Welcome to another installment of Macro Mondays! We continue our 10-part discussion on credit cards with something that the public is all too familiar with: the CONS of using a credit cards. Sure, buying stuff is great, but there can be a downside to having access to so much credit, especially when we look at the possibilities of what it can buy and not about how to pay it back.
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While credit cards are a convenient and secure alternative to cash and checks, they can get you into real financial trouble. Here’s how:
Compound Interest Can Create a Debt Trap
In the last section, we said that the ability to delay payment interest free through a grace period is one benefit of using a credit card. The downside of the ability to delay payment using a credit card is that you can delay payment indefinitely. The only money your credit card issuer requires you to cough up every month is the minimum payment. As long as you pay that sum, you can spend your heart’s content, up to the credit limit, and take decades to repay the balance.
We don’t recommend going this route, because interest charges will make your balance balloon until it becomes suffocating and nearly impossible to repay. Sure, you could declare bankruptcy, but then your credit score will be ruined and it will be difficult to borrow money for years to come. Since some employers check applicants’ credit scores before hiring them, it could even affect your ability to work.
The best way to use a credit card is to pay your balance in full and on time every month so you don’t go into debt or have to pay interest. Still, sometimes going into credit card debt is the least bad option when money is tight. If that happens, limit your purchases to necessities and make a plan to pay off the debt as quickly as possible as soon as your situation improves.
Plastic Can Encourage Spending
That being said, even if you do pay your balance in full and on time each month, studies show that it may be psychologically easier to spend – or to spend more for the same products and services – when you’re paying with plastic than when you’re paying with cash. It can be even more tempting to overspend when you know you’re earning points or cash back. But credit card rewards, with the exception of sign-up bonuses, are a pittance compared to the interest you’ll pay if you carry a balance. They’re also a pittance compared to the overspending you might do when you pay with plastic.
If you’re trying to reduce your spending, try paying with cash more often and see how it feels and whether you do in fact spend less.
Late Payment Fees Can Make It Harder to Catch Up
Understandably, credit card issuers want customers to make at least the minimum monthly payment on time. As a result, they penalize customers who are late. Under the CARD Act, the fee for the first late payment a consumer makes is limited to $25, and the fee for each additional late payment within six months can be up to $35.
While these fees are low in the grand scheme of things, for someone who has fallen on hard times and can’t even scrape together the minimum payment before it’s due, fees can make it harder to catch up. For a customer with plenty of financial resources who has simply forgotten a deadline, late fees are just an annoyance. But they can eat away at your credit score.
High Balances Can Hurt Your Credit Score
Simply carrying a credit card or multiple credit cards will not hurt your credit score. In fact, it can help your credit score, as we’ll explain in next week's article. But if you spend more than 20% of your credit limit – even if you pay your balance in full – your credit score may suffer because using a significant percentage of one’s available credit is considered a risk factor in the eyes of the credit bureaus.