In 2020, Americans carried on average USD5,313 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 a period of time), a lot of people 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 a wise idea for some, especially when you’re paying off credit card debt. But it is not practical (or necessary) for everyone. In our post today, we’ll try and demystify credit cards, so that you can reap the benefits while avoiding the pitfalls.
What happens when you pay by card?
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), you’re entering the mesmerising world of payments. 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.
Issuers and acquirers are (usually) financial institutions. A switch authorises, clears and settles payments. A switch is operated by a scheme (Mastercard, Visa, Union Pay, etc). 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 when?
Let’s say you have to pay $100 for a pair of shoes at a department store. You tap your card on the card reader at the cashier. In split 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 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 to the merchant $98.00 (Acquirer earning = $0.75).
In this (very) simplified example, all fees add up to $2.00 (or 2%) which are carried by the merchant (and passed 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 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 larger 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 case of debit card disputes), but you should get your money back eventually.
- If the product or service you bought paying cash turned out not to be what was promised, you have no legal recourse.
Credit cards provide an interest-free loan
Our credit card payments are due on the 28th of each month. 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 2 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.
In a low-interest-rate environment, this might be less of a benefit but interest rates weren’t always that low (and are going to 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 starting to reap the rewards: you’ve managed to save up a deposit for your first home. You have calculated that your income, however fluctuating it may be, will be enough to cover your mortgage repayments. You apply for a home loan… and it is being declined.
Your income and the fact it fluctuates is something lenders look at when they decide whether to grant a loan or not. Your credit history is another. If you’ve never had credit you don’t have a credit history. You’re somewhat non-existent to a lender. I’m not saying you’ll definitely be granted the home loan if you’d 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 more likely to buy from a business that has (4 and 5-star) reviews than from a business that has none. Likewise, a lender would be more likely to lend money to someone with a good credit score than someone with no credit history at all.
Credit cards may offer rewards
Common rewards offered by credit card issuers are cash-backs, points and miles:
- Cash-backs, as the name suggests, return to you a certain % 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 would accumulate Qantas air miles with every dollar spent. We would use a credit card to pay for everyday purchases we would make anyway. Over time, our regular household spend earned us enough miles to use on international flights and flight upgrades for years to come.
Credit cards may offer other useful perks
Credit cards may also offer other perks that could be of benefit to you.
The air miles card we had in the past for example included travel insurance and concierge service. While we never tested the concierge service, we frequently used the travel insurance, saving us a few hundred dollars for each trip and more than cover the annual fee of the card.
International travel is cumbersome, uneconomical and risky without a credit card
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 your account is debited straight away, you have to have enough in your account to cover both the hire fees and the deposit the hire-company charges.
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
- both the cheque issuer and the institution turning the cheque into cash at the destination made sure they’d earn a decent clip of the ticket.
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.
What are the major pitfalls of credit cards?
Credit cards may incentivise overspending
Having access to money at your 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 had to top up our debit card before we can pay for it.
Credit cards can get costly
Firstly, credit card interest rates are atrocious. A quick google search revealed credit card interest rates in New Zealand 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 it by now: credit cards are big business for the players of the payment world, and for card issuers in particular.
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 to 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 because you have to pay for things anyway, and the card would make it more convenient? 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 for 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 at some stage later, when you can afford it, revisit the idea of getting a credit card.
Match the credit card to your needs
So, how do you figure out what credit card suits your needs? Lets’ go through a few scenarios:
The overseas traveller/shopper
You regularly order items online that come from overseas or frequently travel overseas? You want to look for a credit card that has 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 or rewards: Based on your average spend, calculate whether the rewards earned after a year substantially exceed the annual fee or not.
- 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
You only need/use a credit card occasionally, for example when you travel domestically? 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 few words of advice
Before you sign the dotted line on your credit card application also consider the following:
- There is not a single credit card issuer that has 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 you receive an offer for another credit card don’t accept that card. The more credit cards you have the more likely it is to overspend or miss a payment.
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 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 (just 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.
To give you an example: The credit card statement you missed to pay 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 any ongoing charges, you need to pay $1,000 plus the $25 late payment fee plus the 20% interest charged (and a little bit extra just in case).
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 a bit of 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 paid off your credit card debt, make sure you cancel the balance transfer card.
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. Both of these cards have no annual fees, no foreign transaction fees and no currency conversion fees. They have no rewards either, but that doesn’t bother us.
Having two cards doesn’t mean we use both all the time, quite the opposite. When we are in New Zealand or Australia, we mostly use our respective debit cards (we have a transaction account in both countries). We only use one of our credit cards when we purchase larger items and products or services from overseas suppliers.
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 in advance, 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’d 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 OFX app on our phones.