Using a Credit Card

by Adam on March 1, 2010

Magical Penny is currently exploring the subject of debt as having debt makes growing you pennies more difficult. Previous debt topics include Student Loans, and Car debt.

If you only learn one thing about personal finance it’s this fact: if any of us are going to be successful at saving and investing we need to ensure that there is a gap (preferably a growing gap) between our income and expenses.

Using credit cardsCredit cards, in some ways, remove us from our spending, making saving potentially more difficult. Using a credit card means that  we don’t have to actually pay for our purchases straight away. A credit card allows you to pay just a small amount each month to ‘smooth’ out the cost. Whilst they can be useful tools for some, for many they act as the gateway to bigger financial problems. Certainly credit card debt is one of the most common forms of debt for most of us.

Understanding Credit Cards

I’ve had a credit card for less than a year. In truth I didn’t see the need for one but decided to investigate my options after reading Ramit’s I will Teach You Do Be Rich. I am by no means an expert on this subject but as part of Magical Penny’s foundational series on debt, this article will get you up to speed on credit cards.

Below are 4 reasons most often given for a credit card and the Magical Penny perspective on each of them.

Credit Card Perks

IncentiveCredit cards are primarily marketed to consumers by highlighting the ‘perks’:  the incentives for taking out and using a particular credit card: ‘air-miles’ , ‘points’ or ‘cash-back’ are the most common. However when you’re searching for credit cards most personal finance information online is very US-centric. In the US it seems that credit cards play a much bigger role in the ‘culture’. The ‘perks’ are better too:

My credit card offers discounts on most major retailers, plus discounts on concert tickets and a “Make a Wish” service, which recently got me orchestra tickets I couldn’t get anywhere else.”

Ramit Sethi.

When I began looking at credit cards in the UK, I was little disappointed: the perks on UK credit cards are negligible at best, and even the relatively good card perks  have now been scaled back due to the financial crisis of 08-09.

Ultimately I conclude that even if you do have a card that gives you ‘cash-back’ or ‘points’, it’s a dangerous game to play psychologically because you may be encouraged to spend more to get the rewards. No one gets rich from credit cards, (and it’s particularly true in the UK where the perks seem minuscule).

Flexibility

cautionThe flexibility of being able to buy things before you have the money is helpful for many people and it’s this flexibility that makes credit cards so popular for most people. However it’s dangerous way to live.You can never be sure of tomorrow and you may find yourself in a situation where you’ve bought more than you can afford.

It’s also expensive if you cannot pay off the card at the end of each month as the interest rate is typically over 15%. If you have credit card debt yourself, paying it off should be your first priority if you are ever to be able to grow your pennies. It’s more important than paying off your car and certainly more important than saving up for a house. In fact it should be your most important financial goal.

That said, if you are struggling to pay your bills, your credit cards should be your very last priority because they are unsecured: meaning the credit card company can’t take anything away from you if you don’t pay them (unlike a car loan or house loan where if you stop paying them you risk losing them to your creditors).

Consumer Protection

safetyOne legitimate and positive reason for using a credit card in the UK is to take advantage of the Consumer Credit Act, which protects you from defects and problems with the item or service you buy. The act makes the credit card company equally liable along with company you bought the item from. Crucially this is only applicable on items over £100.

I saw the Consumer Credit Act work in practice when my friend booked flights to Hong Kong with Oasis Airlines in January 2008. The airline went bankrupt on 9 April 2008 but thankfully my friend had booked using a credit card. The credit card company was therefore responsible for getting her and her friends on a flight on the exact date of the original flight, regardless of cost. It only took a couple of phone calls to sort everything out. It would have been  a lot harder to get your money back and replacement flights  if you had used a debit card!

Building Credit

building good creditBuilding a credit score is often cited as an important reason to use a credit card. If you do a couple of minutes of  searching online you’ll quickly come across everyone talking about FICO scores. UK readers need not worry. This is a type of American credit score that is used near universally: for mortgages, car loans, even if you’re wanting to rent an apartment or start a new job!

In the UK, there is no universal credit rating. Yes, there are ‘credit reference agencies’: Experian, Equifax and Callcredit for example,  but each financial lender has its own criteria to ‘score’ you when deciding to offer you a financial product. It’s a little less ‘joined up’ in the UK compared with the US’s mighty FICO so credit scoring is less than an issue of life and death compared with in the US.

Having a credit card does help build your ‘score’ in the eyes of many lenders though because it shows potential lenders that you have the ability to pay your bills on time (assuming you do pay at least the minimum payment on your credit card each month!).

Ultimately if you’re serious about growing your pennies, your credit score shouldn’t matter too much:

  • A car loan?

Buy used with so you can afford your mid-life crisis car.

  • A mortgage?

Save up a substantial deposit to get the best mortgage rate

  • Furniture?

Just make do with what you can scrape together and in the process make your future self proud and avoid bringing risk your life.

In the end I decided to get a credit card for the consumer protection it offers and establishing credit-worthiness (although I’m not fully convinced how big an impact it will have when I’m looking for mortgages compared with the impact of a down-payment). I don’t intend to take out any other form of loan as I’ve made a commitment to live below my means and grow my pennies.

My credit card offers no useful perks but as it’s connected with my current account it keeps things simple with my online banking.

Used correctly I’ve come to the conclusion that a credit card is like a power-tool: in the wrong hands it can be hugely dangerous to your financial life but it can be useful too, although seemingly less useful than if I were in the US, where FICO rules supreme and the perks are more tempting.

Do you have a credit card? What have you found to be useful?

Further reading:

The Consumer Credit Act

Credit rating in the UK

Optimising Credit Card useage (US centric but a fun read….well, fun for me at least!)

{ 4 comments… read them below or add one }

Ronaldo

Hi Adam!

Great post on credit cards!

Since I decided to start a blog on finances focused on the Brazilian reality (only 2 weeks ago.. ;-)) I became a fan of your blog because I think we have quite similar ways of thinking, particularlly when it comes to the “powerful weapon” of compounding.

Credit cards will be a topic of some of my future posts. I personally think that credit card is a great tool if you are a conscious consumer. In Brazil you can have up to 45 days to pay without interest for something you are consuming today. You can then free your cash to work for you with other stuff, like buying stocks for some days, for example, as long as you do NEVER forget you have to pay full credit card invoice on time. Free cash is always good, remember “cash is king!”

Getting mileage points is also something very good. I concentrate most of my payments on my credit cards (I have 2, one Visa and one Mastercard, with due dates spaced 15 days from each other) and have added points enough to get air-tickets.

The rational for me is quite simple, if I have to consume (being conscious, of course!) I pay with credit card and try to get some additional advantage. Credit card statements also help me control my expenses because they clearly show name of stores and dates. I have them in eletronic fomat exported to Excel… 😉

But I never, ever use the CREDIT of credit cards. If you think it’s crazy that in the UK credit card interest rate reaches 15%, in Brazil the rate reaches INCREDIBLE 200% a year!!!

Monevator

I’m like Ronaldo. I buy everything I can on my cashback card. It is set to be paid off with a direct debt every month, and there is zero danger of me ever missing a payment.

Besides the 1% cashback — which isn’t big I grant you, but over a lifetime those pounds and pennies all add up! 🙂 – I also get effectively free use of Amex’s money for a month, which technically saves me a microscopic but still present amount of money, too. It’s a win win.

You’re quite right to warn about the dangers though. Clearly my card provider hopes to trick me into overstretching myself, and it prepared to tempt me with 1% cashback to do it.

A game of cat and mouse!

Adam

@Ronaldo. Thanks for the kind words and great work on your own blog! I’ve been reading it through Google Translate:
http://translate.google.com/translate?js=y&prev=_t&hl=en&ie=UTF-8&layout=1&eotf=1&u=http%3A%2F%2Fwww.ebaratoserrico.com.br%2F&sl=pt&tl=en

Thanks for your detailed comment. It sounds like you have a great strategy that works for you. For me I’ve found that my typical spending in a month is lower than most people so getting to use a ‘free loan’ of a month’s worth of spending has minimal advantages for me.

Thankfully my debit card and online banking works in the same way as your credit card for helping me control my expenses with itemised and electronic lists of stores and transaction dates. As for bonus points, if I were spending larger amounts, say if I had a family and was running all the household bills through a credit card for example I can see how I could get better bonus points and airmiles but for now I’ll stick with my debti card for all but major purchases (where the consumer protection of a credit card comes into play).

Thanks again for commenting and i’ll continue to read you blog in Google Translate as my Portugese is not very good!

@Monevator. Thanks for commenting too. My bank doesn’t give the option of automatically paying off in full by direct debit -its the missing link in my otherwise ‘automated’ finance structure. But for the sake of one mouse click a month I haven’t looked into it further. 🙂

Payday loans from Samedaypaydayloan.com.au

Credit cards help you a lot in building a good credit score. If you use them wisely and keep on paying credit card bills on time, your credit score will automatically get improved.

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