Credit cards often get a bad wrap. They're considered to be one of the biggest reasons why so many people accrue almost insurmountable piles of debt.
It's shocking to realise that 47% of Americans are carrying credit card debt, and the number continues to rise. In 2019, 1.9 million Australians were struggling with credit card debt.
The lure of the magic plastic encourages people to spend money that isn't theirs, and worry about how to pay it at some point in the future. The problem with this approach is the massive amounts of interest they're charged if they fail to pay the balance in full at the end of the month. Credit card annual interest rates can be higher than 22%!
The interest is the killer here, and the only way you get charged interest is from not paying the balance in full.
To put that in perspective, if you whacked $10,000 on your credit and only made the minimum repayment of $255 each month (usually 2 - 2.5% of your balance), it'd cost you $34,326 and take over 35 years to fully pay off! That's $24,326 just in interest.
You can see how credit card debt can easily spiral out of control, and that example assumes you don't keep spending on the card.
I get it, I've been there. Credit cards were used in place of savings and they felt like a great short term solution when I wanted to pay for something and didn't have the money in the bank to pay for it.
Part of the problem stems from how easy it is to apply for - and start using - a credit card. Run out of credit on one, apply for another one and continue the cycle. Without good financial disciplines, credit cards can create a nightmare you can't wake up from.
That all sounds doom and gloom, and it is. But in reality, the credit card isn't really to blame. Your spending habits are.
Believe it or not though, you can use a credit card and pay $0 in interest, and some cards even have no annual fee. The key is to use them responsibly. This is something not many people do.
When used responsibly, credit cards can actually save you money. The amount will vary depending on what card you choose and how you use it.
Here are the some of the best ways to use a credit card.
Pay the balance on time and in full every month
This is the single best thing you can do to ensure you pay $0 in interest on the money you spend on the card. The big, scary 20% APR (Annual Percentage Rate) won't ever impact you if you have the discipline not to overspend and pay back the balance in full every month.
The credit card companies will send you your bill and give you a few options for the amount you wish to pay. They almost always have "pay minimum amount" at the top of the bill in bold, which will usually be around 2-2.5% of the balance or a pre-determined dollar amount specified by the card issuer. This feels like the easy option. Don't take it. It'll cost you a fortune in the long run.
The second option will be the "outstanding balance", which is how much you owe up until the time the statement was issued. If you pay this amount - and you can set it up to automatically do this - your balance will reset to $0 and no interest will accrue.
Keep in mind that the automatic payment of the outstanding balance will be paid on the "due date", which is usually 14 -21 days after the statement period has ended. This means your current balance will continue to climb if you keep making purchases on the card, and will only be reduced by the outstanding balance amount when the bill is paid on the due date.
The automatic payment method for the outstanding balance may make it tricky for you to manage your cashflow and repayment requirements since there is such a lag between the statement period and the due date in which the balance is actually paid. Something to be mindful of.
The third option is to "pay current balance", which is the amount you'll see when you log into your app or online bank for the card. If you like to manage your card repayments manually, this could be a good option for you because you'll be paying off 100% of what your current balance states.
This will reset your balance to $0 within a day or two, and as with the outstanding balance payment option above, you'll accrue no interest with this method. I personally prefer this method as it helps me manage my balance more effectively and keeps my credit usage low.
Choose a card that suits your needs
When selecting a credit card the options are endless. There are literally hundreds available through multiple issuers and it can be difficult to choose what's right for you.
To determine what would best suit your needs you should reflect on your spending habits. You can do this by manually trawling through previous bank statements, or you can use an app that syncs to your accounts and automatically categorises your spend for you. I personally use Pocketbook at the moment, but other free apps are offered by Mint, Money Brilliant, and a new kid on the blog for the millennials out there called Clever.
Once you know how you spend your money, you can narrow down the credit cards to ones that will align with these patterns. Many credit cards offer a rewards or cash back program, in which you accrue points/miles per dollar spent or receive a percentage cashback for each eligible transaction, respectively.
If you opt for a no annual fee credit card the rewards programs are fairly limited, but your card costs you $0 each year so every reward is a bonus. Usually the higher the annual fee, the more rewards are offered to you the customer.
You will need to weigh up whether an annual fee is justifiable for your situation before you commit to it, and you can do this by conducting your own cost-benefit analysis. Let's say the annual fee is $195 and gives you 5x points per $ spent on "dining out and groceries". Let's also say you're an avid traveller and like to zip around the country from time to time.
If you find you spend a fair chunk of your disposable income on eating out at restaurants with friends and feeding a number of people with trips to the supermarket, the $195 fee could pay for itself and then some if you redeem your credit card point for airfare tickets so you effectively fly for free.
It all comes down to how you spend and what you plan to use the rewards points for, so be sure to do the calculations and projections before committing to a card with an annual fee.
Treat your credit card like it's a debit card
Where a lot of people get tripped up is using the credit card while not having enough cash in the bank to cover the cost of what they've just bought.
This is where using your credit card like it's another debit card is essential. With your debit card, you pay for something and the balance is deducted from your bank account almost instantly. If you try to spend more than what's in your account, you'll be declined for insufficient funds, so it's a hard stop and you cannot buy whatever it is you wanted to buy.
With a credit card however, you can continue to make purchases up until your credit limit even if you have no money in your actual bank account. This is where it can be dangerous to your finances.
A good rule of thumb is only spend what you could pay for in cash (debit card). For this to work, you have to be in tune with how much money you have in the bank and keep an eye on the current balance of your credit card.
As an example, if you have $1,000 in your bank account for spending and your credit card current balance is $800, you only have $200 to spare ($1,000 - $800 = $200). If you spend more than the $200 on the credit card you're entering into dangerous territory because you can no longer afford to cover that debt.
Keep a keen eye on your balances and always ensure a buffer so you don't accidentally slip into the red zone!
Stay well below your credit limit each month
Credit cards come with a set maximum you can spend. The amount available to you - known as "available credit" - will vary depending on the card you have, your income level, credit history, etc.
How much you spend of that available credit is what's known as your "credit utilisation". Spend the max and it will be 100%.
It's wise to never approach the maximum amount as this will have a negative impact on your credit score. Where possible, aim to keep your credit utilisation to under 30%. So for a $10,000 limit, this would be $3,000 per month. This tells the credit bureaus that you are responsible with credit and aren't much of a credit risk to them.
Summary
When it comes to the use of credit cards, some will be dead against them and others will rave about the free stuff they get through the rewards programs. Whichever side of the fence you sit on, it's important to remember that credit cards themselves aren't the problem, it's people's spending habits that get them into trouble.
If you have trouble paying your bills on time, have no idea how much you have in the bank on any given day, or have impulse tendencies that cause you to buy crap you don't need, then credit cards aren't for you and should be avoided at all costs.
However if you are good with money, know how to budget and don't think of credit cards as "free money", credit cards can have a place in your financial toolkit.
Treat them like a debit card, pay the balance in full every month, choose a card that's right for you and stay well below the credit limit every month and you'll be just fine. And the most important part is you'll pay $0 in interest and never go into credit card debt, all while reaping the rewards of whatever the card may offer.
Blake - FIRE with a family