Credit Cards: Learn It 2

Risks and Rewards of Credit

Credit cards can give students new opportunities, but owning them is also a big responsibility. Students should consider the advantages and disadvantages of credit before choosing the best plan.

Credit Pros

  • Secure and convenient method of making purchases: When you carry cash, you have the potential of having the money lost or stolen. A credit card or debit card, on the other hand, can be canceled and replaced at no cost to you.
  • Greater consumer protections than debit cards: These consumer protections are written into law, and with credit cards you have a maximum liability of [latex]$50[/latex]. With a debit card, you are responsible for transfers made up until the point you report the card stolen. In order to have the same protections as with credit cards, you need to report the card lost or stolen within forty-eight hours. The longer you wait to report the loss of the card, or the longer it takes you to realize you lost your card, the more money you may be responsible for, up to an unlimited amount.[1]
  • Building credit: If you pay off your monthly credit card every month on time, you will start building credit and have a good credit score early on. Your credit score can be an important factor later on if you decide to open another account or take out a loan. Some employers may even want to see your credit history. While most people associate a credit score with getting better rates on loans, credit scores are also important to getting a job, lowering car insurance rates, and finding an apartment.[2]

Credit Cons

  • Overspending: If something is out of sight, it may be out of mind and the same can be true of money. Sometimes people overspend with credit cards because it’s easy to think that you have more money than you really do.
  • Interest: Credit card companies with student deals still typically include some level of APR or interest rate. If you don’t pay off the entire balance every month, using a credit card can be expensive. 

Suppose you decide to use your credit card to pay for [latex]$1,000[/latex] in school supplies and books. Credit Card [latex]1[/latex] has an APR of ten percent, and Credit Card [latex]2[/latex] has an APR of twenty-four percent.

If it takes you a year to pay off the [latex]$1,000[/latex], you’d actually pay a total of [latex]$1,055.04[/latex] with Credit Card [latex]1[/latex] and [latex]$1,134.72[/latex] with Credit Card [latex]2[/latex] — that’s [latex]$55[/latex] for the first card or [latex]$135[/latex] for the second card on top of the original [latex]$1,000[/latex] you charged.

This example highlights the importance of making sure you pay off the balance as soon as possible AND choosing a credit card with a lower interest rate.

  • Debt: Unlike debit cards, credit cards allow users to borrow money that they can pay back at a later date. While this allowance can be useful in emergency situations, you may end up charging more than you can afford to pay back right away, and you may find yourself saddled with debt. Carrying a lot of debt can damage your credit history and credit score.

The Danger of Debt

When you use a credit card, you take on an obligation to pay the money back, with interest, through a monthly payment. You will take this debt with you when you apply for auto loans or home loans, when you enter into a marriage, when you buy a home, and so on. Effectively, you have committed your future income to the loan.

Compounding Interest

While compounding works to make you money when you are earning interest on savings or investments, it works against you when you are paying the interest on loans. Credit cards acquire compound interest if the statement balance is not paid in full.

The amount of interest you owe on your credit card will vary depending on which credit card you have and what the interest rate is. However, the method most generally used to calculate interest on credit cards is the average daily balance method. This method takes the sum of the daily balances and divides it by the number of days in the billing cycle to determine the average daily balance. The interest charged is then calculated based on this average daily balance.

average daily balance method

The average daily balance method is a way credit card companies calculate interest charges based on the average balance owed each day during a billing period. 

 

[latex]\text{average daily balance} = \frac{\text{sum of the daily balances}}{\text{number of days in the billing cycle}}[/latex]

Paying the minimum payment each month on a credit card will just barely cover the interest charged that month while anything you buy with the credit card will begin to accrue interest on the day you make the purchase. Since credit cards charge interest daily, you’ll begin paying interest on the interest immediately, starting the compound-interest snowball working against you. When you get a credit card, always pay the credit card balance down to zero dollars each month to avoid the compound interest trap.

Signs You Have Too Much Debt

You can consider yourself in too much debt if you have any of the following situations:

  • You cannot make your minimum credit card payments.
  • Your money is gone before your next paycheck.
  • Bill collectors are contacting you.
  • You are unable to get a loan.
  • Your paycheck is being garnished by a creditor.
  • You are considering a debt consolidation loan with extra fees added.
  • Your items are repossessed.
  • You do not know your debt or financial situation.
  1. “Lost Or Stolen Credit, ATM, and Debit Cards.” Federal Trade Commission: Consumer Information, Aug. 2012, www.consumer.ftc.gov/articles/lost-or-stolen-credit-atm-and-debit-cards . ↵
  2. Trouesh, Joshua Escalante. “Four Surprising Ways Your Credit Score Will Affect Your Life.” Purposeful Finance, 2016, www.purposefulfinance.org/home/Articles/2016/four-surprising-ways-your-credit-score-will-affect-your-life . ↵