5.14.2017

How to use a credit card: Part 1.

When I was in college all dorm rooms had landlines, which meant credit card companies would call us constantly, trying to sign us up for an account. Pretty shady, and addressed during our little economic meltdown later that decade. Unfortunately the lure of being able to spend more than c. fifty dollars a month was too great, and I gave in spring of freshman year to Citibank. Later that year, I also sold my soul to Discover.

As you can imagine, I was an idiot with both cards, which is a whole other story I'm too ashamed to tell, and it was a mighty struggle to become debt-free, after which I swore off debt for several years. Along the way, I learned a lot about the good, bad and ugly of credit and credit scoring. Today I have one credit card with a nice credit limit and I spend all my time obsessively not using it.

You can be like me. In fact, I want you to be. So now, for Part 1 of this series, I will launch into everything I wish I had known when Citi and Discover were unethically cold-calling me back in the day.

It's not free money. Period.

Credit cards are not the answer to your prayers. They are not for funding things you cannot afford. They are not for spontaneous splurges. They are not for paying other debts. They are not for when you feel like you want to "be bad." Credit cards are not fun. Credit cards do not make life easier. Credit cards do not give you freedom.

Now that that's been established.

The concept of credit is simple: borrow a sum of money to be paid back in installments over a period of time. It can be helpful in a number of situations, a few of which I'll enumerate at the end. But at no time in human history has credit ever been the same as a gift. If you open a credit card for the purposes of repaying it in installments, you will end up paying more than you borrowed. End of story.

Everyone knows that you have to pay back what you spend with a credit card, but a lot of people don't know how it works. When I got my first credit card I didn't know how to interpret the statement I received, so it was a few months before I understood that I was being charged money on top of what I had actually spent. This wasn't a problem for a long while - I was responsible enough, and they gently increased my credit limit as time went on so I was never in a bind...until I did start approaching that credit limit.

I would call (yes, call) the customer service number to hear my balance. Good enough, I'd think. I'd call back a few days later, having paid my bill but not used the card - yet suddenly I had fifteen or twenty available dollars less than what I thought I should.



The (very) basics of interest.

How do lenders make money? By loaning out ten bucks and getting ten bucks back? No. That's called breaking even, not profit. Therefore, when you borrow money, lenders charge interest. It's basically a fee for them helping you out. I like to imagine old colonial bankers, working out of a musty upstairs room and reading Poor Richard's Almanac, to keep perspective, because modern lending is much of the time predatory, a huge game, or a downright scam (and that is a whole 'nother blog series).

Out of the gate, a credit card comes with an annual percentage rate, or APR; it's the rate at which you are charged for borrowing. It seems nowadays that a person with a "good" credit score (more on that later) is going to start off with an APR between 15-19.99%. Note: that is not a good rate, but it doesn't have to be ruinous, either.

When you get your first statement, having spent a hundred bucks or so, the minimum payment is like the coo of a dove: $25. Wait, you mean I can buy all this stuff and you only want me to pay you twenty-five dollars? SCORE!

Wrong. What happens when you make a minimum payment - or any amount other than the full amount that you owe - is you begin racking up interest charges. There are a few different ways banks charge interest with their cards, but a common method is the average daily balance. The ADB is what you owe in interest every day, based on your average balance on that day of the month, at your card's annual percentage rate.

It's not terribly complicated but takes some time to explain; this site does a good job. The important thing to know is that every day you carry a balance, you are adding to the total monthly interest that will be charged to your balance. It is charged once a month, and can catch you unawares if you don't understand how it works - the way I was constantly annoyed at losing available credit.

And of course, the higher your balance, the more interest you are charged. Why is the lending business so lucrative? Because many people don't understand interest. It will be one shock to realize you owe money you never even spent, and another to realize it has begun increasing your total balance at a rate that's not feasible for you.

Minimum payment amounts are a SUGGESTION.

And by that I don't mean optional. I mean, that's the lowest amount the lender will allow you to pay on what you owe. You can, and always should, pay more.

At the height of my credit card problems, new lending practices during the Great Recession required credit card companies to include on each statement a calculation of how long it would take you to pay off your total balance if you only paid the minimum each month. What those statements told me was that it would take over thirty years to pay off my balance by paying only the minimum (and that's only if I never charged another red cent), and that ultimately I would be paying over five times the amount actually owed during that span.

I didn't pay it much heed - by that time, being very much post-college and having a lot more on my plate, the minimum on both cards was all I could afford. As we tend to do when faced with bleak options, I looked into the hazy future and convinced myself that I would make it work somehow.

The hard truth is that your required minimum payment amount will go up as your balance goes up. Be prepared to say goodbye to that $25 pretty quickly if you use your card frivolously. While calculations vary across lenders, your minimum payment will shape up to be between 1-3% of your total outstanding balance. Doesn't sound like much?

If you get a card with, say, a $4,000 credit limit, and rack up $3,000 in charges, your 3% minimum payment is now $90. Try shoving that into your budget when maybe even a month or two ago it didn't exist. While it may be mind-blowing that some people have $20k and $30k credit lines, remember that if they use a large chunk of it, their monthly payment will look more like a house note.

To go a little more in depth, this article is nice.

There is no such thing as a grace period.

This should be the number one thing to consider before even looking in to getting a credit card. Traditional grace periods, without which civilization would crumble, are incredibly helpful for people who live paycheck to paycheck, or must deal with bi-weekly pay periods, or a host of other reasons. They allow you to re-organize your bill pay to make it work.

Credit card companies, on the other hand, use a different type of grace period, regarding finance (interest) charges accrued on purchases. This does not effect your due date nor does it allow an extra handful of days to pay your bill.

Now, some credit cards do have brief traditional grace periods, but in my experience it's nothing like what you're used to. There is also no industry standard. Some companies may wait until you're the full 30 days late to report it to the credit bureaus; others may report you right away. In both circumstances, you've already incurred a late fee charge, which in almost all instances makes your APR skyrocket as a penalty.

If you think there's a grace period of 3 or 5 days and "use it" one month, you may find that you just missed your payment completely. The absolute best thing to do is always pay before the due date. (yes, you can also ask the company what their policy is...sigh)

Late payments are not the lender's fault.

I never thought they were, but you may be surprised at how many people take to the internet to write scathing reviews of credit card companies, loan companies, etc., enumerating all the awful things that happened to them, when the reason those things happened in the first place was they missed their payment(s).

There are an uncountable number of reasons why someone might miss their payment that have nothing to do with being a bum, but try to keep perspective and be honest. There are stiff penalties when missing a payment because you have been given someone else's money to spend, and in order to stay in business they need to get it back with profit. The only way to ensure that happens is to make it painful to break the rules - late payment fee, increased APR, negative mark on the credit report, and that's just for starters; the longer you go without payment, the more stressful life will become.

Are you ready to hold yourself accountable?

It almost seems antithetical to the modern sensibility, but you really need to take a lot of time to think about whether or not you should have a credit card. Can you afford it, based on what you now know about increasing interest charges and minimum fees? Will you pay attention, and set all the reminders you need to pay the bill by the due date? Are you planning to use it for the right reasons (and no, the spontaneous jet to Paris for dinner just like they do in the movies is not the right reason)? Do you understand that unless you pay off the balance in full every single month (more on why anyone would do that in Part 3), you will always pay the lender back more than you borrowed, and if so, are you okay with that, or do you feel that that shouldn't be how it works?

Taking the time to truly contemplate if you're ready to be in debt is a serious matter.

***

So what now? Credit cards aren't free money, you have to pay extra to use them, the more you use them the more they cost, and you don't even get a grace period. What possible benefit could there be for someone who still wants financial peace of mind in an emergency and to build good credit too?

The great news is that credit cards can be everything you want them to be when used properly, and when you have your own personal budget and financial plan. Believe me - you don't want to have to learn the tricks of the trade the hard way. A fall from grace is often the best teacher, but I still hold out hope that living vicariously can work too.

Stay tuned for Part 2.