Understanding Credit Card Companies

Credit cards can be dangerous! Credit card companies are businesses with models designed to make money from a) interest on consumer debt, and b) fees from merchants who use their services for purchases. When a store sells an item and allows you to purchase it with a credit card, there is a fee made to the card company. That fee is usually a percentage of the purchase price. Once the purchase is made, the consumer has a balance. If the balance is not paid off in full at the end of the billing cycle, a fee of interest is charged to the account. In this model, the credit card company stands to make money on two sides of the same purchase. Not too shabby… for them.

The merchant does well to account for the fee and include it in the total price of the item they are selling.

Paying the Minimum Payment Never Works

Credit card companies require the consumer to pay the minimum payment to satisfy their debt. However, this only keeps the account alive and never really allows the consumer to satisfy their debt. If you charge $1000 to your card in a month and do not pay it off in full, you will carry a balance. Interest will be charged against the balance. It is easy to think that paying $100 a month will pay off the $1000 debt in about ten months. However, with an 18% interest rate the balance will never be paid off. This is how card companies make their money off the consumer’s debt.

Side Note: According to this article, the average US credit card interest rate is between 21– 27%.

A monthly payment of at least $220 would be needed to pay off the $ 1,000 balance in ten months. That is $2,220 to pay for a $1000 balance. At an interest rate of 22%, the payment jumps to $250.

This is why it is vitally important to either not use credit cards or to use them as cash and pay the balance off at the end of each month. Otherwise, they perpetuate a cycle of debt that simply grows beyond control.

Why Use Credit Cards?

Our economy is largely based on debt and credit. Debt in the use of credit cards, auto loans, and home mortgages. Credit on the other hand is a declaration of a consumer’s ability to pay a debt on time. Even your utility bill payments are factored into your credit. When you are delinquent in paying your bills, the company will forward your account to a credit collection agency to get at least some of their money back. This action is reported to the three credit bureaus and subsequently impacts your credit score.

On the other hand, if you establish a line of credit in the form of a credit card, mortgage, etc., and pay the monthly payment on time your credit score will be in good standing. As you continue to do this across multiple accounts, your credit profile builds and becomes favorable to creditors. When it comes time to apply for a loan, the lender will look at your credit profile and if your credit is in good standing and you do not have too many outstanding debts or accounts with the ability to draw debt, you will more likely be approved.

With this in mind, credit cards can be helpful. However, we do not need credit to make cash purchases. The problem comes when it is time to buy a home or a vehicle as these are large purchases for which most people cannot pay cash.

Use Cards Like Cash

To use cards like cash simply create a physical (or virtual) envelope in your budgeting system for the credit card. When you buy groceries with your credit card, you will move the amount spent from the grocery envelope to the credit card envelope. If you do this for every purchase made, at the end of the billing cycle you will have your full balance in an envelope and ready to be paid. No interest will be incurred by you and the credit card company already paid the transaction fee from the store.

Using credit cards like cash is a discipline that should only pursued once you have mastered budgeting. Remember, your credit cards are not free money they are very costly sources of money.