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What do I need to know about credit cards?

Credit cards look so harmless– small pieces of plastic in pretty colours, with our names, and sometimes even our pictures, on them! They are pretty useful too; I carry mine on the back of my phone, which along with my house-key, is all that I leave the house with, most of the time. No need to carry a wallet or purse I can use the credit card to shop for groceries or that impulse buy.

But for those of you who don’t understand credit cards, here’s a little bit on the basics of credit cards –

They’re like unsecured personal loan

There are different types of plastic cards available – debit cards are convenient ways to access your own money; charge cards also basically provide convenience by giving you short-term credit; credit cards are also convenient, but more importantly, offer credit, as the name suggests. Credit means loans; so credit cards are essentially loans.

Unlike home loans though, the issuing banks don’t take something tangible as security i.e. it’s unsecured. They just check your income and expenses to assess whether you can afford to pay back the capital and interest. So you have a personal liability to pay back the amount you swipe on your credit card.

When you use a credit card to buy something, the bank has essentially given you a loan. You can use the credit card any number of times in a month, but up to a certain pre-set amount limit. At the end of the month, the bank sends you a bill with the total amount you’ve spent. Most cards allow you to pay a minimum amount, and ‘carry over’ the rest, but then you will start paying interest on the unpaid amount. You also pay interest on further purchases, possibly from the purchase date.

They’re super useful for budgeting and building credit scores

I find them useful to keep track of my expenses. I just buy everything on my card, so at the end of the month I can see how much I’ve spent. Some banks allow you to export the bill into excel, along with category tags (like restaurant/bars, clothing, groceries etc), which is great for budgeting.

You can also use a credit card to build a ‘credit score’ – a point system that keeps track of any late payments or defaults on utility bills, credit cards and other loans to assess your creditworthiness. You need a credit score when you apply for a home loan, so you might as well have a good one. Make sure you have a separate one from your spouse or children (so have a separate credit card).

There’s a high interest rate, compounded daily

This is where the trouble begins. When loans are secured against an appreciating asset like a house, the interest rate tends to be quite low. Car loans are secured against a depreciating asset, so interest rates are slightly higher. Credit cards are basically unsecured personal loans, so attract the highest interest rates because if you default, the banks can’t sell your house or car. All they can do is chase you, and take legal action. (But don’t even think about not paying; it will destroy your credit score).

Interestingly, credit card interest rates tends to be 15-20%+ per annum, even in low interest rate environments.For some, compounding is like the 8th wonder of the world. Basically, it’s interest on interest. When you’re investing, it’s great because your capital grows at an exponential rate. However, when you’re borrowing, it can be disastrous; your loan spirals out of control at an exponential rate!

Example – if you had to come up with 2k (pick your currency) to pay for an emergency. Your card charges 18% pa interest rate and you decide to make minimum payment. After paying 6 months of minimum payments, the balance you owe will still be more than 1500. Two years later you would still have to pay 703. It will take you 3 and half years to pay it off, and you would have paid 2423 in interest, higher than the original amount. So my advice – pay off your credit in full every month!

In conclusion, credit cards, like credit generally, are just a tool. They are useful when used correctly, but can be trouble if they are not. Make sure you understand everything I’ve said here and use them wisely.

Hansi Mehrotra, CFA is a financial educator who writes and speaks on various platforms, getting named as a ‘Top Voice for Money and Finance’ on LinkedIn for 2015. Hansi has more than 20 years experience in financial services.
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