What exactly does getting a ride in pedicab for portions of a foot race have to do with establishing credit? Smart cookies like you get the metaphor so I won’t bother with a detailed explanation. I’ll just say that establishing a line of simple revolving credit (i.e., getting a credit card) can be a valuable tool for the long haul of the Money Marathon as long as you understand what you must do to avoid the Pits of Pain that can come with using it improperly.
You are already familiar with credit cards. You’ve seen Mom ‘n Dad use them plenty of times, but you may not completely understand how they work, and how they are different from your debit card. I’ll explain.
A credit card is an electronic payment tool granted to you by an issuer (typically, a bank or other financial entity) enabling you to spend up to a predefined amount – your credit limit. When you use a credit card, the issuer actually pays the merchant you purchased goods or services from, and adds the amount to the balance of what you must repay to the issuer, typically on a monthly basis.
While both credit and debit cards offer electronic payment for goods or services instead of using cash, the debit card is directly linked to your bank checking account and nearly as quickly as you used the card to pay, the money is automatically deducted from your checking account. It’s a convenient payment method, but you can’t really spend more money with a debit card than you actually have in your bank account already. With a credit card, you can spend up to the dollar amount of the credit limit the issuer has given you, regardless of whether you actually have the money to pay the issuer back in full at the end of the month or not.
This is how people get into trouble with credit cards.
You see, if you buy more than you can actually pay for at the end of the month, the credit card issuer will gladly offer you flexible terms with a minimum payment that is far less than your total balance (usually between 1 and 3 percent of the balance). Of course, in return for that flexibility they will charge you interest on the amount that you carry forward to the next month.
A lot of interest. How much?
In the previous post, I used the example of 22.99% as the penalty for taking a longer rest in Bart’s pedicab. It was not a random choice. Believe it or not, there are credit cards that charge 22.99% annualized interest on balances carried forward, though the average is around 14 -16%. For context, remember my posts about savings and compound interest. At best, you can expect a bank account today to pay you about 2% annual interest on your money, and many are as low as 0.1%. Even the average returns for your money invested in the US Stock Market is between 7-12%. So, while the best you can plan to make on your own investments is say, 8-10% annually, a bank will gladly charge you 1.5x to 2x that in interest for the convenience of carrying a balance on your credit card. What an awful, awful deal!
To understand just how sinister these terms are and how quickly they can lead you into a Pit of Pain, consider this example:
You get your first credit card with a starter credit limit of $1,000, and you are pleased. It’s a sign that you are making your way in the world, and you are eager to put it to use. You have just the occasion for putting it to work…
The Dodgers are in the World Series for the 11th year in a row, and although they haven’t won it in any of the previous 10, you are sure this is the year. Normally, you wouldn’t even consider attending a World Series game in person because of the cost, but now you have your credit card, and well….you can’t miss this!
Fast forward to the end of November. You can decide if the story goes that the Dodgers finally ended their miserable streak and won it all or choked it for an 11th straight year. It doesn’t matter. What’s important about the date is that this is when you get your credit card bill for the last month’s purchases, which included your World Series adventure. You open it up, take a peek, and nearly faint when you see the dollar amount.
$983.17!
“What in the…?? How did I spend this much? This has gotta be a mistake!!” you whine out loud.
It’s no mistake. With the cost of your ticket, food and drink, and some sweet Dodger gear for the game you racked up over $600 in charges alone. The rest of your expenses were just “normal” things like gas for the car, some work clothes and couple movie tickets. Dang, it adds up fast, and goes easy when you aren’t handing over cash…
“How am I going to pay for this?” you ask under your breath as you pace nervously pace across your living room. Then, you see your saving grace there at the end of the bill.
– Minimum payment: $29.50 –
Whew! You don’t have to come with $983.17. You just need $29.50. No problem. That, you can afford!
With that, you have fallen into the credit card Pit of Pain, as so many people do when they first get a credit card. The issuer is willing to let you spend up to $1,000 that you don’t really have, and all you have to do is pay them back slowly at $29.50 each month.
It seems like a great deal.
It isn’t.
Assuming you have a card that charges “only” 14.99% on balances carried forward, guess how long it will take and how much interest you’ll pay to clear the original $983.17, when paying the minimum each month?
About 7 years of monthly payments and roughly $500 in interest.
That’s right, because your credit card issuer offered such flexible terms of repayment and you used them, you effectively increased the cost of the original purchase to nearly $1500, and saddled yourself with payments for 7 years. And…that’s if you didn’t use the card again and never add to the balance in subsequent months and years.
If that wasn’t bad enough, as you pay it off slowly but diligently, the credit card issuer sees that you can be trusted to make that payment every month, and guess what they do? That’s right….they increase your credit limit.
Originally the maximum balance you could carry was $1,000, but because you are such a reliable customer they increase your limit to $10,000! At first, you have the discipline to avoid using that extra credit, but over time you wear down and start to make more purchases with that card every month. Before you know it, that original $983.17 balance has ballooned and you are carrying a balance of more than $5,000. Now you are looking at nearly $3500 in interest and almost 15 years to pay off the balance if you continue making the minimum payment. Ugly.
It’s a vicious, wealth-sapping Pit of Pain that so many young people fall into.
But, not you.
You as a smart Money Marathoner go ahead and get the credit card – just like everyone else – but you resolve to never charge more to the card than you can afford to pay back in full and on time, every month.
Because you use your credit card this way, there’s never any interest charges to you. What you spent in goods and services the previous month is exactly what you pay back to the credit card company. So just like the agreement you made with Bart for his assistance and access to his pedicab, the credit card is a helpful tool in your progress toward financial independence. Not only do you get the convenience of the digital payment method and a short deferral of having to pay for your purchases each month, but you get something even more valuable out of it: a credit history.
You probably aren’t up to speed on the value in building a good credit history, but over time, it will become abundantly clear. You see, as you are making those in full and on time payments back to the credit card company each and every month, the payment history is being recorded with an entity called a credit bureau. Credit bureau’s hold a great deal of sway over your future financial maneuverability (too much, imho, but that’s a topic for another time) so it’s important you know about them, what they do, and how they can impact your financial future.
The 3 major credit bureaus aggregate the information they get from businesses (banks, lenders, retailers, etc) that have issued you credit. As you diligently pay that bill each month, the credit bureaus will be at work behind the scenes tracking whether you are paying on time or not, as well as other things about you and your credit like: how much total credit you have available, what your balances are and how long you’ve had credit for. In a nutshell, they are building your credit history. Another set of companies use the credit history data to give you something called a credit rating or credit score and the most widely known of these is the FICO score (Fair Issac Company).
As you build a solid history with your 1st credit card, your FICO score will creep up. The better and longer your credit history, the higher your FICO score will go. Of course, things like late or missed payments will make your score go down. There are other things that impact your credit score, but payment history is the biggie, and it’s the one you can most easily control by always making your payment on time and in full, every month.
I realize this is a lot of boring detail about credit cards and how they work, but here’s why it matters. Recall I mentioned the credit bureaus and credit score companies have a lot of influence when it comes to your financial maneuverability? The reason for this is that as you progress through the Money Marathon, you’ll likely have your credit checked by others for a number of reasons, including:
- Additional loans – e.g., a loan to buy a home, an automobile, or business loan
- Renters application – Landlords often do credit checks on prospective renters
- Job applications – Believe it or not, employers often check candidate credit history
With a good credit score, you’ll have access to better loans (i.e., lower interest rate loans) for future strategic purchases, and your score won’t keep you from getting the apartment you want or the job you need.
With a bad score? Everything is obviously harder. Lenders may not lend you money at all, or if they do, they will do so with much higher interest rates because you are a credit risk. That nice apartment complex or awesome new job might just be out of reach because your credit history suggests you aren’t trustworthy and reliable.
Lastly, what about “no” score? What if you have no measurable credit history at all? It might be better than a bad score – maybe – but its definitely not better than a good score. If you are independently wealthy and never need to borrow any money to live the lifestyle you desire nor have to rely on the trust of others for accommodation – btw, let me know about this because I’ll hang in your basement – having no credit history won’t matter much. However, most folks will appreciate the advantages afforded them with a good credit score over the long haul of the Money Marathon.
So, just like seeing the advantages in signing up for Bart’s pedicab, even with the potential risks, do go ahead and get that credit card, and do use it. But…make sure to never spend more than you can payoff immediately, and make sure to make that payment on time and in full every month.
The Money Marathon 