Understanding Your Credit Cards Role in a Financial Plan
Hi Everyone! Welcome back to Melissa Making Cents!
Understanding credit cards and how they work is incredibly important. Parents, kids, and young adults all need to be aware of how credit cards work so they're able to use them responsibly and effectively. As a financial professional, financial planning comes in different forms, one being education. Learning the ins and outs of how credit cards work before you have one is an excellent way to understand the responsibility that you're taking on by using one.
It's not just kids; adults can also find themselves in sticky situations if they're unfamiliar with credit. Money management and credit concepts have gone either untaught or taught with little to no regularity for too long.
Pop culture revolves around spending money, credit cards, flash, and bling. Credit cards can be useful tools for anyone interested in building credit or for an as-needed emergency option. While radio, television, and the internet do everything they can to convince you that having a credit card is a necessary part of being a successful adult, the truth is that there's more to the story. Working with a CERTIFIED FINANCIAL PLANNER™ or financial coach is a great way to get a lot of the information, but we’re going to explore some of the basics.
Credit Cards Seem Easy. Charge them up, pay them off. But they are more than meets the wallet.
Being able to live beyond your means is an incredibly appealing part of having a credit card. I mean, who doesn't want a few extra paychecks in advance, right? With a credit card, you're suddenly able to buy things you want right this second but won't have the money for until next week or next month. This tempting but incorrect approach and ideology can hook and reel in those of us who are most vulnerable and can be especially dangerous when living paycheck to paycheck. The instant gratification provided by using credit cards has become an addiction.
Popular songs and music videos don't tell us that it soon comes time to pay the piper, which leaves many young people owing money months ahead of having it. Even more, unfortunately, interest comes into play.
Before we get further into the weeds, let's quickly define some terms that we will be using!
Credit Card Balance
Your balance is the most straight forward part of your credit card account. A credit card's balance is the amount of money you owe to the institution you're borrowing from. If you bought a nice pair of shoes for $70 and a shirt for $20 using your credit card, then your balance is going to be $90.
Credit Card Interest
When you spend money with your credit card, you'll owe interest on your balance. Interest is extra money you owe an institution as repayment for them lending you money.
Credit Card Limit
Your credit limit is the amount of money you're authorized to borrow and spend.
How Credit Limits Are Set.
Credit limits are set by the financial institution you're borrowing from. If you have a more lengthy credit history, your credit limit will be higher. If your credit history is relatively short, your credit is bad, or you have a history of not making payments on time, then your credit limit will be lower.
There are also other factors that affect credit limits - some are more obvious than others. One relatively straightforward factor is income. Making a lot of money is a signal to banks and other financial institutions that you're going to make good on your word to pay back what you borrow. If you make less money, lenders will be more skeptical of your ability to pay back what you spend (plus interest). Having other credit cards with unpaid balances, where you live, and your personal situation are all factors that go into a lending institution deciding how high or low your credit limit should be.
Understanding your Annual Percentage Rate - APR
Understanding what the APR is and what it does is one of the significant roadblocks many people encounter when trying to become literate with credit cards. It can be confusing at first, but learning what it is and what it does is key to understanding your credit card.
- What does APR Stand For? APR is an acronym for the Annual Percentage Rate. Makes a lot of sense, right? No?
- What does Annual Percentage Rate (APR) Mean? Your annual percentage rate is the rate at which a bank will charge you (in interest) to borrow money. APR is how banks calculate interest. If your APR is 10% and your balance is $100, then you'll be paying $10.
- What is APR good for? APR is useful for understanding your account as well as comparing and contrasting accounts! The lower the APR for your credit account, the better. Every percent makes a difference in the long run; if your APR is lower, you'll pay less money in interest.
Understanding Compounding Interest
A few weeks ago I explained how compound interest works, and how it is beneficial to boost your savings growth. Compounding interest is excellent for investing and savings accounts, but it can come back to bite you with a credit card. Similar to how compounding interest can help you when saving money, it can hurt you when borrowing.
Credit cards compound interest daily, which is very important. People are often confused because APR is an annual rate, but banks charge interest at the end of each day using a formula that divides APR by 365 days and multiplies it by your balance at the end of the day. The interest at the end of each day is added to your balance for the next day and multiplied by your daily periodic rate (APR/365).
How 0% offers and balance transfers work.
If you find yourself falling farther and farther behind with your credit card payments, or you're doing the math and realizing it's going to take you years to pay off your card (even if you're paying higher than the minimum required payment), you may find yourself considering a 0% balance transfer.
What is a 0% Balance Transfer? This is essentially transferring your debt from your current financial institution to another institution that allows you to make payments at zero percent interest.
The Catch(es). While these sound great, there's always a catch, and in the case of zero percent balance transfers, there are more than one.
- Zero percent balance transfers usually charge an upfront interest rate of about five percent. Typically, this up-front interest charge is less than what you would pay in compounding interest while paying down a standard credit card. Still, you shouldn't make that assumption before calculating those differences.
- Missing a payment. While the overall cost of paying down a zero percent balance transfer usually is lower initially, if you miss a payment, you're going to have to start paying interest. This could leave you paying more than you would have initially.
- Balance Transfer Limits. Like other credit cards, zero percent balance transfer cards also have credit limits, which will put a cap on the total amount you're able to transfer from your existing card.
Instant Gratification Vs. Smart Personal Finance
Instant gratification means getting something you want exactly when you want it or having an immediate reward for doing something difficult. Many find instant gratification in shopping. People go shopping, eat out, see a movie, etc. However, the problem is they haven't yet fulfilled the other half of the bargain. To have gratification, you first have to sacrifice. Your sacrifice for eating out or shopping would be the time you've spent at work generating income. When you can forgo the personal sacrifice and skip straight to gratification, it doesn't mean that you won't have to sacrifice, only that you're signing yourself on to sacrifice in the future.
Now that we have a more precise understanding of how credit cards work, it's clear that we're not only bargaining the number of work hours that it would cost to buy what we want, but we're also potentially signing away countless hours of interest payments. In turn, we're flipping delayed gratification on its head for delayed sacrifice and instant gratification for work not yet done.
A CERTIFIED FINANCIAL PLANNER Can Help You Understand The Upside of Credit Cards
Some financial planners or financial coaches will be quick to either get you using a credit card or keep you away from them completely. I believe in a more nuanced and educated approach. Credit cards aren't all bad, and I don't want to make you feel like they're only going to harm you if you use them! They also aren’t all good, and can quickly put you in a hole that’s difficult to get out of if you aren’t vigilant.
I'm personally a fan of making small purchases and paying your credit card off in full each pay period. This will improve your credit history by establishing a track record of on-time payments; not to mention the rewards benefits available with certain cards! Keeping a credit card in case of emergencies is also a great thing, but remember that if you're irresponsible and over-spend, you're not going to be able to use your full balance on emergencies.
There are aspects of credit cards and personal finance that are entirely intuitive, like paying back the money you spend. You'll find yourself saying, "I've got this," but there are other aspects that naturally take a little more time to understand. Credit cards, balances, interest, APR, and zero percent balance transfers can be very tricky to navigate if you're a novice to personal finance. If you need guidance with your credit cards and need to learn how to make them work best for you, please call or email to schedule an appointment with me. Credit cards are just one form of personal financial planning, and working together we can figure out how to make them work best for you.
Until next time...this is Melissa Making Cents!
Melissa Anne Cox CERTIFIED FINANCIAL PLANNER™ is also a College Planning and Student Loan Advisor, and Financial Coach in Dallas, Texas.