If you ever want to start an argument in a financial forum, all you have to do is bring up the topic of credit cards. It seems that everyone either loves them or hates them.
Some financial gurus, most notably Dave Ramsey, see credit cards as pure evil. Ramsey states that “responsible credit card use does not exist,” and maintains that there is simply no good reason for anyone to use one, ever. But others, such as Jeffrey Strain of the investing site The Street, argue just as passionately in their favor. Strain calls credit cards “an excellent financial tool” on account of their convenience and the protections they offer consumers.
Both fans and foes of credit cards have already made up their minds, and nothing is likely to change them. But for those who are on the fence, it’s worth taking a closer look at the arguments on both sides – against credit card use, and in favor of it – to see just how well they hold water.
Disadvantages of Credit Cards
One reason so many people are so strongly anti-credit card is that they’ve seen how much trouble people can get themselves into by using credit cards irresponsibly. Credit card haters often point out that the majority of people who use credit cards – 55% of them, according to the 2010 Survey of Consumer Finances conducted by the Federal Reserve Board (FRB) – carry a balance from month to month, and the average amount of that balance is more than $7,000. Just the fact that it’s possible to run up this much debt with credit cards, they argue, is a good enough reason not to use them.
However, they also maintain that even for those who carry a lower balance (or none at all), using credit cards is a bad financial move. Credit cards, they point out, can suck money out of your wallet in three major ways: interest, fees, and overspending.
1. Interest Payments
The most obvious problem with credit cards is that if you carry a balance, you have to pay interest – a lot of interest. A survey of credit card interest rates by CreditCards.com shows that the average interest rate on credit cards in the U.S. is 15%. And that’s just the overall average – for users with bad credit, the typical interest rate is a whopping 22.73%.
Suppose you’re a credit card user with a balance of $2,600 – a typical amount, according to the FRB survey – and an interest rate of 15%. Based on a credit card interest calculator, if you make only the minimum payment each month – typically 4% of your total balance – it will take you more than nine-and-a-half years to pay off your balance. Over that period, you’ll pay about $1,119 in interest – over 40% more than you’d have paid buying the same items with cash.
Of course, in order to pay off that $2,600 balance, you also have to avoid buying anything new with the card over those nine-and-a-half years. If you charge just $100 a month to the card while paying only the minimum, these new charges offset your payments, and the balance just keeps creeping upward. Instead of being paid off after nine-and-a-half years, your balance will have risen to nearly $3,500.
Fortunately, most credit card users don’t do this. A 2012 survey on budgeting and credit card use by the American Association of Retired Persons shows that only 8% of users pay the minimum amount on their credit cards. If you pay a flat $250 a month toward your $2,600 balance instead of just paying the minimum, you can have the whole thing paid off within a year, and you will pay only $159 in interest.
Better still, it’s possible to avoid interest payments completely by paying the balance each month in full. As long as you pay the full amount listed on your credit card bill before the due date, you don’t have to pay a dime in interest. The FRB reports that roughly 45% of families with credit cards do exactly that. So while credit card interest can certainly be a major expense, it’s also one that’s quite easy to avoid.
2. Other Fees
Interest payments aren’t the only cost of doing business with a credit card company. Credit cards also hit you with fees for just about everything you can think of, including the following:
- Annual Fees. An annual fee is a payment charged once a year just for the privilege of using the card. You’re most likely to find this type of fee on cards that have generous rewards programs, such as cash back or frequent flyer miles. This benefit makes the annual fee worth it for some users, since they can earn more back in rewards than they pay for the fee.
- Balance Transfer Fees. When you transfer a balance from one card to another – usually to take advantage of a lower interest rate – you have to pay a fee to the bank that’s taking over the balance. A typical balance transfer fee is 3% of the amount you’re transferring, but some cards charge 4%. Paying this fee can be worthwhile if the interest on the second card is considerably lower – for instance, if the card offers you a temporary interest rate of 0% for the first 15 months on the balance you transferred. Depending on how big the balance is, that deal could make the amount you save in interest enough to make up for the fee you pay to transfer it.
- Cash Advance Fees. If you need cash in a hurry and your bank account is low, many credit card companies are happy to let you use your card to borrow some cash. The fee for this service is often between 2% and 5% of the amount you borrow. However, the even bigger cost is the interest you pay on the loan. Not only do companies usually charge much higher interest for cash advances than they do for purchases, they also start charging it immediately, with no grace period – so before you even get your monthly bill, you already have interest to pay.
- Foreign Transaction Fees. If you use your card while traveling in a foreign country, you often get charged a fee of up to 3%. Not all cards have this fee, however, so people who travel abroad often can look for a card without it to use when they’re out of the country. Cards with no foreign transaction fees include Chase Sapphire Preferred, Capital One Venture, and the Discover it Miles card.
- Late Payment Fees. If you’re ever late paying your credit card bill – even by just one day – you can expect to be socked with a fee of up to $25. That’s the maximum fee companies are allowed to charge under the CARD Act of 2009. However, if you miss a second payment within six months, the fee can jump to $35.
- Over-Limit Fees. If you try to charge more on your card than your credit limit allows, one of two things can happen: The card issuer can reject the new charges, or it can allow the payment to go through – and then charge you an over-limit fee of around $39. Under the CARD Act, all credit cards must be set to the first option by default, so you can’t be charged an over-limit fee unless you agree to it. A few users, however, choose to accept over-limit fees rather than risk having their credit cards rejected at the register.
- Returned Payment Fees. If you pay your credit card bill with a check, and that check bounces – that is, the bank refuses to pay it because there isn’t enough money in your account to cover it – the credit card company charges you a returned payment fee of around $35. To add insult to injury, you can also expect to pay a fee to your bank for the bounced check – so this is one fee you should definitely go out of your way to avoid.
In many cases, it’s possible to avoid fees by choosing your card wisely and sticking to the rules, such as paying your bills on time. However, credit card issuers can be sneaky. Sometimes they try to tempt you into using your card in ways that will result in a fee, while burying the information about the fee itself in the fine print.
For instance, banks sometimes send you “convenience checks” that you can use like a personal check and have the payment charged to your credit card account. What they don’t usually mention up front is that payments made with these checks are treated like cash advances, with higher interest and no grace period.
Balance transfer offers are another example. Banks often send you offers to move your balance to their card for a temptingly low rate, but you have to read all the way down to the bottom to see the information about the balance-transfer fee they charge for this service. So while it’s almost always possible to avoid credit card fees, you have to be on your toes to avoid being suckered by the banks that issue the cards.
Opponents of credit cards argue that even if you always pay your balance in full and never pay a fee, paying with plastic still costs you money. Simply by swiping your card, they say, you automatically spend more than you would handing over a wad of cash.
This claim sounds bizarre, but there’s research to back it up. One study, conducted at Massachusetts Institute of Technology (MIT) in 2000, invited students to bid on tickets to a pair of sports events: a sold-out basketball game and a baseball game. Half the students were told they’d have to pay in cash if they won the auction, and the researchers checked to make sure they had “ready access” to a cash machine; the other half were instructed to pay with a credit card. The students who were paying with credit consistently bid higher on the tickets for both games than the ones who were paying with cash – in the case of the basketball game, more than twice as high on average.
In another a study published by the American Psychological Association in 2008, researchers at New York University asked people how much they would expect to spend on the ingredients for a Thanksgiving dinner. Participants who were told they’d be paying with credit generally set their budget for the meal higher than those who were told they’d have to pay in cash – but only if they tried to estimate the cost of the whole meal at once. When they were told to estimate the price of each item separately and add them up, the difference between the two methods disappeared.
The authors concluded that people are willing to spend more with a credit card because they don’t feel “the pain of paying” with a card as much as they do with cash. They suggested that credit cards and other “less transparent” forms of payment (such as gift certificates) felt like “play money” rather than real money, making users more willing to spend. When participants were forced to think about the actual cost of each item they were buying, this made the money they were spending seem more real, and the differences between cash and credit disappeared.
However, not all the research on credit card spending points to the same conclusion. For instance, the MIT study also included a second auction, in which students bid on a $175 restaurant gift certificate. In this case, the researchers found that on average, students bid about the same amount when using credit cards as they did with cash. This suggests that knowing the exact dollar value of the item they were bidding on made students less inclined to bump up their bids with credit.
Similarly, a 2009 study at Carnegie Mellon University offered one group of diners entering a cafeteria a gift card if they would pay for their lunch with cash, while another group was offered a reward for paying with credit. The researchers found that on average, people in the two groups paid about the same amount for their lunches. In this real-world situation, deciding ahead of time to use credit did not boost spending.
Overall, studies seem to suggest that people really do spend more with credit cards than they do with cash – but not in all situations. In general, people seem less willing to pay extra with credit when they are thinking carefully about what they’re buying and its actual value. So if you use a credit card, being mindful about your purchases – for instance, by looking at prices and adding them up in your head as you add items to your shopping cart – looks like a good way to protect yourself from the risk of paying a premium with plastic.
Advantages of Credit Cards
Even fans of credit cards admit that it’s possible to use them unwisely. They realize that treating credit cards like free money, using them to load up with fancy clothes and electronics you don’t need and can’t afford, is a big mistake that can get you into serious financial trouble. That’s why arguments in favor of credit card use almost always start with the words, “As long as you pay them off every month.”
For those who have the discipline to use their credit cards this way, supporters argue, paying with plastic makes a lot of sense. It’s convenient, and it offers protections you don’t get with other forms of payment. It also makes it easier to keep track of spending and helps you build up your credit score. And, as a bonus, many credit cards rewards programs offer perks such as cash back or frequent flyer miles, so paying with a card can actually put money back in your pocket.
For many people, the biggest advantage of credit cards is their convenience. Compared to cash, credit cards are easier to use in several ways:
- Fast Payment. 30 years ago, one person paying with a credit card could hold up a whole supermarket line for several minutes handing over the card to the clerk, waiting for it to be run through a clunky machine, and then signing the sales slip. Today, it takes only a few seconds to swipe your card or insert it in a chip-enabled card reader. That means the person using a card is actually faster than the one fumbling with a wallet and coin pouch looking for exact change – or handing over a $20 bill and waiting for change from the clerk.
- Easy Access. When you use a credit card for most of your shopping, you don’t have to worry about how much cash you have in your wallet. This really comes in handy in emergencies – for instance, if you’re stranded late at night in a city far from home and have to pay for a hotel room. Instead of having to wander the dark and unfamiliar streets looking for a cash machine, you can just whip out your card. Also, many hotels require you to present a credit card at check-in for incidentals.
- Fewer Trips to the Bank. When you pay for most things with cash, you either have to carry hundreds of dollars around with you – making yourself a target for thieves – or else make frequent trips to the bank to restock your wallet. However, when you use credit for most purchases, you can walk around with just $20 in your wallet for months at a time. This means you can hit the bank less often and save yourself some time.
- Automatic Currency Conversion. It’s really nice not to worry about how much cash you have on hand when traveling outside your home country. If you use cash for all purchases, you either have to convert a large sum in dollars to the local currency before you arrive – and convert it back when you return home – or spend a lot of time hunting for banks to withdraw more money. But when you make purchases with your card, the amount you spend automatically gets converted to dollars on your bill – often at a better rate of exchange than you could get from a bank. Just be sure that the credit card you’re using doesn’t charge foreign transaction fees.
- More Shopping Options. There’s no way to make purchases over the phone with cash. In that situation, plastic is the only way to go. A credit card is also a necessity for shopping at many online retailers – although many also accept online payment services such as PayPal, which can withdraw money from your bank account instead.
- Making a Deposit. When you make a reservation – for a hotel room, a car rental, and sometimes even a restaurant meal for a large group – you’re often asked for a credit card number. That protects the company by allowing it to charge a cancellation fee if you don’t show up. Without a card, it’s often impossible to make a reservation at all.
Opponents of credit cards point out that you can get most of these benefits by using a debit card rather than a credit card. This, in their view, is much safer than using credit, because a debit card takes the money directly out of your bank account, so you can’t run up debt.
However, this advantage is also a drawback in some ways. Because each payment comes out of your account instantly, you have to keep a careful eye on your balance to make sure you don’t overdraw your account.
With a credit card, you get just one bill at the end of the month, and you make just one payment to cover it. This also reduces the number of transactions you have to enter in your checkbook or bank register, which means you have fewer chances to make math mistakes.
2. Consumer Protections
Another advantage of credit cards over debit cards is the increased consumer protection they provide. Obviously, both debit and credit cards offer more protection than cash. If someone steals your wallet full of cash, the money is simply gone. By contrast, if someone steals your credit or debit card number and uses it to make purchases, you aren’t required to pay for them.
There’s one key difference, however. By the time you discover your debit card has been stolen, the thief could already have used it to make purchases with money that came directly out of your bank account. You can report the theft, but you still have to wait to get your money back.
With a credit card, on the other hand, the thief’s purchases simply get added to your bill. Since you can report the theft before you actually get the bill, you never have to pay for the purchases you didn’t make. Even if you fail to report a theft right away, your credit card still limits your liability. According to the Federal Trade Commission (FTC), the most you can possibly be forced to pay for false charges made with a credit card is $50 – and if it’s only your credit card information that’s stolen, not the physical card itself, you don’t have to pay a single cent.
With a debit card, on the other hand, you could be on the hook for hundreds or even thousands of dollars. Under the Electronic Funds Transfer Act, which governs debit card transactions, the amount you owe depends on when you report the loss. It also varies depending on whether your card was actually stolen or just used fraudulently.
- If you report the loss before the thief makes any transactions, you owe nothing for any transactions made after that.
- If you report the loss within two business days after you discover it, you owe a maximum of $50 for transactions made by the thief.
- If you report the loss within 60 calendar days after receiving your statement, you owe a maximum of $500. If your card number was used without your permission, but the physical card wasn’t lost, you owe nothing.
- If you wait longer than 60 days after receiving your statement to report the loss, you lose all the money the thief took from your account, and there is no way to get it back. In this case, it doesn’t matter whether the physical card was stolen or just the card number – after 60 days, your money is gone either way.
Credit cards protect you against other forms of loss as well. For instance, if you order something online and you never receive the package – or you receive the wrong item, or the item arrives broken – then you can formally dispute the charge with your credit card issuer. (However, this is a last resort after you’ve tried to rectify the situation with the merchant.) With a debit card, the best you can do is complain to the seller and hope to get your money back.
On top of that, some credit cards offer additional perks that protect you in case a purchase goes wrong. Examples include:
- Purchase protection, which refunds your money if a brand-new purchase is lost, damaged, or stolen
- Price protection, which pays you the difference if you see the item you just bought on sale for a lower price
- Return protection, which allows you to get credit for unwanted items if the store refuses to take them back
- Extended warranties, free of charge, for items such as electronics
3. Credit Score
Using a credit card regularly, and paying the bill on time, is one of the easiest ways to build your credit history and develop a strong credit score. Your credit score is a measure of how creditworthy you are – that is, how likely you are to pay money back on time when you borrow it. The higher this score is, the more eager lenders are to make loans to you at favorable rates.
Having a good credit score can save you money in several different ways:
- Better Credit Card Deals. The better your credit score is, the better your chances of getting credit cards with good perks, like the consumer protections mentioned above. Users with good credit also get offered lower interest rates, lower fees, and better rewards programs.
- Lower Interest Rates. When it’s time to borrow money for a home mortgage or an auto loan, borrowers with good credit get offered the best rates. Because mortgage loans are so large, a difference of a point or two in interest can add up to many thousands of dollars in savings. For instance, according to Credit.com, a user with poor credit who wanted to borrow $200,000 for a mortgage would be charged nearly 5.5% in interest and would end up paying almost $408,000 by the time the loan was paid off. By contrast, a user with excellent credit could get the same loan at just over 4%, reducing the lifetime cost to just under $345,000 – a savings of more than $63,000.
- Cheaper Auto Insurance. The rate you pay for auto insurance depends mostly on your driving record, but many companies look at your credit score too. That’s because studies by both the FTC and the University of Texas show that drivers with higher credit scores are also less likely to be involved in accidents. Three states – California, Hawaii, and Massachusetts – don’t allow car insurers to look at credit scores, but in most states, higher scores mean lower premiums.
- Better Cell Phone Plans. Cell phone companies also check your credit score before giving you a contract. Business Insider reports that users with lower credit scores usually have to put down a higher deposit in order to get a phone – as much as $500 per line. They’re also more likely to have spending limits imposed on their usage.
Some opponents of credit cards argue that if you never borrow money, your credit score doesn’t matter. For instance, Dave Ramsey refers to the credit score as the “I-Love-Debt” score and claims that people who always pay with cash don’t need a credit rating at all.
However, even Ramsey admits that most people can’t afford to buy a house without borrowing money. That means the lower rates on mortgage loans are actually an important benefit for anyone who ever intends to become a homeowner. Similarly, the lower rates on auto insurance and cell phone plans affect everyone who drives a car or uses a cell phone. The bottom line is, it never hurts you to have a good credit score, and it often hurts to have a bad one.
4. Record Keeping
When you make most of your purchases with a credit card, you’ve got an automatic record of your spending. Your credit card bill lists all the purchases you made during the month, with their amounts, so you always know exactly where your money is going. This information can be very handy for creating a budget, or for making sure you’re sticking to the one you already have.
By contrast, when you buy most things with cash, it’s easy to lose track. You can find yourself down to your last $20, even though you know you took $60 out of the ATM at the start of the week, and have no clear idea of where the other $40 went. Of course, you can always keep track of cash spending by saving receipts or writing your purchases down in a notebook, but you have to remember to do it. With a credit card, record-keeping is automatic.
Perhaps the main thing credit card fans love about their cards is the rewards. The three main types of reward programs are:
- Cash Back. This is the simplest type of reward: The bank takes a percentage of the money you spend and returns it to you, either as a check or as a credit toward your bill. Many cash back cards pay 1% on all your purchases, but some give you an additional bonus on certain purchases in certain categories, such as gas or restaurant meals. In many cases, these bonus categories change every few months, so you have to stay alert to get the most out of your rewards.
- Travel Rewards. Some credit cards reward you with frequent flyer miles, which you can save up for free or discounted airline tickets. In some cases, you can also cash in the miles for gift cards, merchandise, or cash. Some travel rewards cards also give you bonus miles for money you spend on travel expenses, such as hotels and car rentals.
- Points. The trickiest credit card programs are the ones that pay your rewards in “points.” Once you earn enough points, you can cash them in for gift cards or merchandise, or transfer them to other travel rewards programs. However, in many cases, the cash value of the items you get with your points isn’t stated, making it hard to figure out exactly how much value you’re getting out of the program.
Credit cards can earn you hundreds of dollars in rewards each year. For instance, if you have a 1% cash back card and you charge $2,000 to it each month, you earn $240 per year. If that same card also offers 5% cash back on travel and dining during one three-month period, and you spend $3,000 in these categories during those three months, that tacks on another $120. Additionally, many credit cards offer lucrative sign-up bonuses, such as “50,000 points after spending $3,000 within the first three months of card ownership.” If you anticipate heavy spending, this could be a good way to rack up rewards quickly.
However, no matter how good a rewards program is, it’s never a truly good deal if you carry a balance. There’s no benefit to using your credit card instead of cash to earn 1% cash back if you immediately turn around and pay 15% in interest.
In the credit card debate, there’s something to be said for both sides. Credit cards can either help you or hurt you, depending on how you use them. Treating your credit card as free money, never thinking about whether you can really afford what you’re buying, is a one-way ticket to financial ruin. But using it wisely, spending within your budget and paying off the balance every month, helps protect your assets and can even put some extra cash in your pocket.
If you want to enjoy the benefits of credit cards while avoiding their pitfalls, it helps to keep a few simple tips in mind. First, always pay off your balance in full to avoid interest payments. Second, avoid fees whenever possible. Keep a close eye on your account to avoid being late with your payments or going over your credit limit, and steer clear of cash advances and balance transfers.
Finally, be mindful when you shop with your credit card. Pay attention to prices, and add up the total in your head before you head for the register, rather than carelessly swiping your card with barely a glance at the cost. Checking the balance on your credit card regularly throughout the month – say, once a week – is another good way to remind yourself of how much you’ve spend and keep yourself focused on your budget. And if you’re going out to a particular place where you have trouble controlling your shopping impulses – a bookstore, a bakery, or whatever your personal weakness is – try leaving your card at home and limiting yourself to the cash in your wallet.
What’s your position on credit cards? Are you for them or against them?