Our article below shares eight easy-to-learn but extremely important facts about credit cards, including the credit card trap and how to avoid it and why you shouldn’t be a “credit card tart.”
All consumers should know how credit card debt is easy to get into, but harder and harder to escape as time goes by. They should also know it’s easy to avoid the credit card debt trap, and how to do it. Other must-know facts about credit cards include the different ways credit cards affect the credit score, why and how to avoid being a “credit card tart,” and how to choose the right credit card. Consumers should also know why not all credit card debts are equal, and the importance of understanding the different interest rates on their credit cards.
1. Credit Card Debt is a Trap that Gets Stronger With Time
Credit cards can put consumers in a financial trap that eventually can become impossible to escape from.
The $30,000 Television
A consumer who buys a flat screen TV for $1,000 on even a low-rate 12% interest credit card will rack up $120 in interest during the first year. While that doesn’t seem like much, if that same consumer can’t pay off the debt in year two, an additional $134 in interest charges will accumulate. The third year will add $150 and the fourth $169. The interest charges keep growing each year, and by year 30 they’re $3,210. Adding up all the interest charges for 30 years, the total cost of that $1,000 TV in fact has become $30,000
The Six Million Dollar Habit
While nobody intends to put $1,000 on a credit card and then fail to pay it off for 30 years, this exact situation happens every day. The person who buys a $1,000 TV might buy gas, groceries and other items the same month, then pay off those other purchases but be unable to pay off the TV. Month to month, as bills and purchases pile up, that $1,000 can easily linger on the bottom of the credit card balance for decades.
Terrifyingly, the $1,000 example above is actually a best case scenario. The average American has $16,000 in credit card debt. Carrying that balance with typical 15% interest payments for the average working lifetime of 40 years will amount to a staggering $4,286,000. Boosting that interest rate by just one percent adds another million and a half for a total of almost six million.
The credit card debt trap can and does happen to anyone. Worse, studies show that credit cards make consumers spend more. The thinking is that cash “hurts” while credit cards seem easy, encouraging higher spending, which of course results in higher debt and a stronger debt trap.
The average credit card interest rate is 14.95%. Some credit cards have slightly lower rates while others can be significantly higher, up around 35% or more. Even using a low interest credit card with an almost unheard of low rate of around 12% could devastate someone’s finances.
Also see: Best Student Credit Cards
2. It’s Not Hard to Avoid the Credit Card Debt Trap
To avoid the credit card trap described above, credit card users should steer clear of interest payments altogether. This can be done by adhering to the following rules:
- Pay off credit card debt monthly. Paying off credit card debt each month and reaching a $0 balance not only feels good, it also avoids interest charges.
- Never use credit cards to buy things you can’t afford. Using credit cards to buy products or pay off debts you can’t afford only creates a bigger problem the next month. Someone who can’t afford a $1,000 TV this month likely won’t be able to afford the $1,000 debt the next month either.
- Use credit cards only for things you can afford. There’s no denying that carrying a plastic card around is easier than carrying and using cash or a checkbook. Having a budget and sticking to it can help you avoid the credit card debt trap and interest payments. In fact studies show that those who use budgets are 20% richer than those who don’t. For help starting a budget, check out our related articles on how to make a budget and the 7 best iPhone budget apps.
- Use credit cards to build a good credit history. Using a small amount of available credit each month and then paying it off builds a strong credit score. Using too much credit or carrying a balance won’t just cause high interest charges – it’ll also make a credit score nosedive.
- Always pay more than the minimum balance on credit cards. This is another way of saying, “pay off credit card debt monthly,” but its importance can’t be overstated. Those who only pay the minimum can easily end up paying more in interest than the cost of the items they bought.
3. Know How Credit Cards Affect Your Credit Score
Good credit is vital. People with good credit get approved easier and get lower interest rates on credit cards and loans than people with bad credit. Someone with a credit score in the 750-850 range can expect an interest rate 1.5% lower on a home loan than someone with a score in the 580 to 640 range. While 1.5% doesn’t seem like much, the home buyer with the 1.5% lower interest rate will pay about $65,000 less for the same 30 year $200,000 home loan. Put another way, someone with good credit who carries a $500 credit card balance for five years can pay $1,300 less interest than someone with poor credit. That’s because the person with good credit can likely get a credit card with a 15% interest rate or lower, while someone with bad credit might be up in the 36% interest range.
Credit cards affect a person’s credit score in a number of ways, including:
- Late credit card payments wreck credit scores for a long time. A late payment sticks to a credit report for seven years, dragging it down significantly. Credit card payments aren’t considered “late” just because the payment didn’t arrive by the due date on the bill. Though credit card companies can charge late fees and interest for a payment that’s one day past the due date, they can’t report a late payment to a collection agency until 30 days after that.
- Delinquent credit card debts crush credit scores. An account is considered delinquent if no payment has been made 30 days past the due date. Delinquent accounts stay on credit reports for seven years. Delinquent accounts that go 60 days hurt credit scores even more. At the 90 day mark, delinquent accounts hurt still more. According to data from FICO – the company that computes credit scores – even someone who’s never missed a payment before can see a 110 point drop in their credit score from one 30 day delinquent account.
- The “right number” of credit cards can raise or lower a credit score. While there’s no exact right number of credit cards, too few cards can hurt a credit score because of something called the credit utilization ratio, explained below. Too many credit cards can also hurt, because banks might decide the consumer has too much potential debt.
- The credit card “utilization ratio” can raise or lower a credit score. The utilization ratio is just a measure of how much available credit someone has compared to how much credit they’re using. A consumer with a single card with a $1,000 limit and a $500 balance has a 50% ratio. Someone with two cards, each with a $1,000 limit and a total of $500 in debt has a 25% ratio. Generally speaking, the lower the ratio, the better the credit score.
For more information on credit scores, credit reports and how credit cards affect them, see our article on good credit scores and our piece on how to hack your credit score.
4. Don’t be a “Credit Card Tart.”
There’s a lot of advice on the internet telling consumers to transfer their credit balances to new cards with 0% interest on a continuing basis. A credit card tart is someone who takes their credit card debt, for example $2,200, and transfers it to a 0% card and leaves it there until the card’s six month or one year introductory period ends. They then transfer the debt to a new card with another introductory 0% interest rate and leave it there for another short time.
While being a credit card tart does avoid interest charges, it can also damage a credit score. That’s because one factor that affects the credit score is the average age of the consumer’s credit accounts. Someone who keeps transferring balances from one card to another will have a lower account age than someone who sticks with the same card year after year. While this factor has less of an impact than payment history or the credit utilization ratio, it can still hurt a credit score.
A far better policy than being a credit card tart is paying off the debt every month and not letting it grow to an unmanageable size in the first place. That said, someone who’s already built up a pile of credit card debt will save money by moving balances ever year or two to 0% interest cards. The interest savings in high debt situations will likely outweigh the damage to the credit score.
5. You Can Find Out What Credit Card Companies Are saying Behind Your Back
Credit card companies talk to each other about consumers all the time, through reports they make to collection agents and the three credit reporting bureaus. Based on what credit card companies and banks say, other credit card companies may or may not approve consumers for credit cards. The information in the reports also helps decide whether a consumer gets a high interest rate or a low one. That could mean the difference between a 15% card that charges $3,000 in interest on a $1,000 purchase over ten years, or a 36% card that charges $20,000 for the same purchase.
To find out what’s in the reports, each consumer should get a copy of their free credit report and examine it as often as possible.
6. Know Which Credit Card to Choose
There are many different kinds of credit cards. Regular credit cards, secured cards, rewards cards, business cards, prepaid cards and student credit cards offer different perks. Knowing which card to choose can save money and provide different benefits. Subrpime credit cards are pricey cards for people with bad credit and consumers should generally avoid them.
- Regular credit cards charge interest for purchases and come with different interest rates.
- Rewards credit cards offer additional incentives like cash back or airline miles.
- Business credit cards can have higher credit limits and help business owners keep business and personal finances separated.
- Student credit cards can give students a way to build a good credit history.
- Prepaid credit cards or debit cards don’t help users build their credit score.
- Subprime credit cards often have very high rates and unreasonable fees and should be avoided at all costs.
- Secured credit cards help those with poor credit to build a good credit score. For more info, see our full article on secured credit cards.
For more details on the different types of credit cards above, see our full article on the different kinds of credit cards.
7. Not All Credit Card Debts Are the Same
Some financial advisors recommend paying off the most expensive debts first. A consumer who consistently pays down their debt on a credit card with a 12% interest rate while leaving a $1,000 balance on a 36% card will owe $20,000 more after 10 years than someone who shifts the balance to the 12% card.
Even Debts on the Same Card Can be Different
Some credit cards have higher rates for purchases than for balance transfers. That means the same credit card might charge 0% for balance transfers and 20% for purchases. Cards can also charge higher rates for cash advances and late payment amounts. The credit card companies keep a record of which debts are which in each account.
Credit card issuers are required to apply payments above the minimum payment amount to the highest balance first. However, for people who make only the minimum payment, credit card companies apply the entire payment to the debt with the lowest interest rate, ensuring higher total interest payments. This “negative payment hierarchy” on minimum payments is another reason to pay more than the bare minimum every month.
Reading the fine print at the bottom of any credit card offer can make a difference of tens of thousands of dollars. For more on how to use a card’s interest rates to save you money, see our full article on credit card interest rates.
- Rate Survey: Credit Card Interest Rates Fall to 14.95 Percent – CreditCards.com
- Controlling Your Personal Debt – CNN.com
- Spending and Credit Cards – Psychology Today
- Can One Late Payment Affect My Credit Score? – Equifax.com