Charge Me Up – How Credit Cards Work

I was first handed a credit card at the age of 16, when I got my driver’s license. You see, my first car was a 11-year old Volvo. It was just old enough to be old but not old enough to be vintage. In other words, it wasn’t a cool car, but it was four wheels that got me where I needed to go and that was the important part. Let’s circle back to why I started this story in the first place. The car was in perfect working order, except for the gas gauge. It was my family’s spare car for a number of years, and we knew the car could safely go 240 miles on a full tank. That meant every time I got gas, I had to fill the tank all the way, and it was imperative to remember to reset the mileage counter. Unlike my friends who could put in $5 of gas at a time, I had to have the funds to cover up to a full tank of gas every single time I was at the pump. This was no easy feat for a 16-year old.

A credit card is a short-term loan.

 

The Economic Principle:

Credit cards offer consumers the ability to charge items without having to immediately pay cash. We’ll get into why this is good and bad below.

 

The thing about credit cards is that handled responsibly, they can give you a great many benefits. These can include things like cash back, miles, points to stores, etc. Basically, you’re getting these benefits for free when you spend money you were going to spend anyhow. Here’s the rub: it’s only a benefit if you pay your card off every month. If you’re carrying a balance, those benefits are not free.

 

Credit cards make money off of you in a few different ways:

• Purchases: The credit card company charges vendors (the places or people you pay) a fee on every charge
• Late Fees: Make sure you pay at least your minimum payment on time every month. These fees are the equivalent to lighting money on fire. You are in full control of your payment being made on time, so just make sure you do, okay?
• Interest Charges: This is the scourge of anyone with a balance on their cards. Usually, the rates are very high, and they charge compounding interest – some daily, some monthly. Compounding interest means that you get charged interest on your interest. This makes credit card balances the equivalent of very expensive loans
• Annual Fee: Some cards that offer great benefits charge an annual fee for the privilege of using the credit card. If you use the card a lot and the benefits surpass the fee, this may be a worthwhile expense. That said, if you’re carrying quite a few cards and they all have annual fees, maybe focus your spending on one or two accounts and forego the rest.

 

As we discussed in last week’s blog post, while carrying a balance on your cards will impact your credit score, consistently paying at least the minimum payment every month gives you a good payment history, which is the largest percentage of what makes up your credit score.

 

So, what can you do if you’re carrying a credit card balance? I’ve seen a few recommendations for working with professional companies to help you reduce your interest rates or consolidate your loans. If you want to try going at it alone first, a popular method is called the Debt Snowball.

 

The Debt Snowball:

This method consists of paying off your smallest debts first, so you rack up wins along the way in your debt payment journey. Simply put, make a list of all of your outstanding loans in order by amount. Pay the minimum amount on all of your debts every month and any extra money should go to the smallest debt. As you get rid of the smaller debts, you can put more money towards the larger payments until you’re down to one large debt and you are focusing all of your payments on that single debt.

 

With all that said, I’m going to end this blog post sounding like a PSA: charge responsibly!