Let’s talk about credit cards. Hot-button issue alert, right? Everybody has an opinion about them. Some good. Some bad. So how do you figure out what’s right for you?
There is no one-size-fits-all answer on this topic. It all comes down to you. Your situation, your goals, your spending habits, your philosophy on money, your values, and your discipline.
Credit cards are not good or evil. They’re just pieces of plastic (or metal, if you’re fancy). There are legitimate use cases for them. Just like there are legitimate risk factors.
But what makes a credit card a good or bad decision for you depends on the context of your own unique situation. Not anybody else’s opinion. And it is almost inevitable in the world we live in that someday you’ll encounter credit card offers.
Which is why our team thought you might as well get acquainted with some pros and cons. So you can make an informed decision for yourself, if and when the time comes. Plus, for those of you who determine a credit card works for your situation, we’ll also share some tips and best practices.
Keep in mind this is just a primer. So we won’t get too lost in the weeds, but we point to resources where we recommend further independent investigation.
Now that’s out of the way, let’s dive in, shall we?
What To Expect in This Post:
- Credit: What Is It and How Does It Work?
- The Pros and Cons of Using Credit
- Your Credit Score and What It Means
- Credit Card Basics
- Researching & Applying for a Credit Cards
- Resources for Managing Your Budget & Credit Cards
- Recommended Reading
Credit: What Is It and How Does It Work?
If you’re unfamiliar with credit, don’t sweat it. That’s what this section is for – to give you a basic understanding of credit, how it works and why (or why not) credit might be a useful tool in your personal finance toolbox.
Quick version: In simple terms, credit is access to borrow money with a promise to repay.
Credit comes in many different forms. But for the most part it all works similarly. Basically, credit enables you to borrow money, and in return you agree to pay that money back according to certain predetermined terms. Usually, using credit involves paying back the money you borrowed with interest – and often within a certain period of time.
There are many different uses for credit. More on this later. But for now, let’s use a common example to illustrate.
For instance, let’s say you’ve decided to buy a car. If you don’t have enough money for the car right now, you have a couple of options. You could save and wait until you have enough money to buy the car with cash. Or, you could use credit to finance the purchase.
Financing the car using credit allows you to buy the car today, and make monthly payments until you’ve repaid the dealership (or lender). So long as you repay the entire amount of money you borrowed to buy the car, once you make your last payment, you’ll own it outright. Basically, you’re borrowing the car from the dealership until you repay the cost – with interest.
And if you don’t repay, some guy named Vinny comes and breaks your legs. Just kidding. But in all seriousness, if you don’t repay the money you borrowed to buy the car, the dealership or bank has a legal right to come repossess the car (which is a fancy way of saying, they’ll come take it back).
Still with me so far? Good. Let’s dig a little deeper.
In the car example, the type of credit at work is called a loan. Loans basically work as a cash advance for the borrower. Usually loans have a fixed repayment period and fixed interest rate. In other words, when you use a loan, you get cash upfront in exchange for agreeing to repay the amount you borrowed at a certain rate, over a certain period of time.
This process of a fixed repayment of borrowed money is commonly referred to as amortization. For each payment you make, a portion is applied to repaying the amount you borrowed (principal) and a portion of your payment goes to the lender as payment for lending you money (interest). When you use this type of credit – a loan – your required payments are usually the same amount for the entire length of the repayment.
Now let’s use an example to illustrate how revolving credit – the type of credit most credit cards rely on – works and differs from a loan.
Most credit cards use a type of credit called revolving credit. In simple terms, revolving credit is access to borrow up to a set limit of money that replenishes as you repay what you’ve borrowed.
Here’s how it works. Let’s say you decide to buy a TV that costs $500 using a credit card that has a $1,000 credit limit.
When you swipe your card at the register, you use $500 of your available $1,000 of credit. After you buy the TV, you have $500 remaining that you can spend on that credit card. You still have a total credit limit of $1,000. But you can only use $500 more of it.
Before buying a TV: $1,000 Credit Available of a $1,000 Credit Limit
Swiping your card for the TV: $500 Credit Balance, $500 Available Credit of a $1,000 Credit Limit
But here’s where the magic of revolving credit happens. If immediately after you take your new TV home and set it up, you use $500 of cash in your bank account to pay off the $500 charge on your credit card, you replenish your credit limit.
When you pay off your balance – pay the credit card company back the $500 they advanced you to pay for the TV – once the funds clear your bank and the credit card, you have your entire $1,000 of credit available again.
Clear as mud? Okay. Let’s move on.
The Pros and Cons of Using Credit
There are tons of different philosophies on money out there. And for good reason. Different people have different goals in life. And different values. And different risk tolerance levels. Not to mention, different levels of financial literacy.
Throw all those differences in a blender, and you get quite a mess. Especially when it comes to professing financial advice. Most financial advice is generally bad. Not necessarily because it’s ineffective or harmful. But bad precisely because it usually lacks context of the person on the receiving end.
Financial advice – like most advice – taken out of context of your goals, is just a waste of neurons. Not all advice applies equally to everyone. I know that probably sounds obvious. But it’s worth repeating: Not all advice applies equally to everyone.
We’re all working toward unique, specific goals. And unique, specific goals require unique, specific strategies. Without the context of your unique, specific goals, a good amount of generic financial advice could actually be ineffective at best – and harmful, at worst.
So anytime you’re considering advice – especially financial or career advice – it’s in your best interest to filter that through the context of your own unique, specific goals. And not just take it as gospel.
Okay, now that I’ve got that off my chest. Let’s discuss some of the biggest pros and cons of credit.
Pros of Credit (Especially Credit Cards)
In no particular order:
Credit can come in handy in a pinch. Imagine you have an emergency expense come up and don’t have cash on hand to cover it – access to credit can help you fill a gap. (That said, it’s often good practice to have an emergency fund saved for just such cases. Hence the name, emergency fund.)
Responsible use of credit begets better access to credit. Let’s say someday you want to buy a home. When you go to the bank or mortgage company to borrow the money, they’ll want to check your credit score and credit history (more on this later). In other words, they’ll want to see how responsible you’ve been with repaying borrowed money in the past. If you’ve never borrowed money before, or been irresponsible repaying when you have borrowed, then you may not be approved for the loan, or you may be approved but at a much higher interest rate. Which means that same home will cost you far more money over the lifetime of the loan. Establishing a credit history and using credit responsibly enables you to borrow money at a lower rate – which can save you tens if not hundreds of thousands of dollars over the course of your lifetime.
Credit cards offer consumer protection. Many credit cards have security features and guarantees built into your agreement that offer you great protection. Compared to a debit card, for instance, if someone steals your card they can wipe you out. Many credit cards will freeze your card or contact you immediately in the event of suspicious activity (though many banks offer this too). But credit cards also offer protection against fraudulent charges or billing errors. Not to mention, with credit cards, you can’t be overdrafted. Once you hit your limit, most cards don’t allow you to make additional charges.
Credit can help you better manage cash flow in your personal finances or business finances. For instance, let’s say you get paid on the 10th and 25th each month. But you have bills due in between those pay dates. Credit is one way to reduce the chaos of money coming in and out. By using credit, you could charge all of your expenses to one place (like a line of credit or credit card), and then make one monthly payment from your bank account. In other words, credit can enable you to increase control over the flow of your money. Credit cards also enable you to pay over time – when you have an occasional big expense come up, credit cards make it easy to cover the cost and then pay for that expense over time. Not to mention, many credit cards have interest free periods – which allow you to make purchases without paying interest, so long as you pay off the balance in time.
Credit can increase your purchasing power. This is where credit card rewards can be useful. Some credit cards offer perks for spending money – like cash back or travel rewards. Basically, credit card companies reward you for using your card to make purchases. For example, let’s say a cash back card gives you 2% for each dollar you spend. If you spend $100, you get $2 back – which you can use to pay off your card or receive as cash. So a $100 purchase, with cash back, is similar to a 2% discount.
Credit can increase your leverage. Credit increases your purchasing power. It enables you to pay for things you don’t have enough cash for. This can be useful in some circumstances. Like if you’re an entrepreneur and trying to get your business off the ground but can’t convince banks or investors to give you money. Or maybe a unique investment opportunity pops up but you don’t have immediate access to cash – credit can be a stop gap to help float your investment. (There are risks involved using credit for leverage. This is just meant as an illustration.) Or, credit could be used as a different type of leverage, as well. You could use your money or an asset you own – like your home or car – as collateral to access money. In other words, you use your money (or house or car) as leverage.
Alright, those are by no means the only pros. There’s a long list. But they’re some big ones. Later in this post we’ll also feature Recommended Reading. So be sure to check that out if you’re interested in more uses for credit.
Let’s move on to some big cons of credit (especially credit cards).
Cons of Credit (Especially Credit Cards)
Credit cards have very high interest rates. Especially if you have bad credit or limited credit. If you don’t pay off your credit card balance every month, then this interest can rack up fast. Sometimes this interest can be as high as 20-30%. Which means for every dollar you borrow and don’t pay off, you could end up paying $1.20 – $1.30 in return.
Credit access can increase spending. I know, I know. You’re responsible. I get it. We all believe we’re the best, most responsible version of ourselves. But having access to credit can introduce the temptation to spend money you don’t have, on stuff you don’t need, to impress people you don’t like. Contrast that with having no credit card. You can’t spend money you don’t have access to.
Credit use adds risk to your financial picture. Responsible use of credit can increase your ability to borrow money – and borrow it at better rates. But on the flipside, irresponsible use can have a serious toll on your financial picture. When you miss a payment, or make a late payment, or default on a loan, most lenders will report this to the credit bureau. And once those stains are on your record, they can be tough to scrub away. Some of these negative reports can follow you around for up to seven years – which impacts your credit score, and as a result, your creditworthiness in the eyes of lenders.
Credit can enforce bad money habits. This is especially important to keep in mind if you’re young or just getting started trying to implement budgeting or better money habits. Credit cards make it easy to spend – and not just spend, but easy to spend more than your income. If you have difficulty delaying gratification or saving money, this can be a tough habit to break, let alone when you have access to a credit card. Not to mention, using credit can tempt you to get behind on your expenses. It’s not uncommon for people to get in the habit of paying off last month’s expenses with this month’s income. Which can make it more difficult to save money. And also substantially increase your personal financial risk in the event you experience any irregularity in your income – like getting laid off – or in the event of an emergency.
Those are some of the obvious cons. To explore other cons (and pros), I recommend this awesome post from WalletHub, as well as the Recommended Reading section later in this post.
Starting to get the picture yet? When it comes to credit, there are pros and there are cons. Much like everything else in life. If you’re irresponsible, the consequences can suck. But if you’re responsible, the benefits can offer serious advantages.
If you’re considering applying for credit or a credit card, just walk into it with your eyes open. And have a plan for managing your use – especially while you’re just getting started.
Next up, let’s talk about Credit Score.
Your Credit Score and What It Means
Imagine there’s an invisible force that monitors you everywhere you go – from every job you take, every dollar you earn, to every purchase you make, and every apartment you lease. Then assigns a number value to you based on that activity. A number which is used to signal whether you’re on the proverbial Naughty or Nice list.
Well, that’s basically what a credit score is (except maybe not quite as creepy?). Basically, a credit score is a representation of your creditworthiness. Lenders use your credit score to estimate how risky it is to lend you money. The higher your score, the more favorable you are in the eyes of lenders. The lower your score, the less favorable.
Being favorable in the eyes of lenders can be a huge advantage. A higher score usually translates to lower interest rates and increased access to credit. Where a lower score can significantly limit your access to credit – and increase the amount it costs to borrow.
I’m not going to get too lost in the weeds on credit scores. There are plenty of fantastic articles on the interwebs that explain this in far more detail than I’m capable of. But let’s run through a quick hit list, shall we?
First, credit scores range from 300 – 850, the scores on the low end are bad and scores on the high are great. Here’s a quick snapshot of the different credit score ranges courtesy of our friends over at Investopedia:
- Excellent: 800 to 850
- Very Good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: 300 to 579
Basically, you want to be at or near the top of those scores if you can. But just know, it’s not necessarily easy to have a “Very Good” or “Excellent” credit score. Because it’s not graded like a college exam – and there’s definitely no curve. A credit score is a living representation of your risk profile. So it takes time to build your credit, and it constantly evolves based on your behavior.
This is why some people advocate starting as early as possible building your credit history. Because several factors – like length of credit history and number of accounts – have a major impact on your score.
So, how is your score calculated and how can you build credit should you decide credit is right for you? Well, here are a few tips, then I’ll share some recommended articles, and we’ll move on. Sound fair? Great.
How Your Credit Score is Calculated & How To Build It:
Without getting too overcomplicated, your credit score is evaluated based on the following five dimensions:
- Your payment history – how responsible have you been in the past? Do you always pay on time? Do you always pay your full balance or the minimum? And so on.
- Total utilization – basically, how much money do you owe? And what percent of unused credit do you have available?
- Length of credit – how long have you had credit? What amount over what time over how many accounts? What is the average age of those accounts? And so on.
- Types of credit – do you have loans? Credit cards? A line of credit? Business credit? Consumer credit? (Hint: different types of credit are treated differently)
- New credit – how frequently do you apply for credit? Each application can have a temporarily negative impact on your score, though this is legally supposed to be disclosed to you in advance. (And for “soft” credit checks, you don’t have to worry about hurting your score).
That’s it. Those are the five big ones. Though they each carry different weights in your total score (for instance, payment history can account for up to 35% of your credit score).
If you want to build your credit score, then the best thing you can do is – first make sure you’re responsible with credit you do have. Which means always pay your bills on time. And bonus points for always paying off your entire balance. Above and beyond that, don’t keep high balances on your cards. Pay them off, or at least pay them down. If you do those things, you’ll be on the right track.
Separately, I recommend checking your credit score from time to time. Personally, I’m a huge fan of sites like NerdWallet and CreditKarma, which both allow you to keep a soft pulse on your credit report.
But if you’re still curious about more things you can do to start running up that score, then here are two recommended articles from Experian (they’re one of the three credit bureaus that determine scores, so they know what they’re talking about):
Excellent. Ready to move on? Next let’s cover a handful of Credit Card Basics.
Credit Card Basics
We’ve covered a lot already – which should’ve given you a great foundation for how credit cards work. So we’ll keep this next part brief and focused on filling in some gaps.
First off, let’s talk about a few different types of credit cards. There are all kinds of credit cards. They vary by use case, credit score, types of rewards, life stage, and so on. We won’t cover them all. But here are a few that are worth being aware of:
- Secured Credit Cards: these are basically like debit cards on steroids. They’re really meant for people who have no credit (or bad credit) or are trying to build credit. Basically, you apply for a card and if you’re approved you make a deposit, and the credit card company holds onto that just in case you don’t repay. There are even different types of secured cards – like prepaid cards.
- Student Credit Cards: these cards are specifically designed for students who have no credit or limited credit. But one huge bummer about these cards is that you usually have to be enrolled at an accredited university.
- Personal Credit Cards: I’m going to roll this category all into one. Basically, a personal credit card is any credit card designed for personal use. This could be through a credit card company or a bank or whatever. But they’re intended for personal – and not business – use.
- Rewards Cards: chalk this category up to any credit card that offers perks. And there are tons of different kinds of perks. There are balance transfer cards. Travel cards. Cash back cards. And so on. Basically, you get rewards for signing up and for spending. Those rewards can be exchanged for all kinds of things depending on the card.
- Business Credit Cards: as the name would imply, these are designed for business use, and usually require the application to be associated with a business. These often have higher credit limits. But like personal credit cards, these come with a variety of different features and requirements.
There you have it. Some of the most popular types of credit cards. And for more on this, here’s a great article from The Balance on types of credit cards.
But before we move on, let’s run through a quick credit card vocabulary crash course. Some terms and definitions you need to know.
Credit Card Balance: your credit card balance is the amount of money you’ve spent on your card and haven’t yet paid back. It’s the total amount of money you owe if you were to pay the entire balance off right now. *But, it’s not entirely straightforward, because most credit cards operate on statements. Meaning you’re only required to pay off the amount you charged in a previous statement.
Statement Balance: this is the amount you charged to your card during your most recent statement period. In other words, this is not necessarily the total amount you owe to the credit card company. It’s usually the amount you borrowed from them last month. And it’s what you owe now.
Statement Period: A statement period is the period between billing cycles for your credit card. Say you’ve got a statement period from the 1st-31st of the month. Each month, you’ll receive a statement for the charges you made last month between the first and last day. Charges you rack up after the last day of last month will go on next month’s statement.
Grace Period: Many credit cards offer a grace period. Basically this is a period of time you’re allowed to pay off your statement balance without incurring interest. These are usually at least 21 days, though some are longer. But beware, if you don’t pay your full balance by the end of the grace period, you’ll start incurring interest on the remaining balance. And different credit card issuers have different terms.
Annual Percentage Rate (APR): this is what it costs you to borrow money from the credit card company. Basically, this is the rate at which you’re charged for money you’ve borrowed but haven’t paid back by the end of your grace period.
Minimum Payment: this is the amount you’re required to pay each month. It’s usually a percentage of your total balance or a flat rate, and varies by card. This is not the total amount you owe. This is what you must pay to avoid a late fee. Just be aware if you only make your minimum payment, any remaining balance above this after your grace period ends will incur interest.
Outstanding Balance: outstanding here is not meant to be a term of endearment. It’s what you owe the card from previous periods and haven’t paid back. This is where you can get into trouble. An outstanding balance is where interest is charged on.
Credit Limit: This is how much credit you have available to you on a card, if you didn’t have a balance.
Available Credit: This is how much credit you have available to you. It’s a function of your credit limit minus your credit balance.
Before you apply for a credit card, be sure you’re at least familiar with these terms, what they mean, and how they apply to your card. And for an extended vocabulary lesson, check out this awesome Glossary of Credit Card Terms from Credit Cards Dot Com.
Now you’ve got the hang of the basics, let’s talk about evaluating credit cards.
Researching & Applying for a Credit Cards
So you’ve read up and decided to open a credit card, have you? Well, where do you start? That’s a million dollar question. Because if you hit the internet, you can wind up down a blackhole before you know what hit you. So it helps to have a decent starting point of what you’re looking for – before you even start your search.
Here’s what I’d recommend. Before you ever type in “Best Credit Cards” – figure out what’s important. Are you trying to build your credit? Are you looking for awesome travel rewards, cash back, something else? Try to get a good idea of what’s important to you first.
Then, before you go haywire, go request a free credit report. You can usually do this up to one time per year for free. Or some sites, like NerdWallet and CreditKarma can help you keep track of this.
Once you’ve got that info in hand, go nuts. Or, to save yourself some hassle, go check out a few of these resources:
- I already mentioned NerdWallet and CreditKarma – which are both great resources.
- Bankrate: this is a great site for analysis, comparison, and general personal financial insights.
- The Penny Hoarder is another great site for reading up on how different cards compare. Though they usually seem to highlight cards they have partnerships with, so sometimes they don’t have all the details you might be looking for.
- I Will Teach You To Be Reach: this is a great resource not just for getting info, but also for learning better money management practices or finding useful courses.
Those are some great starting points. There are plenty of other awesome sites, too. But if you do your research and compare a few options before jumping on the first offer you see, you won’t regret it.
Alright. We have covered so much already. Feeling like a credit card expert yet? If not, no worries. Before we land this plane, I’m going to offer up a few resources to help you manage and then we’ll close out with some recommended reading.
Sound good? Great. Let’s do it.
Resources for Managing Your Budget & Credit Cards
For me, everything starts with the budget. Before you get crazy with credit, it’s useful to understand how your money is flowing. How much is coming in? How much is going out? How often? Understanding your current financial situation and cash flow is the foundation to controlling your financial fate.
If you don’t have at least a basic understanding of these things, I cannot advise you strongly enough against considering a credit card. Master the basics before you set yourself up for success.
And to do that, I recommend a few great budgeting resources. Like:
- Free budget planner from NerdWallet – this one is based on a “50/30/20” model, which basically means 50% of your income goes toward needs, 30% toward wants, and 20% toward saving and debt repayment. Or for the Excel nerds out there like us, you can download the planner in workbook form, too.
- You Need A Budget – finally, an app to pull all of your accounts into one place to help you manage your monthly money on a real-time basis. Fair warning this is a paid product, but does offer a free trial. Still, their site boasts this claim: “On average, new budgeters save $600 their first two months, and more than $6,000 their first year”
- Nudget – this is a quick-entry, easy to use, and beautifully-designed simple budget app that offers some easy insights and useful features.
- But if push comes to shove, and you don’t love apps, then nothing beats a good old fashioned Google Sheet or Excel Spreadsheet. If that’s you, then here’s a very simple Personal Finance and Budget Template I built a while back.
Okay. That’s it for resources for now. Before we say goodbye and send you on your way, how about those recommended reads I promised you?
Want to know the easiest life hack for learning any new skill? Books. Whether you read or listen, books are the easiest, most cost effective way to tap into the brightest minds of our time (and even previous generations). And that’s why I’m such a fan.
But as it relates to your finances, here are some of my absolute favorite money books:
The Richest Man in Babylon by George S. Clason
The Last Safe Investment by Bryan Franklin and Michael Ellsberg
The Psychology of Money by Morgan Housel
Rich Dad, Poor Dad by Robert Kiyosaki
Think and Grow Rich by Napoleon Hill
I Will Teach You To Be Rich by Ramit Sethi
The Millionaire Next Door by Thomas J. Stanley and Willliam Danko
The Total Money Makeover by Dave Ramsey
Fail-Safe Investing by Harry Browne