Credit Cards…Friend or Foe?

People buy a lot of things that they don’tCReditCardPic need, and in some cases don’t even want, and they often buy them with credit. It’s interesting that people who use cash spend less on average than people using debit or credit cards. Apparently we’re less likely to buy when we see the money that we’re spending, as opposed to just swiping a plastic card. But credit card offers fill our mailboxes on a regular basis, and stores offer us discounts if we sign up for (and use) their credit card on the spot. The use of credit has reached a critical point for a lot of people, and at the same time it’s becoming an acceptable way to buy almost everything.

Credit allows us to stretch out the cost of the item with payments over time, making things seem more affordable. Maybe I can’t afford $500 today, but I think that I can afford $50 a month for ten months. But with interest, it’s really not a $50 payment for ten months. There is always a price when we borrow (use someone else’s money), except on those rare occasions when we can borrow at zero percent interest.

There are three variables at work with paying over time: the loan amount, the term (length) of the loan, and the interest rate. Changing any of these will change the total amount that we pay and the monthly payment. With credit cards, the duration or term of the loan is determined by our balance and our payment habits. We’re not borrowing for a specific length of time with a credit card unless we make the minimum payment. If we pay the balance in full, then the term of the loan is zero months, and there is no interest paid.

The problem with credit cards occurs when we don’t pay the full amount each month. In fact, many people pay the minimum amount. To show the effects of payment habits, the table below shows four scenarios with the same credit card balance of $500 with an interest rate of 12%, but using different monthly payments. Changing the monthly payment changes how long it will take to pay off the balance (term in months) and the total interest that will be paid.

Credit Card Balance: $500                                      Interest Rate: 12%

Monthly                    Term in                   Total                        Total
Payment                     Months             Interest Paid        Amount Paid

$25.00                      23 months                   $60.67                 $560.67
$50.00                       11 months                  $29.49                 $529.49
$250.00                        3 months                    $7.63                 $507.63
$500.00                        0 months                    $0.00                $500.00

Credit card companies now include on their monthly statements the length of time that it would take to pay off the balance and the total amount paid if we choose to make the minimum payment. In the table above, the first row shows the results of making the minimum payment, and the example assumes that this credit card is not being used to make purchases. The balance is reduced as a result of the payment and the interest charged. When we continue to use a card that already has a balance, the balance and the interest paid are affected by our monthly charges, and the duration and interest we’ll be paying increase.

The example above assumes that this credit card is not being used to make purchases. The balance is reduced as a result of the payment and interest. When we continue to use a card with a balance, the balance and the interest paid are affected by our monthly charges. Consider if we only made the minimum payment of $25.19 and typically charged another $100 each month to this card. Since the payment is less than we’re charging each month, we know where this is headed.

We would be paying $25.19 each month, but the payment would only lower the balance by just $18.69 (the payment of $25.19 minus the interest charge of $6.50), and the balance would increase as a result of the $100 in additional purchases. As shown below, this is a recipe for problems since the balance just keeps growing.

Credit Card Minimum Payment

Starting balance                                                        $650.00

Portion of payment applied to the balance        $18.69*

Monthly charges                                                       $100.00

New balance                                                               $731.31

* $25.19 payment – $6.50 interest = $18.69

There are practical reasons for using a credit card, but we have to consider the cost and be sure to only buy using a credit card when we have the money available. That way we can pay the balance in full when the bill is due. Before making a purchase using credit, we should always ask ourselves if we really want to borrow the money. In many cases, waiting and saving for the purchase is a wise choice, and if we think that we can’t wait, we should remember that we’ve done just fine without it so far.

Given the recent security breaches and credit card information theft, are you using cash more?

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