How to Manage Your Credit Card without Falling into a Debt Trap
Many old-school financial advisors draw a line on sand saying that credit cards are not to be dealt with – ‘They are evil. Do not own them and do not use them.’ But we, at PersonalFinanceGuide, do not fall into that category of advisors. In fact, we encourage you to use a credit card. But there are a few golden rules to follow if you choose to do so. In this article, we explore how you can stay ahead of the debt traps of credit card companies.
Credit cards give benefits
One of the main reasons why we encourage the use of credit cards is to rake up those benefits they provide. They give you cashback, reward points, travel miles, financial benefits, and so on. Granted these are very minimal benefits, but they are a minimal increase of benefits over what you would have gotten if you used cash for the same transactions.
Cashback credit cards give around 1% cashback on the purchases you make. Other cards give 1 reward point for every dollar you spend, and so on. These can add up and in a year or two, you might be able to enjoy a free hotel stay thanks to this.
Of course, this is negligible to a millionaire. But for us, who live paycheck to paycheck, these small benefits can help.
Credit cards are not charitable organizations
Of course, credit card companies such as VISA or MasterCard, are not non-profit or charity organizations to give you benefits and sit back and watch you enjoy a hotel stay. They are some of the meanest financial institutions when it comes to fees, but it is also how they earn their incomes and facilitate a world of electronic payments possible. They are an integral part of the world economy right now and will become more popular in the future.
In the third quarter of 2021, VISA Inc. earned net revenues of USD 6.1 billion (yes, billion). While not all of this is interest paid by credit card holders, half of it is (around USD 2.8 billion). For context, for the three months ended June 30, 2021, VISA Inc. saw credit transactions of around USD 1.3 trillion (yes, trillion)!
Usually, all credit cards carry an interest of over 21% on overdue balances. These rates are even higher on cash advances on your card. And this is extremely high and credit card companies will keep on piling up enormous interest on your cards if you do not manage them properly.
Credit card companies charge a higher interest rate because they are nice enough to give us credit without holding any collateral. They take a pretty big risk of giving almost everyone upwards of $2,000. For comparison, banks give you cheaper interest rates because they hold some form of collateral in the event you default on the repayment. So their loan is essentially ‘secured’ by some asset (cash in your savings account with the bank, your house for a home loan, your car for an auto loan, etc.). Since credit card companies have nothing to fall back to, they mitigate this risk by charging a higher rate if you default.
The illusion of money
The old-school investors were half wrong. Credit cards do tend to make you think that you have more money. In our heads, this makes sense. You get a paycheck of $2,000 every month and your credit card has a $2,000 limit. You can essentially purchase $4,000 worth of goods and services in a month, right?! Wrong!!!
A credit card does not inflate your purchasing power (i.e. your ability to buy goods and services). A credit card merely ‘advances’ your spending by a month. Instead of using this month’s paycheck on what you need to buy, you can use the credit card to make the same purchases and use this month’s paycheck to settle the credit card next month.
This is the name of the game!
Restructure your mindset
Credit cards do not give you more money. They simply give you an advance on the money you already have. This is a 30-day money advance. Nothing more. Nothing less.
If you think like this, you will not drag yourself into debt situations that you cannot get out. Credit card companies are not inherently evil. It is our poor management of the cards that get us in trouble.
How much should you pay to settle your credit card every month
You MUST pay the total outstanding on your card statement every month. This is why we said that credit cards only give you an advance on cash. You simply have to pay back everything you purchased on credit within one month. So, essentially, you can only spend the money you already have with you.
Credit card statements can be confusing to read. You will see ‘minimum monthly due’ in BOLD text on top of your statement. This will be a tiny amount compared to what you have actually spent on the card. This is NOT the amount you have to settle though.
‘Minimum monthly due’ or ‘minimum payment’ is only the amount you can pay to keep your card active (well, your card will not likely deactivate even if you don’t make this payment). This is only a mind trick to get you to not feel the weight of your credit card usage. This is also NOT the amount you have to pay to keep your card from accumulating interest.
I picked this credit card statement to show how ridiculous the minimum payment is. I have an outstanding balance of $1,902 on my card that needs to be settled and the minimum payment due is $10!!! Had I paid just the minimum due, my card would start accruing interest on $1,892 at 19.99% per annum. And credit card companies like this.
If you used your card for $2,000 worth of transactions in June, your June statement will show a small amount like $50 as the minimum payment due. But if you only pay this $50 and think everything’s right in the world, you will be slammed with interest on the balance of $1,950 starting from the date of the transaction (not even starting from the statement due date)!!
Check out this explanation by RBC VISA credit card;
“If you do not pay your New Balance in full by your Payment Due Date, you must pay interest on each new purchase retroactively from the transaction date until the date we process your payment in full for those purchases. The accrued interest will appear on your next statement.”
This is as clear as they come. But we fail to read this text that is written in greyed-out tiny letters underneath the credit card statement.
Golden rules to follow when using your credit card
So, in a nutshell, follow the below best practices to avoid falling into a massive debt trap with your credit card.
- Never spend more than you earn
- Your credit card/s are only an advance on the money for a month
- You MUST settle the total credit card statement balance every month
- Set a reminder (if you have a habit of forgeting) on the due date of the credit cards each month
- Do not take cash advances on the credit cards (unless absolutely necessary, but prepare to be penalized heavily)
- Take a couple of hours every month to carefully go through all the transactions on your latest credit card statement, and check for any errors
- Pick credit cards with benefits that you would actually use
- Try not to max your credit cards (rule of thumb is keep the credit utilization below 30% on each card)
Hopefully, this article helped you to rethink your approach to using credit cards, and hopefully, it helps you not to fall into their debt traps.
Follow these golden rules and accumulate those reward points and enjoy something free once in a while.
Let us hear what you think about this article in the comments below.
