Credit cards – they certainly can be one hot topic of discussion. Unfortunately, some of those conversations I’ve been a part of end up being one hot mess. Everybody seems to have an opinion. Many of those opinions are based on something someone told them somewhere. But you know what they say about opinions – they are like butts. Everyone has one and a lot of them stink. So let’s get rid of the credit card opinions out there and deal with the facts. Just the facts.
There are a few common credit scoring models out there. Each of the three main credit bureaus have their own scoring system. Then they’ve come together to cooperatively build another scoring model. The Fair Isaacs Corporation (FICO) is independent of the credit bureaus and is the score that 90%-95% of lenders use to decide where or not to lend to a consumer. Because it is so commonly used, the information below is based on the FICO system.
Working with the counselors at Center for Financial Resources, I’ve come up with a list of lies you may be told regarding credit cards. Below is our list and then the facts debunking those lies.
“Credit cards are evil (or just not a good idea).”
It’s an idea that’s out there, sometimes even supported by more well-known financial ‘gurus’. But it’s wrong. The card isn’t the problem; it’s the way some people use them. Run up a large amount of debt, then pay late or don’t pay and yes – you will pay a lot of penalties and interest.
But use credit cards wisely and you build a solid credit history. Because credit card accounts can be kept open indefinitely, they provide a long-term example of you being able to maintain an account in good standing. Credit cards can help cover unexpected expenses that may be necessary, like fixing the car so that you can get to work, get paid, and continue to pay your bills.
Other benefits of credit cards include convenience and security (try stopping anyone from using the cash that you lost somewhere). And then there are the perks – the side benefits. I know of one small business that uses their credit card for all purchases and then uses the points to take their employees to the Caribbean for a “staff meeting”. How is that evil?
“Charge a little each month to help your credit score.”
I get it. Every time you swipe your credit card, you are taking out a loan. Without using it, you aren’t making a payment and so don’t get that benefit to your credit report. Except, based on research and my own credit report, this isn’t quite right. Even in months when I never used a card and so had a zero balance and no payment due, my credit report still showed my payment as arriving on-time an in-full. Further, not using the card at all keeps your credit usage ratio down, thereby actually improving your credit score.
There is, however a reason to use a card occasionally. Without at least occasional use, the account may be shut down by the credit card company for non-use. This, in effect, may hurt your credit score because you no longer have the credit available to you and have stopped the clock on an account when you get credit score points for account longevity. Just be careful of the slippery spending slope. A monthly pack of gum may well be enough to keep the card open. You don’t need to go buy a new car on your credit card.
“Close any accounts you aren’t using.”
It’s a security thing. Your accounts won’t be hacked, stolen, or otherwise be tempting you to exploit them. Except FICO bases your score in a large part on how much credit you currently have available to you. Shut down your unused accounts, and you reduce the credit you have available. This can further hurt your score as they then calculate how much of your available credit you are currently using. This is your credit usage ratio. Decrease the amount of credit available to you and you increase your usage ratio without even spending another penny. This can hurt your score, sometimes significantly.
A word of moderation – You can actually have too much credit available to you. If you have a dozen different cards out there that you aren’t using, closing a card or three may not have that much of a negative impact on your score. It’s going to be a bit of a balancing act for you.
“Minimum payments are sufficient.”
True, you are meeting the credit card’s requirements. But let’s do some math here. Say you have a $2000 balance on a credit card with an annual percentage rate (APR) of 18% and a minimum monthly payment of 2% of your balance. These are pretty average numbers across the industry. Your minimum payment for the first month is going to be $40. But that doesn’t all go to pay down your balance. Based on these numbers, $30 of your $40 payment will go to pay interest. That means your balance is only reduced by $10.
When interest is calculated the next month, it is now based on the reduced balance. Your interest due is reduced by a whopping $.15. That’s right, you are now only paying $29.85 in interest and an extra 15 cents towards your balance. But if you are sticking to only making minimum payments, your minimum total payment for the month is now only $39.80, meaning you are only applying $9.95 towards paying down your balance. THAT’S LESS THAN THE FIRST MONTH’S PAYMENT!!!
If math isn’t your thing and this isn’t quite making sense, let me simplify all of this. Making minimum payments on $2000 of credit card debt will take you over 30 years to pay it off. If you don’t add any more debt to the credit card. That’s longer than it takes to buy a house. ‘Nuff said?
“If you are approved, you can afford it.”
“They aren’t a lender. They are your partner for life and business. They are here to take care of you.” Huh? I thought lenders are, first and foremost, in business to make money. They may or may not look into your income and other debt. They most likely won’t ask about your other goals that will require some money. They are, in effect, finding the balance of being able to make the most money possible off of you without risking absolutely everything of their own. Don’t get me wrong. Lenders are generally good and even a necessary part of life. But let’s be honest about their priorities.
This is really going to be on you to figure out exactly what you really can afford. While most lenders will use your gross income for their calculations, you should use your net income. Your net income is what is left after taxes, deductions, and whatever else comes out before you actually get paid. Net income is what you actually deposit in your account and have available to pay the bills. This is the amount a functional budget should work with.
Perhaps it’s too late for you. You’ve believed the lies or perhaps just ended up in trouble. Now your credit card bills are starting to overwhelm you. Don’t worry, there is hope. You have a number of options available with varying degrees of success and impact. If you aren’t sure where to start, a first appointment with one of our counselors at the Center for Financial Resources can help you start to sort things out. Just give us a call at 605-330-2700 to schedule your visit. We won’t get hung up on the past, but will look forward to the future and dealing with your debt.
And if you have one of ‘those’ people in your life that insists they are right because Someone somewhere said something, find out where Someone lives. While I’ve heard a lot about Someone, I’ve never actually met them before. I sure would like to ask Someone a few questions…..
written by Breck Miller
images courtesy freedigitalphotos.net