjoy the benefits they bring!
"Simply put, if you are paying interest and penalties on your credit card, you are not only making the banks more profitable, you are also subsiding those of us who aren't."
