While the primary focus of my thoughts on the topic of credit cards has been to illustrate how beneficial they can be, I’m not blind to the potential for credit cards to result in increased costs in the form of interest payments.
Interest is a tool used by banks and other institutions to mitigate some of the financial risk they take in lending you money or other resources. Although they don’t work quite the same as a loan, credit cards work similar to short term loans. Imagine you ask a friend, “Hey man, I forgot my wallet at home. Can you cover lunch and I’ll pay you back this weekend?” Your friend pays for your lunch. You now owe your friend that money. It’s not a loan, but it functions much in the same way as a loan. This is how credit cards works.
When you want to buy a car, you ask an institution to cover the cost of the car upfront, and you agree to pay them back with monthly payments over the course of multiple years (usually). There is a decent amount of risk involved in such an arrangement because it’s tough to be sure that you will always have a job and won’t have any major cash flow problems for the next 3 to 5 years. To compensate for this risk, the lender charges you interest. You pay them extra for taking the risk and putting their faith in your ability to pay them back (there’s also the issue of requiring profit in order to run an institution so that loans are available, but that’s a different topic).
When you use a credit card, you will incur interest charges for balances that you have not paid off in a certain amount of time. If you spend $15 at McDonald’s on Monday, January 11, and then pay your credit card balance off on January 23, you don’t get charged any interest. However, if you are only making your minimum payments, and the amount you owe on your credit card carries over to the next billing cycle, then you begin to incur interest charges. If you have not paid off balances within a 3-4 week period following when you used your credit card, it becomes clear that there is now a risk that you will not pay it, or will pay it much later than you were expected to.
It’s actually quite simple to avoid paying interest; if you pay off your credit card every month, you never have to pay interest. How can you make sure that you always pay off your credit card every month? You make sure that you never use your card to make a purchase that you could not cover with the cash you currently have minus the liabilities you currently have. Basically, if you couldn’t make the purchase in cash without the credit card, don’t make the purchase with a credit card. Just remember, this advice is on how to avoid interest. There are times that emergencies happen and unexpected expenses pop up. It’s not always possible to avoid swiping a card for an expense that you can’t afford. Just recognize that if you are responsible (and emergencies don’t waylay your financial position), then there is no reason you should ever have to pay interest.
Just as a quick aside, I highly suggest that you set up automatic payments so that you are never late. If you are late, or forget to make a payment altogether, you’ll have the double whammy of interest payments and a hit to your credit score.
Lance Out Loud 