Free Money

Remember in “The Flintstones” when Wilma and Betty would go shopping they’d say “CHARGE IT!” and that horn-heavy warsong would play in the background?

I’ve heard from more than one friend that credit cards are “basically free money, right?” No, they’re definitely not free money. You’re paying to use that line of credit–and if you’re not doing it wisely, you’re paying a lot when you could be paying nothing.

Credit cards were invented because some fancy-schmancy Manhattan businessmen forgot to bring enough cash to pay for their power-lunch on 5th. One of the guys thought–‘Wouldn’t it be cool if I had a card that acted like money so that if I didn’t have enough cash they could just… charge it?’ And thus, the Diner’s Club was born–the first card that pretended to be money if you didn’t have enough on you. Fast forward almost 50 years later and credit card debt is cited as among the top reasons for people declaring bankruptcy, foreclosure, forbearance and divorce (believe it or not).

What the heck happened? How did we go from using cards to cover lunch to using cards to cover… everything?

The Fresno Drop. In 1958, Bank of America mailed 60,000 all-purpose charge cards to the people of Fresno, California. By 1960, the number of cards was 400,000 throughout America. By 1968, Bank of America had made over $400 million off the cards (how did they do that, you ask? Interest.). The industry wasn’t fully formed; meaning, there wasn’t a system of background checks to make sure the person applying for a card could actually afford to repay (what we think of now as a credit check), there wasn’t a fraud department, no collections department, there were no limits. Everyone was approved for credit. People bought things they couldn’t afford, and when they couldn’t pay their credit card payments, debt collectors came and repossessed anything the debtors had that could pay for the purchases they bought and the interest that the purchase accrued. (Nancy Trejos)

It seems that we forgot this little mishap in American history because basically the same thing happened in the late 1990s and early 2000s. People were approved for credit–in the forms of cards and mortgages– but they couldn’t actually pay for the huge purchases they were making. The industries were also doing terrible things–like suddenly and without notice changing the interest rates. Bankruptcy and foreclosure ran rampant. And thus, the Second Depression was born. Obama did some important stuff for the regulation of credit cards and mortgages, so fortunately we’re slowly but surely coming out of the Depression. But for some reason, it seems that our mentality about credit cards hasn’t changed much– this is evident to me when my extremely intelligent friends remark that credit cards are “free money.”

Just recently a close friend told me someone in their workplace said that it was a bad idea to pay off your entire credit card balance every month. This, unfortunately, is so wrong it’s not even funny. This is a myth that for some reason is still propagated– “use it or lose it.” People still think that if you have a credit card, but you pay it off, the creditors are going to think you’re not using the card. That if you don’t have a balance, they won’t know you’re using it. That’s simply not how it works.

The truth is that you should pay off your balance entirely every month if you can because doing otherwise means you pay unnecessary interest and you “carry a balance,” which the creditors actually think is bad. Creditors want to see that you make purchases that you can pay off almost immediately. In fact, every time you don’t carry a balance, your credit history improves. The opposite is true if you don’t pay off the balance every month. Because then the creditors think, “Oh. This person is buying stuff they can’t actually pay for.”

Credit cards are not free money. There’s this little thing called interest. APR. Annual percent rate. Companies try to get you to apply for the card by offering intro rates (that, thanks to the Prez are kept the same for six months)– 0% APR for Six Months! But after that first six months, it’ll skyrocket to a new rate. How high the new rate is depends on the economy and your credit history. People with no history or bad history might pay somewhere around 25%. OUCH. The total annual interest is charged per day, so every day you have a balance, you’re getting charged daily in interest. And your card charges you interest on that interest if you don’t pay it off.

Say you buy $100 worth of shoes. But you don’t pay it off when the due date comes; instead, you pay the $10 minimum. Well, if your interest rate is 18%, now you’re new balance is $91.33. Why? Because 100-10= 90. 90 x .0.0004931 = 0.044379 x 30 = $1.33. Wondering where that 0.0004931 came from? That’s your annual interest rate per day. And if you carry that $90 balance for 30 days, you’re paying 0.044379 of a cent per day. You now owe more than what you paid for those Nikes–all because you didn’t pay the balance off completely. And the creditors notice that you bought something you couldn’t pay for, even after a month.

The interest rate is the price of borrowing money. If you have a credit card or are thinking of getting one, you need to have this basic principle in your mind every time your hand touches the card. While credit cards are a very important element to your financial portfolio– it’s very difficult to build credit history without having one– you need to use it very wisely, otherwise you’ll find yourself owing a lot of money. The second principle you need to have in mind when using a credit card is: can I afford this and when? Credit cards are not to be used to buy things you want that you don’t or won’t have the money for soon.  Credit cards are for emergencies, traveling (because most cards don’t charge for international use and they’re safer to use abroad), and for budgeted purchases, such as gas, groceries, bills–things you were going to pay for with money you plan on having anyways. If you only use your card for those purposes, the chances of you getting into credit card debt are slimmer. If you want to use your card for drinks, clothing, entertainment and other non-necessity purchases, you need to budget for that or pay in cash.

Now, to those of you that don’t have a credit card because you think they’re unnecessary or you’re afraid of getting into debt–you’re only hurting yourself. When you want to rent or buy a car, rent an apartment or buy a house, or even get a job, — you’re going to need good credit history. You should very seriously consider applying for a credit card in order to start building healthy credit history. It’s not scary. If you need help or have questions, IDK Wednesday is there for you.

Credit Cards 101

  • Apply for a credit card that has no annual fee. Annual fees are for people who can afford it.
  • One application per year. Hard credit checks stay on your credit history for two years. You don’t want too many checks on your history at any given time because it makes you look like a risky borrower. Keep it at two.
  • Know what the intro rate is, know when it changes, and know what your new APR is when it changes.
  • Know your cycle– when is the due date? When do you get charged interest? You can find this online or you can call.
  • Know your limit. Creditors think it’s best (and your credit history improves) if you either pay off your balance completely each month or you keep your carrying balance at or below 30%. If you absolutely can’t pay off your credit card balance, pay it down to 30% of the total limit. In fact, you’ll stay safest if you pretend the 30% cap is your limit, as opposed to the actual limit. So, if your total card limit is $500, your 30% cap is $150–so either don’t spend over $150 or pay your balance down to there if you must carry a balance, or pay off your bill completely.
  • Know your rewards. Do you get flyer miles? Cashback for purchases at certain places or for certain things? Knowing what your card is giving you for using it can be helpful, but don’t let it dictate your spending.
  • Know what you’re using your card for and stick to it. Is it for emergencies only? Is it for gas? For groceries? For bills? For one bill, like your Netflix account? The one thing you should NOT use your card for is unexpected, impulsive purchases like clothing, or video games, or movie tickets. Know why? Because if it’s unexpected, it’s unbudgeted, and if it’s unbudgeted, you don’t have the money for it. Two caveats: if you have the money for it in savings, then the purchase is up to your discretion. If you know you absolutely, positively, 100% without a doubt will have the extra money come next paycheck, then the purchase is up to your discretion. But just remember– unexpected costs cost the most. You need to have diligence with your credit card because it’s attached to a report about you that depicts what kind of purchases you’re allowed to make in the future. Don’t rob yourself.
  • Pay if off. If you have a balance on it, pay it all of. If you can’t pay it all off at once, you need to develop a plan to pay it off. I’ll be writing a post about paying down debt, but until then, pay the minimum and a half. So if your minimum is $10, pay $15.
  • Negotiate. Call up the company and ask for a lower rate. Or a higher limit. Or for no annual fee, if there is one. Threatening to stop using the card (not closing it) might get you want you want.
  • Don’t close it! Closing an account is a negative hit on your credit history. The longer you have an account open, the better your score gets. If the card sucks–high interest, annual fee, etc– call to negotiate. If nothing comes of that, pay off the card and then stop using it. Don’t carry it in your wallet. Just leave it there to collect years, but not money. If you’re comfortable, you can assign one small task to the card–like Netflix– and leave it at that. Just remember to pay off the balance before the due date, so there’s no interest.
  • Don’t go crazy. You only need one to three credit cards, max. Any more and you run the risk of losing track of them. Having more can also trick you in to spending more, which is how many people fall into credit card debt. You only need 10-25% of your annual income in credit. In other words, you can have and use a $25,000 limit if you could afford to pay off $25,000 plus its interest in a year. If you do have a limit that high–now or ever–and you couldn’t actually afford to pay off $25,000 in a year, only spend 30% at the most.

A line of credit means that you are guaranteed X amount of money by the bank because you’ll have the money plus extra to pay for borrowing that money from the bank in a short time, you just don’t have it now. Something tells me that if you’re reading this blog, you’re not going to have $5,000 on your next payday. Remember how credit cards came to be? The fancy-schmancy Manhattan businessmen who couldn’t cover lunch? The point is: they had the money to pay for the lunch, just not in cash at that particular moment. They could afford the lunch.

So the rule is: if you can’t pay the balance in full or down to 30% by the due date, don’t use your credit card. You can’t afford it. Literally and figuratively.





PS: I know you’re all impatient to read the posts about paying off debt, living within your means and budgeting… but remember what we talked about in my post introducing you to Ignorance, Denial and Indulgence? And how you have to understand these three concepts in order to make a plan? We’re 1/3 of the way there. The next post will be about Denial. It’s about to get real up in YWM.