Credit Cards (the Sneaky Loan) and Your Credit Rating
Part 3 of a Series: A CPA’s Advice to Young Adults
This article is the third in a series containing advice from a CPA to young adults. The series tackles issues that should be formally taught in high school or college, but seemingly are not, and its goal is to encourage good financial habits early in life. Although directed toward young adults, the series’ content should be relevant to people of all ages and stages of life. The first few installments are skewed heavily toward various aspects of debt, including this one and its predecessors, Let’s Talk about Debt: Your Financial Frenemy, and How to Understand and Compare Loans . . . and Choose the Best One, both of which are found on our website.
This article will explain how credit cards are excellent vehicles for some transactions, but horrible tools for others. It also will address your credit rating.
Credit cards – the sneaky loan
It may not seem like it, but each time you use a credit card, you are taking out a new loan or adding to an existing one. Here is how it works: Each transaction represents your agreeing to pay the amount of the transaction to the card-issuing bank. When you use your credit card to pay, several things happen. Behind the scenes, that bank and other parties arrange to pay the store the amount of your purchase (less of course, a “convenience fee” for their efforts). The card-issuing bank tracks all the purchases that you make in a month, and sends a bill to you. That bill includes the total of all charges you made that month, plus the total of any previous months’ purchases not yet paid off, plus interest due on the balance. It also will tell you the minimum payment amount due at that time.
There are two types of credit card users: (1) those who pay their balances in full each time they receive a bill, and (2) those who occasionally or always “carry a balance,” meaning that their current balance consists of new charges and old charges (and interest) that they did not or could not fully pay in an earlier month or months. This arrangement is a type of revolving line of credit.
Those in the first category generally use their cards solely for convenience. They have the money to pay for the purchase, but do not care to carry cash or a checkbook for every purchase. These people tend to shop “within their means.” Although it is of a very short-term nature, they are borrowing money from the card-issuing bank. However, because nearly every credit card arrangement charges interest only if the balance is not paid in full when billed, they are borrowing at a 0% (zero) interest rate. Using a credit card in this manner represents a shrewd way of handling personal finances.
Those in the second category may also appreciate the convenience, but they also are incurring interest on their loans, simply by not paying the full amounts due. Unfortunately, of all the types of loans available, credit cards tend to charge some of the highest rates – often by a wide margin. Although in some cases carrying a balance from month to month may be necessary, this is not the best way to borrow money if it can be avoided, and those who perpetually are unable to keep up with the monthly credit card bills should take a hard look at whether each charge is truly necessary.
The high interest rate that applies to most credit cards is worth a harder look. Let’s compare some interest rates on different types of loans: A common mortgage rate today (for a home loan) may be 4%, while a common car loan rate is perhaps 5 or 6%. Part of the reason these rates are this low is that the lender is somewhat protected because the loans are “collateralized” – if you do not pay, they can repossess your property to settle the debt. (A car serves as “collateral” for the related loan.) Credit card rates vary widely, but often they are in the 15% – 18% range. These rates are so high that if you fall behind and your balance is large enough, you may find yourself facing payments that are applied mostly to the interest on the loan, without ever paying off much of the underlying principal. For this reason, credit cards easily represent one of the worst choices for a loan (even though they may be the easiest to obtain).
Those who carry balances on credit cards may not necessarily be poor managers of their money, but there are better ways to borrow money, and credit cards often entice people into buying more than they can truly afford. Some people would be better served with a debit card instead of a credit card, because debit cards do not let you spend what you do not already have. Debit cards and credit cards are very different animals. Their differences are explained in another BNN article entitled “Debit or Credit – Which Card Should I Use?”
A good way to use credit cards is to use them only as a way to avoid carrying cash for every purchase. Use them only if you already have the money to make those purchases, and plan to pay off the credit card bill each month when you receive it. If you pay your balance in full (which I hope you develop the discipline to do) you will incur no interest, thereby achieving a short-term, interest-free loan. Cards should not be used as a source for long-term loans. If you routinely carry a balance on a card, you are borrowing money expensively under some of the worst possible terms available, and should look for some alternative both for future borrowing and for paying off existing credit card debt.
Credit cards often offer their users the ability to build up points in the form of cash back, travel miles, or free loot. They also can be used to help establish, or help destroy, your “credit rating,” as discussed in the next section.
Credit rating – you are being watched (and why it matters)
Long before security cameras began popping up everywhere and advertisers began paying Facebook and ISPs to track our every digital move, several companies began gathering financial information on borrowers. They then sold that information to potential lenders, to help them determine whether particular borrowers are likely to pay back their loans. Experian, Equifax, and TransUnion are the three biggest such players in the industry, and you can assume that any time you borrow money (other than from a relative or a loan shark), your payment history is being reported to one or more of these credit bureaus. They each use a proprietary formula to determine your rating, which goes up when you do financially prudent things, and goes down when you do less than prudent things. This tracking occurs whether or not you want it to. You cannot opt out. You will have a credit score for the rest of your life. Why does this matter?
You can assume that any time you apply for a new loan, potential lenders will check with one of those bureaus to find out your “credit score.” If your score is good, you will find doors open to you. You will be more likely to be offered a loan, and may qualify for favorable terms (like low interest rates or a small down payment). You will also be more likely to qualify for larger loans than otherwise would be the case. Conversely, if your score is poor, you will be more likely to be denied a loan, or (to account for the lender’s greater perceived risk) you will be charged more interest, asked for a larger down payment, or be capped at a smaller loan amount. Prospective employers or landlords may check your credit rating before making you a job offer or renting an apartment to you. Your credit score could be described as your lifetime financial reputation. It should be protected.
There are a number of proprietary factors used to determine your credit rating, but at the core, you can best protect your rating by making all of your existing loan payments on time. If you hold a credit card (discussed above), you can favorably impact your rating by using that card, but avoiding the use of the full amount allowed (“maxing it out”) or carrying too large of a balance.
Potential lenders will use your credit rating as just one part of their analysis, which will include a look at your total assets (savings accounts/investments) and income. Most recent high school or college graduates do not yet have significant savings or income, though, which makes a good credit rating all the more important. Although it generally is a bad idea to incur debt unnecessarily, having a good credit score requires actually having a credit score, so incurring a small, manageable amount of debt at an early age may be a wise move.
Observation: Some of the best advice my father gave me while I was a teenager was to borrow a relatively small amount of money when buying my first car, even though I had saved enough money to pay cash for the entire cost. He advised me to carry the loan for at least a year, and be sure I carefully made every payment in full, on time. Dad had to co-sign the loan, but it still began establishing credit for me. Young adults – even those still in high school – will find that my dad’s advice holds true today. Credit sometimes can be established for a teenager simply by adding the teen as an authorized user on a parent’s credit card.
At the core, smart borrowing is a significant piece of making smart financial decisions. This includes proper use of credit cards, and a conscious effort to repay loans on time, which will help you establish and maintain a good credit rating.
Any use of credit should first involve a determination of whether you can afford the repayment. Unless you are raking in significantly more income than you are able to spend, it is highly advisable that you create a budget, which should list the income you will earn, and the categories and amounts of costs you will face. That will be the subject of the next installment in this series.
For more information, please contact Stan Rose at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.