This article may contain links to products and services we use and recommend. We may receive compensation when you click on links to those products. For more information, see our Disclosure Policy.
In 2020, Americans carried an average of USD 5,313 in credit card debt. Credit card balances in New Zealand added up to NZD6.457bn in November 2020 – about NZD1,313 for every Kiwi. While the pandemic saw people repay more credit card debt (at least for some time), many still stumble into the debt trap credit cards can become if you don’t know how to use them.
Some finance gurus recommend cutting up your credit card. That might be wise for some, especially when paying off credit card debt. But it is not practical (or necessary) for everyone. In my article today, I’ll try to demystify credit cards so that you can reap the benefits while avoiding the pitfalls.
Disclaimer: While we share what we have learned working in the financial services industry for almost two decades and managing our finances, this article does not constitute financial advice.
Used properly, credit cards can be a useful cash management tool
What happens when you pay by card?
The mesmerising world of payments
You’re entering the mesmerising world of payments whenever you use your credit or debit card at a merchant terminal (or just the numbers on the card online). This world comprises a few players worth knowing about:
- You, the consumer,
- the issuer of your card,
- the merchant requesting payment from you for their product/s or service/s,
- the company that acquires your payment/pays the merchant (on your behalf), and
- the switch that processes your payment.
Payment Process Players
Issuers and acquirers are (usually) financial institutions. A switch authorises, clears and settles payments. A scheme (Mastercard, Visa, Union Pay, etc) operates a switch. The scheme’s logo is on your card (in addition to that of your card issuer). The scheme also sets the standards for the payments processed through its switch.
Card payments: Who earns what and when?
You must pay $100 for shoes at a department store. You tap your card on the card reader at the cashier. In seconds, the system checks if your account has a sufficient credit limit (or account balance in the case of debit cards).
Once the payment is approved, your $100 will not only pay the department store (the merchant). They also pay the other players in the payment world, with each of them getting a clip of the ticket:
- Your issuing bank debits your account with $100 but only passes $99.00 to the switch (Issuer earning = $1.00).
- The switch pays $98.75 to the acquirer (Switch earning = $0.25).
- The acquirer pays the merchant $98.00 (Acquirer earning = $0.75).
Payment Process Earnings
In this (very) simplified example, all fees add up to $2.00 (or 2%), which the merchant carries (and passes on to the consumer for the convenience of card payments through higher advertised prices or a surcharge for card payments).
In reality, the charges are significantly more complex. Not only does the scheme/switch charge other fees to both the issuer and the acquirer. The fees charged by the scheme/switch also vary, pending
- the type of product/service purchased,
- whether a credit or debit card was used,
- whether it was a corporate or personal card,
- if the card was present (the card was physically used on a merchant terminal) or not present (the card data was entered online),
- whether it was an international transaction, etc.
What are the key advantages of credit cards (over cash or debit cards)?
Credit cards are safer
If you want or need to make a more significant purchase, paying by credit card is significantly safer than carrying a stash of cash around:
- Credit and debit card transactions (through the schemes) are automatically protected against fraud. Unauthorised transactions or transactions where the promised product or service wasn’t delivered can be disputed. If someone stole your card details and went on a shopping spree, it may take a while for the issuer to process the dispute (especially in the case of debit card disputes), but you should get your money back eventually.
- If the product or service you bought paying cash was not what was promised, you have no legal recourse.
Unauthorised card transactions can be disputed
Credit cards provide an interest-free loan
Our credit card payments are due on the 28th of each month, and the card statement is issued on the 3rd of each month. If we purchased something at the beginning of the month (just after the card statement was issued), payment for the item would not be due until almost two months later. We could have paid for the item upfront, but we chose to keep our savings in a high-interest savings account to earn some interest in the meantime.
This might be less beneficial in a low-interest-rate environment, but interest rates weren’t always that low (and will rise again at some point).
Credit cards may help to build a credit history
Imagine you have recently started your own business. You’ve worked hard to get it up and running. And you’re beginning to reap the rewards: you’ve saved up a deposit for your first home. You have calculated that your income will be enough to cover your mortgage repayments, however fluctuating it may be. You apply for a home loan… and it is being declined.
Lenders look at your income and the fact that it fluctuates when deciding whether to grant a loan. Your credit history is another. You don’t have a credit history if you’ve never had credit. You’re somewhat non-existent to a lender. I’m not saying you’ll be granted the home loan if you had a credit card in the past and always paid your statements on time, but it can help.
Think about it this way: your credit history is what customer reviews are for a business. As a consumer, you are likelier to buy from a business with (4 and 5-star) reviews than from a company with none. Likewise, a lender would be more likely to lend money to someone with a good credit score than someone with no credit history.
Used properly, credit cards may help build credit history
Credit cards may offer rewards
Common rewards offered by credit card issuers are cash-backs, points and miles:
- As the name suggests, cash-backs return a certain percentage or amount for every dollar you spend, effectively giving you a discount on your purchases.
- Alternatively, you can earn points or miles with your purchases and use these points or miles in future purchases.
When we lived in Australia, we had a credit card that accumulated Qantas air miles with every dollar spent. We used the card to pay for everyday purchases we would make anyway. Over time, our regular household spending earned us enough miles to use on international flights and flight upgrades for years to come.
You can earn airmiles with everyday purchases and use these airmiles for future trips
Credit cards may offer other useful perks
Credit cards may also offer other perks that could be of benefit to you.
For example, the air miles card we had in the past included travel insurance and concierge service. While we never tested the concierge service, we frequently used travel insurance, which saved us a few hundred dollars for each trip and more than covered the card’s annual fee.
International travel is cumbersome, uneconomical and risky without a credit card
Have you ever tried hiring a car using cash or a debit card? Most companies don’t accept either. Let’s assume you find a hire company that accepts your debit card. Given that your account is debited straight away, you must have enough to cover both the hire fees and the deposit the hire-company charges.
Cash or debit cards are not always accepted
No one in their right mind would carry large amounts of cash on them when travelling overseas. When Paul and I started travelling internationally, traveller’s cheques were the safest way to pay for our expenses overseas. We would buy them before our trips, and if they got stolen, the issuer of the cheques would replace them. It was safer than cash but also very cumbersome and costly:
- you had to estimate upfront how much money you might need (mind you, that was before you could google ‘average travel costs in country X’) and
- the cheque issuer and the institution turning it into cash at the destination ensured they’d earn a decent ticket clip.
Traveler's cheques used to be the safest way to pay or exchange money when travelling overseas
With credit cards, you no longer need to estimate your trip costs upfront (though we do recommend creating a budget and saving the money for your trip before you leave). Paying by credit card also gives you access to the scheme’s FX rates. These FX rates are as close to interbank rates as consumers can get – at least if you pick a card that doesn’t slap foreign transaction fees and currency conversion fees on top.
Securing your currency needs overseas can be expensive, but it doesn't have to be. We've saved a significant amount of money over the years simply by knowing what to do (or, more importantly, what not to do).
- How not to get caught out by alarming FX rates and exorbitant commissions;
- How to exchange cash on your overseas trip.
- Which debit/credit card is best for your overseas trip, and
- How do you avoid unnecessary fees when withdrawing cash?
Suppose you need to transfer money to pay for your travels upfront. In that case, we recommend Wise and XE Money Transfer (we use them interchangeably, depending on which one offers the better foreign exchange rates and lower commissions).
What are the significant pitfalls of credit cards?
Credit cards may incentivise overspending
Access to money at our fingertips may lead us to buy stuff we may not buy if we had to count out the notes in front of the cashier or top up our debit card before paying for it.
Credit cards can be costly
Firstly, credit card interest rates are atrocious. A quick Google search revealed that credit card interest rates in New Zealand are as high as 29.95%. For comparison, the official cash rate is currently 0.25%, and the lowest 1-year home loan rate is 1.99%.
If you can’t (afford to) pay your credit card statement in full every single month stay away from credit cards!
Apart from interest, issuers may also charge annual fees, foreign transaction fees and currency conversion fees. Cash withdrawals (including paying for foreign currency at a Money Exchange) trigger cash advance fees (at a similar exorbitant rate as any interest charged). Late payment fees apply if you miss your monthly payment – even by just one day!
If you haven’t guessed by now, credit cards are big business for the payment world’s players and card issuers in particular.
If you can’t (afford to) pay your statements in full every single month stay away from credit cards
Credit card debt reduces your credit score
We spoke about credit cards helping to build a credit history. On the flip side, credit cards can also impact your credit history detrimentally: If you don’t pay off your credit card statement in full every single month, your credit score will take a hit. This, in turn, may impact your ability to secure credit in the future, for example, if you want to secure a home loan.
How can you use credit cards to your advantage and avoid debt?
Ask yourself why you need one and if you can afford it
As with many things in life, determine your needs first. That’s especially important with credit cards, as we want to take advantage of them and not be enslaved to them. Right?
So, firstly, ask yourself why you need one. Is it because your peers have one? Or would the card make it more convenient because you have to pay for things anyway? Whatever your reason might be, Only get a credit card if you are able and willing to pay your credit card statement in full and on time – every. single. month.
Credit cards are no replacement for lack of funds. If you can’t pay for something because you don’t have the income or savings to cover it, getting a credit card is the wrong move.
If you can’t afford a credit card, make a budget, start saving, build up a decent emergency fund, and maybe revisit the idea of getting a credit card later when you can.
If you can’t afford a credit card make a budget and start saving first
Match the credit card to your needs
So, how do you figure out what credit card suits your needs? Let’s go through a few scenarios:
The overseas traveller/shopper
Do you regularly order items online that come from overseas or frequently travel overseas? If so, you should look for a credit card with no foreign exchange and currency conversion fees.
The regular spender
You have grocery bills that are pretty much the same every week. Or you have regular business expenses you pay for upfront (and claim back from your employer). A rewards credit card might be most suitable for you.
Shortlist the cards that would give you the highest reward at the lowest annual fee, and pick one of those.
- If you have to choose between no annual fee and rewards, Based on your average spend, calculate whether the rewards earned after a year substantially exceed the annual fee.
- Also, exclude any cards that require a minimum spend or at least only include those in your shortlist that are well within your regular spending budget. Never sign up for a card that stretches your budget!
If you travel frequently, you may want to consider cards in your shortlist that reward you with air miles. Use the air miles accumulated to book flights or upgrades, but don’t use the rewards card to pay for your overseas expenses (unless they also have no foreign exchange and currency conversion fees).
The occasional user
Do you only need/use a credit card occasionally, for example, when you travel domestically? If so, you’d be looking for a credit card with no annual fee. If it comes with rewards, pick one that doesn’t require a minimum spend.
A friendly reminder
Before you sign the dotted line on your credit card application, also consider the following:
- There is no single credit card issuer with your best interests in mind. So, always read the terms and conditions. We know it’s tedious, but doing it will save your butt!
- With that point in mind, you may get a limit increase offer from time to time. It might be flattering, but… unless your current limit is too restrictive and the new limit is well within your ability and willingness to pay it off in full every single time, kindly decline any limit increase.
- Likewise, if you already have a credit card that matches your needs and receive an offer for another credit card, don’t accept that card. The more credit cards you have, the more likely you are to overspend or miss a payment.
While tedious, reading the terms and conditions before applying for a credit card might save your butt
Pay your statement in full and on time EVERY. SINGLE. MONTH.
To avoid paying interest (and late payment fees), pay your statement in full AND on time during every billing cycle! We can’t stress this point highly enough. This is the Achilles heel of credit card usage.
To never miss a payment: Set up a calendar reminder with plenty of buffer. Or even better, set up a direct debit (make sure you have enough funds in your transaction account when the debit happens).
If you do miss a payment you need to pay off the whole credit card balance (not just the statement you missed to pay on time) immediately to reset your credit card balance to zero and avoid any ongoing charges.
For example, The credit card statement you missed paying on time was $600. Since the statement issue (3 weeks earlier), you have already spent another $400. The day after your statement was due to be paid, you are charged a late payment fee of $25 and 20% interest. The interest is not only charged on the $600 invoiced but also (pro-rata) on the $400 you spent since the last statement was issued. To reset your balance to zero and avoid ongoing charges, you need to pay $1,000 plus the $25 late payment fee plus the 20% interest charged (and a little extra, just in case).
To avoid paying interest and late payment fees, pay your statements in full and on time every month
Can balance transfer cards help to get rid of credit card debt?
The short answer is: it depends. If you have credit card debt that you can (realistically) pay off within 6-12 months on your current income and with some discipline, getting a balance transfer card might be a good option – especially if you have no other debt.
Specifically, you’d be looking for one that offers
- 0% interest for those 6-12 months (depending on how quickly you can pay off your debt),
- a sufficiently high credit limit to cover your balance transfer/s, and
- has (ideally) no annual fee.
Transfer any balance/s to this new card and cancel (all) your old one(s). Create an automatic repayment plan so that you have paid off the balance/s transferred before the 0% intro rate finishes. Stick to that plan, and don’t add any more credit card debt.
Put the balance transfer card somewhere you can’t easily get to. Or do what some finance gurus suggest: ceremoniously cut up the card. Once you pay off your credit card debt, cancel the balance transfer card.
Some finance gurus recommend to cut up your credit card when you pay off credit card debt
How do we use our credit card/s?
Firstly, and most importantly, we always pay our credit card statements in full and on time. To achieve that, we have set ourselves a calendar reminder for the 15th of every month—plenty of time until our payment is due.
We have two credit cards, both issued in Australia. They have no annual fees, foreign transaction fees, or currency conversion fees. They also don’t have rewards, but that doesn’t bother us.
Having two cards doesn’t mean we use both all the time; it’s quite the opposite. In New Zealand or Australia, we primarily use our respective debit cards (we have transaction accounts in both countries). We only use one of our credit cards when we purchase larger items and products or services from overseas suppliers.
To avoid cash advance fees, credit cards need to carry a credit when used to withdraw cash
When we travel outside of Australia or New Zealand, we use
- one credit card to pay for flights, accommodation, food and activities, and
- the other credit card to withdraw money from ATMs, ensuring it is topped up (that is, it carries a credit) before we withdraw to avoid cash advance fees.
Each withdrawal costs us 2% of the withdrawal amount or $4 – whichever is greater. We need to plan our withdrawals, as the transfer to the card account may take a few days to be processed. And the amount we need to transfer needs to include the expected withdrawal fee. For example, if we want to withdraw USD400, we would transfer the AUD equivalent of USD408 (plus a bit more to be on the safe side). For a quick check of the FX rate at the time, we use the XE Money Transfer app on our phones.
What do you think are the real credit card benefits or pitfalls?
Credit cards are not something we should be afraid of nor something worth despising for the risk they pose. We need to (know how to) use them properly. If I missed any benefits or pitfalls worth mentioning, let me know.
Before you go, if you liked our article and found it helpful, we would appreciate it if you could share it with your friends and family via the Share buttons below. Even better: Leave a short review on Trustpilot or Google, which would help us further build our online reputation as a (trustworthy and helpful) travel and lifestyle blog.
