By Carol Glynn, Chartered Accountant, Finance Coach, and the founder of Conscious Finance Coaching
Credit cards are the most common form of credit for average consumers. It follows that they have a significant part to play in toxic debt and paycheque-to-paycheque living.
But are they inherently a bad idea? Are they a financial necessity in the 21st century? Or maybe it’s something in between.
There are a lot of strong opinions out there about credit cards. Love them or hate them, they are a normal part of life.
Credit cards are an integral part of our financial systems. It is assumed everyone has one (not true). Many have multiple cards (this is true).
Sometimes they are the only accepted method of payment so they can be hard to avoid having or using.
So where do I sit on the love/hate spectrum?
I am a big fan. I love credit cards. But similar to any other healthy and mutually beneficial relationship in my life. I have strict boundaries with them. I am very selective and discerning about the type of card I have and when I use it. I only have credit cards that work for me and help me achieve my financial goals. I am clear on what my requirements and responsibilities are and I understand what the card is providing me and bringing to the table! They are a very beneficial part of my financial toolkit.
What do you need to know about credit cards?
Experience has shown me that most people don’t understand how credit cards work so let’s cover the basics.
Understanding terms and conditions
If you don’t understand the interest rates and how they are calculated you are not alone. Few understand what happens if you don’t pay the minimum balance. They don’t understand the impact of paying only the minimum balance. They don’t understand the impact of credit limits and outstanding balances on their credit score.
Before you sign on the dotted line, educate yourself on how credit cards operate. It might feel daunting now but it will be worth it as it could save you thousands of dirhams, prevent the stress, worry and shame credit card debt brings to your life and also flip them into assets that are saving you thousands of dirhams every year!
Don’t judge yourself if this is all new information for you. You are not alone, in fact, I would hazard to say you might be one of the majority.
It is understandable that so many don’t know this because the terms and conditions tend to be overly complicated and heavy with financial jargon. I’ve yet to come across a banking institution that makes it easy for the average person to understand the terms and conditions, written in teeny tiny font that I am now at the age where I need to put on my glasses to see!
It is not always possible for a non-financially trained person to understand the language, terms, mechanisms and true impact on their financial lives without first investing hours of confusion and frustration, before throwing their arms up in frustration and giving up.
So if the banks aren’t forthcoming with useful information, where do you look to educate yourself? It can be very difficult to find someone to help who does not have a vested interest in you signing up for that product or service. Read on and I will do my best to make it easy.
First and foremost, the goal of credit card companies or banks that issue them is to earn interest from unpaid balances. Never forget that. The longer you leave the balance unpaid, the more they earn.
The much-missunderstood minimum payment
What is the minimum payment and what is its significance to you as a credit card user?
Credit card providers will clearly communicate your obligation to pay a minimum amount each month by a certain date. This is calculated as a percentage of the outstanding balance at the end of the month. It’s usually anything from 2 to 5% of the outstanding balance.
If you don’t pay this amount on time, the bank will charge you a late payment fee. This is usually a set flat fee and is not dependent on the total amount you owe.
What they tend to be less clear about is that the bank will charge you interest if you only pay the minimum amount each month.
Many people have told me the credit card salesperson misled them on this point. They had no idea they needed to pay the balance in full to avoid interest.
If you learn just one thing from reading this, it’s that you only avoid paying interest if you pay off the full balance each month. Never forget that.
Why is credit card interest so much more toxic than interest on loans?
Warren Buffet famously said compounding is the 8th wonder of the world. It’s a magical concept that works in your favour when you are investing money.
However, it is not your friend when it applies to debt.
So what is compounding? Compounding happens when the bank charges you interest on interest.
This happens when you do not pay off your card in full and so the bank adds an interest charge to your balance due. The next month you are paying interest not only on the money you charged to the card but also on the interest from the previous month.
Here’s an example. Charlie charged AED 4,100 to his credit card in May. When he received his credit card bill, he diligently pays the minimum balance.
Let’s say Charlie decides to put that card in the drawer and not use it anymore. He plans to repay it by paying the minimum balance each month. His interest rate is 1.67%. Tiny right?
Credit card cash advances are very expensive. In the UAE they are anything from AED 99 to AED 250 per cash withdrawal. You will be charged a fee for the transaction immediately and interest starts accumulating from the day you withdrew the money, not from the end of the month like expenses. And the interest rate applied to cash advances is usually higher. It’s a very expensive form of cash advance.
This is why many find their credit card balances growing out of control despite not charging much or anything to the card. 1.67% is quite a low rate too. Most credit cards in the UAE are closer to 3.5%. Ouch!
It is like financial quicksand. It can feel like no matter what you do, you cannot get out of it and feel like you are only sinking further.
Interest Rates
Interest rates can be disclosed in two ways. The annual interest rate (APR) and the monthly rate. In most jurisdictions, banks will disclose both. In the UAE, we tend to see only the monthly interest rate.
So let’s put this in context. If your bank tells you the interest rate is 2.8%, that doesn’t sound like much right? But that is an annual interest rate of 33.6%. Let that sink in. Would you sign up for a personal loan or mortgage with an annual interest rate of 33.6%? This is one of the reasons credit cards are very expensive sources of debt.
So, how do you make a credit card work for you?
Don’t let this scare you away. There are ways to make your credit card a financial asset.
Number one rule: always pay it off in full every month.
How can you protect yourself?
If you do not have the cash to pay for your purchase, do not charge it to your credit card. Treat it the same as your debit card. If the money is not in your bank account, you cannot charge it to your credit card.
Keep your credit card credit limit low, ideally less than your monthly service
Don’t just accept the credit limit the bank allocates to you. If it is more than your monthly salary and you are concerned you may overspend, then call the bank and instruct them to reduce the credit limit to the limit you are comfortable with.
If you have a month where you need more credit, then you can pay your card in advance and this will in effect temporarily increase your limit. You can also request a temporary increase.
Set up an auto payment?
Automate your monthly credit card payment. There are a few benefits to this. It removes the risk of forgetting to pay on time and so accidentally incurring late payment fees and interest. It means you have one less thing to do or think about every month. There is an element of accountability as if you know the total outstanding balance of your credit card will be charged to your current account, you may be less likely to overspend and risk the payment bouncing.
Never take cash out on your credit card
Credit card cash advances are very expensive. In the UAE they are anything from AED 99 to AED 250 per cash withdrawal. You will be charged a fee for the transaction immediately and interest starts accumulating from the day you withdrew the money, not from the end of the month like expenses. And the interest rate applied to cash advances is usually higher. It’s a very expensive form of cash advance.
I have taken cash out on my credit card by accident. I was distracted and put the wrong card in the ATM machine. How could I have protected myself from this mistake? You can turn off this option. On your banking portal, there will be an option to block cash advance requests. Turn that on. Another way is to have a different pin for your debit card and credit card. If I had this at that time, the wrong pin alert would have brought the mistake to my attention.
Oh and if like me this was a mistake, call the bank, speak nicely but firmly ask if they can give you a get-out-of-jail-free pass this one time. I did and they refunded the cash advance fee and waived any interest charged. Banks aren’t all bad!
So how can you turn your credit card into an asset?
Now to the exciting part. I love my credit cards as they are like an income-generating and cost saving asset for me! How? Let’s break it down:
Online fraud protection
Credit cards provide additional fraud protection over debit cards. It is significantly easier to resolve fraud issues on credit cards than on debit cards. There is insurance covering credit cards that do not apply to debit cards. I never use my debit card for online transactions, the risk is just too high. I won’t expose my cash to that.
Points systems
Find a card that provides benefits you will actually use. For example, my card is linked to my airline of choice. This means every time I use my credit card, I am accumulating air miles for my chosen airline. By doing this, I have accumulated enough miles to only pay taxes on my annual flights home every year. These benefits far outweigh the fee I pay the bank to have the card. I have saved 10s of thousands in travel costs by doing this. And I also get awarded free upgrades. Who doesn't love travelling business class for free!
Just this week I paid my internet and phone bills using points I accumulated on my credit card. That alone was a savings of AED 954 and free internet and phone usage for a month. What’s not to love about that?
Keep The Costs Low
There are many credit cards available in every market. Choose a card that does not have an annual fee or if it does, ensure the benefits it provides are more in value than the fee you pay.
Cashback Options
Be wary of cashback options. Read the fine print because while 10 per cent cashback on every purchase may sound great, there is almost always a cap if you read the fine print. Look for the asterisk beside the shiny offering. For instance, the lower of 10 per cent, or AED 25 per transaction, means you get AED 25 in cashback, not AED 100, on a AED 1,000 transaction.
Credit Card Benefits
Make sure you know the other benefits that come with your card. Most credit cards provide travel insurance coverage for free if you book your flights using that card. Some have discount agreements with restaurants, gyms, spas, cinemas, retail stores and other outlets. Before paying, ask the cashier if they have any discounts running. Just the other day I got 10% discount on my new wifi routers as the store had an offer if I used my credit card to pay. But I only knew because I asked, so don't be afraid to ask or assume the sales assistant will volunteer the information.
Is a credit card a good tool in emergency situations?
Sometimes emergencies come up and if you don’t have an emergency fund, a credit card can be a great way to fund a sudden expense. But it’s not the best way to manage emergencies or surprise expenses in the long term.
If you do need to use it, make paying it off as soon as possible a priority so you don’t end up paying multiple times for that emergency cost. And then focus on saving for an emergency fund so that next time you have the cash available and protect yourself from raising this expensive form of debt. By all means, use your card to pay the expense, collect the points, get a discount maybe and then use the money from your emergency fund to pay what you charged to your credit card.
The number one rule when you are tapping that credit card is to ensure you can pay off the balance at the end of the month. Otherwise, you not only can’t afford your purchase, but you will also end up paying much more than the cost shown on the cash register.
Do you have credit card debt and would like to have a plan in place to clear it in a way that is personalised to you, your financial situation and your goals? Contact me @consciousfinancecoaching or book a free discovery call here, I'd love to help.