Spending on Credit
How to leverage credit and steps to get out of debt.
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TL;DR
- Debt should be used sparingly, given the associated costs and risks
- You have more than one credit score, a number between 300 and 850 that represents your personal creditworthiness, that you can check periodically for free
- Credit card incentives should never be considered a tool to make money
- Getting out of debt starts by categorizing what you owe and budgeting monthly repayments toward high-interest, revolving debt
What is Credit
Credit is a financial relationship between a creditor, or lender, and a borrower, or debtor. The borrower promises to repay the lender, often with interest, or risk financial or legal penalties.
Credit allows you to pay for expenses before you have the cash in hand to do so. This can be useful for many scenarios ranging from paying bills before you receive a paycheck to using a loan to finance college, a car, or a home. When borrowing money, you, as the borrower, have an obligation to repay the lender when the balance is due. If you don't, this can negatively impact your financial reputation and potentially cause you to lose the items not yet paid off.
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Use credit to pay when you don’t have cash
This chapter focuses on credit cards and debt management best practices, while other chapters explore student loans, auto loans, and home loans in more detail.
Credit Advantages
A credit card is an open-ended loan that allows you to borrow money up to a certain limit and carry over an unpaid balance from month to month. There is no fixed time to repay the loan if you make the minimum payment due every month. A credit card company limits how much you can charge to your card when it is issued to you; this is called a credit limit. You can then use the credit card to make purchases up to this limit.
Credit cards can be a useful tool for spending on everyday expenses so long as you can repay the balance on time. Doing so improves your credit score, a number between 300 and 850 that represents your personal creditworthiness. The higher your credit score, the easier it is to be approved for recurring expenses like an apartment lease or phone plan. Additionally, institutions reward those with higher credit scores by charging them lower interest rates — the fee for borrowing money.
Credit Risks
Risks to spending with a credit card emerge when you can’t repay the balance. When repaying credit card debt, you can pay either the total balance due or the minimum balance, a lower amount that allows you to pay back the difference later. Credit card companies make money by charging interest on this outstanding delta. The average interest rate is 24.37%, but this can be lower or higher depending on your credit score.
Repaying credit at a later date is, therefore, significantly more expensive than repaying the total balance each month. As this debt accrues, it can become more challenging to repay the minimum balance, and if you don’t repay the minimum balance on time, your credit score can be negatively impacted.
A lower credit score makes institutions less trustful of your money habits and more likely to deny you a loan or charge a higher interest rate. This can lead to a negative cycle in which those with growing debt find it increasingly more expensive to repay.
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Credit Score Factors
Cultivating and maintaining a high credit score is imperative to maximize the utility of borrowed funds. To attain a high credit score, pay your credit card bill and other debts on time to show you are a reliable money manager. In general, only make credit card purchases for expenses you can afford to pay off immediately or within a reasonable time frame. Whenever possible, pay your credit card bill in full each month, but if you can't do that, pay as much as you can over the minimum amount due.
Check your credit reports regularly to ensure your personal and financial information is accurate. If you find errors on your credit report, take steps to have them corrected.
Credit bureaus — private companies that determine individual creditworthiness – calculate your credit score by using data provided by lenders. There are three major credit bureaus: Experian, TransUnion, and Equifax, and each has its own unique rating system referencing (potentially) different lending data. Therefore, you actually have three credit scores that each can be referenced depending on the lender. While each bureau’s rating system is proprietary, all three rely on similar inputs to determine your credit score:
- Payment History: This reflects whether or not you make payments on time on each of your accounts. Payment history makes up ~35% of your credit score.
- Credit utilization: This refers to the percentage amount of available credit used. If possible, spend below 30% of your total available credit. Credit utilization accounts for ~30% of your credit score. You can ask your creditor to raise your credit limit, therefore decreasing your credit utilization, however, you should wait to do this until you're making more money and you have good credit. This request will likely be denied if you show signs of financial distress.
- Credit age: Credit age shows how long you’ve had credit and how old each of your accounts is. Try not to close older accounts unless they’re full of negative information. Credit age makes up ~15% of your credit score.
- Credit mix: This covers the types of revolving and fixed-payment credit accounts you hold. Lenders prefer a diverse credit mix. This factor accounts for ~10% of your credit score.
- Credit inquiries: This is the number of times you applied for new credit in the last few months or years. These applications make up ~10% of your credit score.
Under the terms of the Fair Credit Reporting Act, a law that protects information collected by credit bureaus, you can view each of your credit reports for free once a year via AnnualCreditReport.com. You can also purchase copies of your credit reports directly from the bureaus. And if you get rejected after applying for credit, you’re entitled to a copy of your credit report then.
Choosing a Credit Provider
Different credit card providers charge different interest rates and fees, so it’s important to understand all expenses involved before making a decision. When choosing which is best for you, compare terms and decide which card type meets your needs. An overview of terms to compare is below.
APR: A credit provider’s interest rate is called its Annual Percentage Rate (APR), a standardized measurement of the yearly interest rate charged to borrowers. Sometimes a credit card offer lists a range of rates, and you won’t know the rate you’ll get until you’re approved. Would you still want the card if you had to pay the higher advertised rates? Some credit card providers offer an introductory or promotional APR, which is lower for the first six months of owning the card than after. As you’ll likely be using the card far beyond the introductory period, the post-introductory period APR should be your primary point of comparison with other providers.
Fees: Compare the fees listed for each card. Common fees include a cash advance fee, a late payment fee, and for some cards, an annual fee.
APR for balance transfers: If you plan to transfer your balance from one card to another, compare the interest rate you are paying now with the rate you’ll pay on the new card after the introductory rate, plus any balance transfer fee.
Penalty APR Check for a penalty APR: The offer must tell you what the penalty rate is, what triggers it, and how long it would last.
Begin your comparison of credit providers by starting at your bank or credit union, as your existing relationship may qualify you for a better offer. Next, compare that offer against others you’ve received or seen online. If you have a credit card and are happy with the service but think you’re paying too much interest or fees, ask the issuer to match or beat the terms of the new card you’re considering. Only apply for the credit you need, as applying for too many cards over a short period can lower your credit scores.
If you have an existing credit card and are deciding whether to transfer the balance, pay careful attention to the associated fees. Even a zero percent interest rate on balance transfers may not be free, as some credit card companies charge a one-time fee of 3 to 5 percent of the balance you’re transferring. Additional information regarding fees, terms, and transfer best practices is available on the CFPB website.
In addition to fees, focus on the credit card type best suited for your needs, given your credit experience. There are many different types to choose from, varying in complexity and promotional features. The simpler the card, the easier it is to manage and build credit. Once spending with credit becomes comfortable, you may opt for a specialized card offering more features.
Introductory Credit Cards
- Student Credit Cards: These cards are designed to help current college students establish and build credit. Student cards may have lower credit limits and provide tools to help students manage their cards. Some student cards offer specialized benefits, including cash-back and travel rewards.
- Secured Credit Cards: A secured credit card requires you to provide a cash security deposit, usually equal to your credit line. The issuer holds the deposit if you don't pay your bill; you get the deposit back when you upgrade to a regular "unsecured" card or close the account in good standing. Because the deposit protects the issuer from losing money, secured cards are easier for people with bad or no credit to qualify for.
- Standard Cards: The standard credit card allows you to have a revolving balance up to a certain credit limit. Credit cards have a minimum payment that must be paid by a specified due date to avoid late-payment penalties.
Specialized Credit Cards
- Rewards Credit Cards: As the name suggests, rewards cards offer perks on credit card purchases. There are three basic types of rewards cards: cashback, points, and travel. Cashback cards return a percentage of cash to the cardholder for every dollar spent on credit, while points represent money that can be redeemed for cash or other merchandise with partners of the credit card issuer. Travel rewards cards give users points that can be used on flights, hotel stays, and other travel expenses.
- Affinity credit cards: Affinity credit cards are those offered in partnership with a non-banking institution such as a sports team, store, or charity. These cards offer promotions and discounts as incentives to use them as a source of credit.
This list is not exhaustive. Additional credit card types are listed on the FDIC website.
The Risks of Rewards
Many credit card companies offer rewards in the form of points, miles, or cash back as an incentive to use them. These incentives can be appealing to those comfortable managing their credit and a liability to those who are not. Each of these incentives works by providing users a portion of the money they spend on credit back to them. On average, for every dollar spent on credit, the value of the point, mile, or cash back is one percent: a penny. Compare this with the average credit card interest rate in America, 24.37%, and you can understand why credit card companies provide this incentive: they make more money from customers than they reward them.
Credit card reward systems come with some additional limitations. Companies that offer rewards often charge additional fees to use the rewards you earn. The value of the rewards can fluctuate, be difficult to redeem, and may come with surprising restrictions. For example, a travel rewards card may offer one point or “mile” for every dollar spent on credit. Knowing that the average mile is worth one penny, a $500 flight paid for with points would require spending approximately $50,000 on your credit card. Using these points may come with additional fees and blackout days on travel. And, if you miss any payment while spending on credit, the added cost of interest further depreciates the value of points earned. For these reasons, a credit card should never be seen as a tool to make money. Much like a casino, the house always wins.
Managing Debt
