How to manage credit cards
Credit Card Poll
What is the first thought that comes to your mind when you think of credit card
Do we really need a credit card?
Credit card is one of the least understood financial products of our time and the most profitable for card companies. The question that rarely gets asked is : Do we really need a credit card? In today's electronic world can we really live without a credit card?
Most people having credit card feel some sense of freedom and power since they can buy anything they want without worrying about the cash position in their bank account. The problem is that very few understand the financial implications of misusing the card. So how does one use the credit card responsibly and avoid getting into debt? How to squeeze out the card-companies rather than you getting squeezed?
I have been particularly wary of using credit cards for many purchases and more so for online transactions. A less realized point while using a credit card is that the card user is borrowing the money (on high-interest) from the card-issuer rather than owning that money. The fact that the credit card business is one of the most profitable business implies that the card companies never market the cards as a form of short-term loan to the end customer.
So do we really need a credit card? In today's world, many people would be amazed if you tell them that you do not own any credit card. It has become as ubiquitous as having electricity in your home. But a credit card is not really a must-have. In fact, I do know of many people who still do not use credit cards and they are not doing badly.
A credit card is a double-edged sword. If managed properly, it can provide you with excellent rewards and benefits, but mis-manage it and you may end up bankrupt.
Some of the benefits of a properly managed credit cards are:
Building a good credit history
It is crucial to understand what is credit score and why it is important. Wikipedia defines it as
A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person. A credit score is primarily based on credit report information typically sourced from credit bureaus.
In India, although there are four credit bureaus approved by RBI, CIBIL is the most popular one. It is a simple matter of filling up the online form and paying 450 INR to get your CIBIL TransUnion Score. After paying up the fees, you will asked three questions about your credit history for authentication purpose. Once completed you will get your credit score in email. The score ranges from 300 - 900 and the more the better.
Why credit score is so important?
At first you might think that credit score is only important to get approval of your home loan or car loan. Well that is somewhat true! Check out the graphics below indicating that higher credit score has better chances of housing loan approvals from banking institutions.
But now-a-days practically every service provider is asking for a CIBIL score. Here are some recent examples in India
1) Banking institutions are using it to provide you housing loans, car loans and doling out credit cards
2) Employers (not only in financial domain) are looking at credit history as part of background verification
3) Landlords are asking credit score befor renting out their apartments
4) Telecom companies or other service providers require credit score before they can start providing service to you, ensuring your creditworthiness
5) If you want to start your own business, then your low credit score can become a hindrance in getting any business loan
So bottom-line is that establishing a good credit score is becoming a must for our survival going ahead. So why not take steps to improve it now! Here are some quick tips on staying good on credit bureaus' books:
How to keep a good credit score?
- Do not miss payments for credit cards or pay only minimum balance
- Do not miss EMIs for your car loans or home loans
- Avoid showing "credit hunger" by repeated requests for loans or multiple credit cards with maximum credit utilization
- Do not become a guarantor for other's loan (even if you know the person closely)
- Keep being active in credit history, since if you don't use cards or have loans, you will not have a good credit score
Availing the benefits and rewards
Using credit cards instead of other modes of payment can help you garner some additional benefits or rewards. You may:
- Earn points for your purchases, which can be redeemed later for various items
- Get easy EMI offers or 0% interest charges for certain product purchases
- Get extended warranty on various purchases via specific credit cards
- Get complimentary air tickets via tie-up with specific travel portals
- Get discounts on gas purchase on select gas stations
- Receive cash-back offers on certain purchases
- Have special privileges like airport lounge access or restaurant club access with some credit cards
These are just few examples and most credit card companies have tie-ups with various service providers, online retailers or shops for providing specific discounts or offers to end-customer.
Note: There are always terms and conditions associated with any such rewards or benefits, so read carefully before signing-up!!
Check out the picture below for some additional examples of rewards/benefits for credit card users
Tracking your expenses
One of my 7 rules of financial success, includes reducing your spending. But the fact is that you can reduce your spending only if you can track your expenses. It is simply too time-consuming to jot down each and every expense manually or via any software. It also requires a huge amount of self-discipline and frankly the efforts put does not really gives much output.
The simple solution is to use credit card for much of your spending and voila you have complete tracking of your expenses, free to download, from credit card website. With the statement in hand, you simply need to check out your spending pattern, end of every month. This way you can conveniently identify the superfluous expenditure, which can be avoided next month on-wards.
Secure and convenient money
Of-course the biggest advantage of using a credit card is the convenience offered by the plastic money. It is easy to carry, safer than cash, accepted at almost all places, and extremely useful in emergencies. Now-a-days most credit cards have inherent protection against theft or fraud. It also gives you interest free money for some days i.e. you start using the product/service now, but pay later.
With so many useful and advantageous features, it should be really a heaven for consumers, but it does comes with certain constraints. Here are some of the hits from a poorly managed credit card:
Trapping in ever increasing debt-cycle
Many people hate credit card simply due to it's vicious debt-trap. The problem is not in the credit-card product, but in the way a credit-card holder manages the payment cycle.
I am not sure who first invented this, but the most brilliant innovation in credit-card history is the "minimum balance" payment method. Think about it from the perspective of credit-card issuing company, if every credit-card holder starts paying money on time with out any carry-forward balance, the company will go bust. The same will happen if majority of card-holders keep on buying using credit-card, beyond their means and unable to pay the monthly balance. If most users starts defaulting, then again the company will go bust. So these companies require a middle-path, which also allows the card-issuers a really handsome profit. In comes the minimum balance payment.
It is not simply based upon financial calculations, but also takes into account human psychology. Check out this research paper(pdf) on how minimum Payment plays with human psychology
If decisions about credit-card repayments are anchored upon minimum-payment information, then people will repay less than they otherwise would and incur greater interest charges (Thaler & Sunstein, 2008, independently made the same suggestion).Consistent with this hypothesis, I found a strong correlation between minimum payment size and actual repayment size in a survey of credit-card payments.
Here is the how the debt-trap happens : If you made a purchase of INR 10,000 on your credit card and assuming a 2% minimum balance each month (INR 200), you will pay-off the principle amount in 50 months (> 4 years). But another problem is the exorbitant interest charged on any outstanding balance. Typically it is as high as 25-30%, which means if you keep on paying only the minimum balance every month, you would require more than 40 years to pay-off the debt. The interest that you will pay will be much more than INR 10,000. This is under assumption that you have made no further purchases on this card.
This is simply mind-boggling stuff and brilliant from credit-card companies' perspective. A sure-shot killing machine for you and your family.
I got this tip from a friend. A simple way to avoid credit-card debt for heavy users is to celebrate a "no credit-card week" every month. What he does, is to nominate say 2nd week of every month as no credit-card week. So beginning Monday, he will remove all credit cards from his wallet and makes every purchase via cash or debit card. It is really simple and effective way to control your spending. It not only helps in saving from unnecessary shopping, but also, affects human psychology when you have to pay hard-cash for purchase. In most-cases paying by cash, forces you to weight the pros and cons of buying that attractive product/service. One more tip that I use, is that whenever I cross 30% - 40% of credit balance on my card, I lock all the credit cards in a locker at my home, for the rest of the billing cycle. It's indeed a very effective method for controlling expenses.
Check out this awesome video on "Why we should start hating debt?"
Hate your debt!!
Getting hit on fees and interest
The best method of making profit for credit-card companies is to charge interest rate on the outstanding balance.
APR is the 'Annual Percentage Rate'. Credit card companies charge you interest every month on the outstanding balance, depending on your purchase transactions. When you calculate it for a year, you get the APR for your card.
The APR may be fixed or variable depending on your Card Agreement at the time of subscription. The per month interest could be as high as 2-3%, indicating an APR of 24-36% interest P.A, which is really exorbitant.
This is not the only charge applied by card companies. There are other charges like late fees, annual fees or other charges.
With a poorly managed card, these charges can really hit you badly. One simple tip to avoid getting hit on late payments, is to create a stack of fixed deposits of your average monthly spend. So for example, if you know that your monthly spend is say averages at INR 2000, then you can create fixed deposits every month for three months period. You keep on creating stack of FDs month after month. Once the first FD matures, you can use it to pay-off the credit card balance. Now with the system in place, you will have one FD maturing every month to pay-off your credit card bill without any default.
Possibility of a credit-fraud
The biggest problem with credit cards is the possibility of becoming a victim to credit card fraud. As the history of credit-card fraud indicates that the more security is put in place, hackers get smarter & find new ways to dupe credit card holders.
In majority of the cases, the scam can be avoided simply by being alert while making the credit card transaction or sharing any personal information. Here are few must things to do, for protecting yourself:
- There is no need to share personal information to anyone. A thorough identity check should be done before revealing any such information to government agents.
- Be aware of "skimming" while swiping you credit card.
- Never reveal your security code, PIN or CVV number to anyone.
- Use virtual cards backed by your credit card for online shopping.
- Have multiple cards with lower credit limit rather than one single card of high limit
- Keep your SMS alerts on and report lost/stolen card immediately.
Simply put, be alert and paranoid while using credit card!!
A Final Thought
It is important to understand that credit-card is a convenient way to spend what you earn and not an extra income in itself. It should not be used to inflate your lifestyle. If you spend beyond your means, you are digging your own financial grave. And finally teach you children the mechanics of credit card very early. Tell them from where the money comes in the credit card and how you have to pay it back with interest. This can really be the greatest gift you can give to your children.