We love reading those personal finance blogs and success stories about how this person got out of $80K debt or someone else paid off all of their credit cards in less than a year. Which is no wonder considering the average American has a credit card balance of $6,375 (1) and has 2-3 credit cards open at a time. (2) But why don’t we hear more about the individuals who completely avoid racking up all this debt and live comfortably within their means? Or better yet, how about those individuals who reap the benefits of healthy credit without paying any fees or interest?
Credit doesn’t have to be a scary topic; in fact, there are some great benefits to be gained if you use it thoughtfully and strategically. Before we get into these smart credit strategies, let’s first cover the basics on what credit is and why it matters.
Although we are all likely very familiar with credit cards, it’s important to note the difference between credit and other forms of money management. At a basic level, credit cards can be used to make charges up to an assigned credit limit (say, $10,000). This can essentially be considered a flexible loan from the bank for you to make a purchase within that limit. You have a short-term period of time – a “grace period” -- typically 30 days, to pay back the amount you used before you start incurring fees. You have the option to either make a minimum payment on that outstanding balance, or more, to minimize or avoid interest fees. Interest is typically charged at an APR, or Annual Percentage Rate, which can quickly accumulate month-over-month if not properly managed. For example, if you went out to buy a new $500 flat-screen TV and don’t pay it off for an entire year, you’d end up paying an additional $75 in interest.
Credit is different than a conventional loan (such as student, auto or mortgage loans), which include a fixed end date and reccurring payments on your balance due. Furthermore, it is also different than a straight cash or debit purchase where you need to pay for the item up-front.
Before you ever decide to cut the cord on using credit, there are 5 key advantages to note that contribute to an overall gauge of your financial health, both now and in the future (3):
- Factors into Overall Credit Score: this is critical if you plan to borrow money in the future, such as for a home mortgage. The bank you intend to borrow from will asses your ability to pay back the desired loan. It does this by evaluating your credit history and track record to paying it back (on time). You lack this insight from a debit or all cash history.
- Bonuses and Rewards: this can be your best friend or worst nightmare. Typically credit cards will offer a steep promotion to entice you to sign up – such as a cash back lump sum, bundle of airline miles or travel points. Then for the money you spend, these continue to add up. If you can pay off your balance each month to avoid an interest charge, this can be a rewarding bonus for the money you’re already spending.
- Fraud Protection: unfortunately, identity theft is something most of us will encounter at one point or another in our life. Since funds aren’t withdrawn immediately on a credit card (as opposed to a debit card), it can be less disruptive to your budget. Once reported, the credit card will be frozen to investigate the situation and resolve the matter, without losing access to your checking or debit account with your liquid funds.
- Necessary when Traveling: when booking a hotel room or rental car, the business will typically put a deposit on your card for incidentals (that can range up to a few hundred dollars). On a credit card, this hold can process and be removed without any interruption to your spending. This can get tricky with a debit card. Furthermore, most credit cards are accepted internationally, which can minimize high exchange rates if using straight cash.
- Built In Grace Period: credit cards typically have zero interest for 30 days (sometimes up to months for specific promotions). So if you’re in a bind or need to make a purchase without money in-hand, you have that flexibility without taking out a personal loan.
Although credit cards have their benefits, it’s important to be mindful and implement smart money managing habits early on. After all, several studies have revealed that people spend more money when using a credit card than other forms of payment. (4) Therefore, here are some best practices to implement in your life for achieving financial independence, while enjoying the benefits of credit cards:
- Pay off your balance in full each month – obviously; but this is often easier said than done. How can you make it a habit? Create a budget of everything you buy each month (include subscription payments such as gym memberships or cable bills, as well as flexible spending such as entertainment and groceries). Ensure your income exceeds what you plan to spend. You may even consider tracking your categories of spending using an application such as Mint.com to monitor and adjust where needed.
- Actively manage your finances instead of waiting to see what happens. Implement good habits of self-discipline and minimize impulse buys because you “can with a credit card.”
- If needed, pay for a large purchase over time and take advantage of 0% APR promotions.
- Don’t chase rewards – consider these as a bonus, not an incentive to buy.
- In addition to having an emergency savings fund set aside, also have an emergency plan if your credit card gets off course. Consider putting it away and refrain from using it until the balance is paid off in full to avoid a debt spiral.
- Understand ALL fees associated with your card, including your annual fee, late fee, interest charge, and foreign transaction fee to name a few.
- Protect your information and shred any papers with account information on it (including credit card promotions you receive in the mail).
- Use common sense. If something seems too good to be true, do your due diligence to follow up and clarify details before signing up.
- Check and monitor your credit score. Did you know you can receive a free copy of your credit report every year from each of the three credit reporting agencies (Experian, TransUnion and Equifax). Make sure you take advantage of this and consult with a professional to ensure you’re in control of this important part of your overall financial picture.
- Responsible money habits early on can be the difference between financial health and financial struggle. Implementing these best practices into your approach to credit can help ensure you’re on the right track, both now and for your future.
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