Image Credit: iStock
When I got my first credit card at age 24, I felt like a new world had opened up to me.
Just that fast, I could swipe a card and purchase anything I wanted. Well, not anything, of course. My credit limit was only about $10,000 or $15,000. But almost anything less than that I could buy with the snap of my fingers, even though my net worth was basically nothing (or less than nothing)..
Like many young people, I had plenty of debt (mostly student loans) and few assets. Yet someone deemed me a low enough risk to issue me a card, and I quickly began using it like crazy.
I’d go to the movies with a date. Swipe.
Go to dinner. Swipe.
Buy beer, gas, and clothes. Swipe. Swipe. Swipe.
It was rather empowering and made me feel like an adult (which I was, even if I rarely felt like one). Even better, I learned I was actually earning rewards for swiping my card! It was like I was getting paid for the convenience of swiping. I didn’t know how any of this worked, mind you, and had never really thought about it before.
From the beginning, my experience with credit cards was a positive one (with a lone exception that I will explain in a moment). The horror stories you hear about people drowning in credit card debt and paying insane amounts of interest was not my experience.
Looking back on it, I understand why. So here are a few things you should know before you get a credit card yourself.
1. Credit Cards Are a Road to Good Credit
One of the reasons I got a credit card in the first place was because people told me I had to “build a good credit rating.” It turns out this was good advice.
“Getting a credit card and using it regularly and responsibly is one of the quickest and most effective ways to build or rebuild your credit,” Nerd Wallet explains.
Building good credit is important for a couple of reasons. Unless you’re super wealthy or have rich family members who just love spending money on you, there’s a high probability that you’ll need to borrow money from a bank someday to make a big purchase, such as a new car or a house.
Having good credit means you’re more likely to get that loan, which is important. But it also means you’re likely to get a better interest rate on your loan because the bank sees you as a lower risk.
A lower interest rate on a long-term loan is a big deal. It could mean the difference of tens of thousands of dollars (or more) depending on the type of loan and its duration.
The caveat, of course, are those two words NerdWallet used: “regularly” and “responsibly.” Which brings me to point two.
2. Paying Your Monthly Balance Is Smart
As mentioned, I used my credit card for almost everything I bought, which was great because I built up rewards for every purchase I made. But I also made sure to do something important: I paid off my credit card balance every month.
This is smart for two reasons. First, making regular payments on your regular purchases is how you build that good credit rating. Second, by paying off your balance each month you’ll pay zero interest on your credit card.
Zip. Nada. $0.
This is important, because credit card interest rates tend to be pretty high. A typical student loan interest rate these days is about 5.5 percent for undergrads. Home mortgage rates are nearing 8 percent. The average auto loan for a used car is about 11 percent. The average APR on a credit card right now beats them all—24.5 percent, according to Lending Tree.
Pay your balance each month, however, and you don’t need to worry about that sky-high rate. If you ignore this advice, you could find yourself as one of the people carrying $85,000 in credit card debt and no way to pay it off with the juice running.
3. Know Your Rewards
I’ve written before about how much I love my credit card rewards. So what are rewards?
For those who don’t know, credit cards generally come with one of three types of benefits: cash back, miles, or points. Cash back is my personal favorite because, well, who doesn’t love cold-hard cash?
Points were the first type of reward I had with my Amazon card. I’d accumulate points by using my credit card, and I could use those points to make online purchases on Amazon.com. Miles, meanwhile, are offered with many travel credit cards. Instead of making general purchases, points can be applied to flights (and often hotels) to reduce the expense of air travel.
Know which card best suits you, and make sure to redeem your points.
4. Understand (Daily) Compound Interest
Understanding compound interest can be a great way to get your financial house in order if you’re trying to leverage your wealth to benefit you in retirement. But not understanding can also lead to financial ruin.
As I mentioned, paying off your credit card balance is the way to go. But not everyone reading this article will follow that advice. There may be times you simply can’t pay off your balance because you don’t have the money. (The reality is, a stunning percentage of Americans today use credit cards today to make ends meet, meaning they are living paycheck to paycheck and using credit cards to fill in the gaps.)
If you need to run a balance on your credit card for a while during a tough stretch, ok. Just remember that the (high) interest is running, and there’s a good chance the interest is accumulating daily.
Most people probably know how compound interest works, but I’ll offer a refresher. Interest accumulates—whether it’s on a loan or in a savings account—at a rate: daily, monthly, quarterly or annually. The more interest compounds, the faster the amount grows.
If you have a certificate of deposit with daily compound interest, that’s great because your interest is accumulating daily, which means more interest. Daily compound interest on debts is another story. It means interest on your debt is being accumulated daily, which means your debt will snowball faster.
Most credit card companies use daily compound interest, which is why so many Americans find themselves in credit card debt. A high-interest rate combined with daily compound interest is a formula for trouble for the undisciplined credit card holder.
5. Too Many Cards Can Cause Problems
As mentioned, my experience with credit cards was mostly good. Which is to say I did have one bad experience.
After using a credit card for a couple of years, I got the bright idea of getting another one. It happened when I was shopping at Banana Republic and the cashier said I’d get a 40% discount on my clothes if I signed up for their credit card. It seemed like a good deal; so I signed up and used the card sparingly for a couple years, always paying off the balance.
At some point, I decided to get rid of the card because I rarely used it. So I paid the balance and canceled the card.
I thought it was over, but it wasn’t.
Months later (I don’t recall how many) the credit card company sent me a bill, telling me there was still an outstanding balance on the card from a single small charge that had grown to more than $100.
How the charge got there I don’t know. Perhaps I used it by mistake at the bar after a few drinks and the charge hadn’t been processed yet when I canceled the card, or perhaps I was the victim of fraud.
Whatever the case, that small charge turned into a headache for me because I told them I wasn’t going to pay it. (Eventually I settled the charge, but by then for more than double the $100 I initially refused to pay.)
All of this is to say credit cards can be useful and beneficial, but they need to be managed responsibly. Having multiple cards can make it more difficult to track spending and pay your balance, which my case demonstrates.
Managing finances isn’t easy, and many of us learn lessons the hard way. But armed with basic financial literacy and self-discipline, the industrious person is likely to find the path to financial independence easier than he might think.
The post 5 Things You Should Know Before Getting a Credit Card was first published by the Foundation for Economic Education, and is republished here with permission. Please support their efforts.