What is a Credit Card and How do I use One?
Credit cards are the most dangerous thing in your pocket but they can be safely used.
I love shopping! Unfortunately I don’t always have the money to get what I want. At this point I have two options: wait for the money or buy on credit. Today I’ll demonstrate how to decide.
You will see the word cash used a lot in this article. Take that to mean money in your chequing account, not bills.
What is a Credit Contract?
A credit contract is an agreement between you and someone lending you money that you will pay it back over a period of time, usually in equal sized chunks every month, plus an agreed rate of interest.
What is interest again?
Interest is the money you pay someone in exchange for them taking on the risk of lending you money they might never see again. This is explained in depth in here.
What is a Credit Score?
Credit scores are a measure of how good the financial system thinks you are at paying back your loans. Scores usually go from 350-850, higher is better. They are assigned and monitored by a few dozen credit rating agencies (data collectors) around the world. In Canada, the big ones are Equifax and TransUnion with Experian also operating in the U.S.
These scores go up and down every time you have a credit interaction. These include but are not limited to paying (or missing) a credit card bill, opening a net-30 payment account (things that you get service for in advance but you only pay at the end of the month - think phone bills, water, electricity, rent), or even using instalment financing providers such as Affirm.
Every time you make a payment on time, your credit score goes up or stays the same. When you miss a payment your score goes down.
And Why Would I care About My Credit Score?
This score is used by lenders and others to determine how risky you are for money lending. If you have a low score, this shows banks that you either have a short credit history and/or you have missed multiple payments.
This will make you ineligible for larger loans, loans from conservative lenders, or decent interest rates. This is the difference between being charged 8% instead of 4% on personal loans or home equity loans - which adds up to a lot when dealing with large amounts over longer time horizons.
See the two graphs below for a demonstration.
How Do I Build My Credit Score?
Make yourself look like a reliable person.
According to the government of Canada, using no more than 35% of your available credit is a great way to increase your credit score with every card payment. This demonstrates to the bank that you’re not desperate to make purchases that you don’t have the cashflow to sustain.
Further, pay back the entire credit balance at the end of the month whenever possible. This tells the bank that you keep your promises and they can count on your to be a lower risk (keeps interest rates lower).
Don’t use your credit card all the time. If you only use credit for occasional purchases this tells the bank, again, that you have enough cash to sustain your lifestyle. Spending money you don’t have (which is exactly what credit is) should only be done when strictly needed. For example do not buy food on credit if you can afford it, but do buy a new phone (if you need one!) on your card and pay it off in two instalments in the same month when you get paid.
What is a Credit Check?
A credit check happens every time you try and get goods and services and pay later (to be clear subscription services like Netflix do not count because you pay at the start of the month for the services. When you sign up for the service, the seller takes your personal information and fills in a portal to look at your credit score. The credit rating agencies see every new monthly payment as an increase in risk that the existing payments. These hard credit checks can reduce your credit score by up to 10 points.
You can also run soft credit checks on yourself at any time by going to the credit agency’s website. These do not reduce your credit score, neither do business that run credit checks on existing post-paid accounts.
So What Should I Use My Credit Card For?
Credit cards are important tools for deploying extra spending power in case of emergencies if you are short on cash. Also, if it’s time to buy something expensive and you can pay it off in 2-4 instalments. Running a small credit balance, while not ideal, is not a huge problem provided that you pay it off. Items that require more than four instalments should not be paid on credit, but saved for in cash. Adhering to this rule prevents you from spending beyond your means.
Buying things that will rise in value over time. This is a tricky one because you should never buy stocks on credit. Bonds are guaranteed to be repaid with interest, but likely will not pay more than interest on credit card debt.
What Should I Not Use My Credit Card For?
Regular purchases that can be made in cash. Your grocery bill should be limited to what you can really afford on one paycheque (I will have a full article on ways to reduce your grocery bill).
Do not use your credit card to buy extravagances (vacations, fancy restaurant meals, jewelry, cars, etc.) Save up after you make room for necessities and investments.
Do not EVER use a credit card to buy stocks or things where the sale price goes up and down frequently. You may be left in a situation where the stock goes to zero and you’re left with the debt.
Final Thoughts.
Credit cards are important tools and they have a key place in our economic system. What we are told about them being the regular tools to pay for everything is bad advice however. Depending on the cards, there are advantages when fighting fraud charges and its up to everyone to decide whether the tradeoffs are worth it.
Share you thoughts about the best way to use credit cards!
Sincerely,
James Davies