Credit Card Debt

This week, we will look at credit cards.?As my friends and family know, I am a bit of an adventurer.?My vacations usually take me on hikes in the wilderness and up mountains.?I have done the Milford Track in New Zealand, Kota Kinabalu in Malaysia on the island of Borneo, Mount Kilimanjaro in Tanzania, the Annapurna Mountains in Nepal, and most recently, Machu Picchu in Peru.?These were all amazing and challenging experiences.?Initially, these trips allowed me to really appreciate and be thankful for all that we have here in Trinbago, including credit cards.?You see, a lot of these countries were heavily cash and paper based and I had to carry lots of cash with me or I would have starved.?Today, credit cards are accepted by almost everyone in most places and the convenience for travelers like me cannot be underestimated.

A credit card is issued to cardholders to enable them to pay merchants accepting the cards for goods and services. ?The bank creates a revolving account and grants a line of credit to the cardholder.?When the cardholder uses the card, the bank pays the merchant less any fees and charges and the cardholder pays the bank later on.?A credit card is different from a debit card because the debit card holder is spending his own money and not taking an advance from the bank.?When the card holder uses her debit card the bank pays the merchant and takes the money out of her account.

Benefits to Cardholders

The main benefit to the cardholder is convenience. ?This is what I really missed while hiking in the early days.?Compared to debit cards and checks, a credit card allows small short-term loans to be quickly made to a cardholder who need not calculate the funds available before every transaction, once the credit card limit is not exceeded.

Many credit cards offer rewards and benefits packages.?As Ramit Sethi notes in his book "I Will Teach You to be Rich", “credit cards give you thousands of dollars’ worth of perks. ?If you pay your bill on time, they’re a free short-term loan. ?They can help you keep track of your spending much more easily than cash, and they let you download your transaction history for free. ?Most offer free warranty extensions on your purchases and free rental car insurance. ?Many also offer rewards and points worth hundreds or even thousands of dollars.”

Benefits to Merchants

For merchants, credit cards are often more secure than other forms of payment, such as cheques, because the issuing bank commits to pay the merchant the moment the transaction is authorized, whether or not the consumer defaults on the credit card payment. ?In most cases, cards are even more secure than cash, because they discourage theft by the merchant's employees and reduce the amount of cash on the premises. ?Finally, credit cards reduce the back-office expense of processing checks/cash and transporting them to the bank.

Prior to credit cards, each merchant had to evaluate customers’ credit worthiness before extending credit. ?That task is now performed by the banks which assume the credit risk. ?Credit cards can also aid in securing a sale especially if the customer does not have enough cash on hand or in a checking account. ?Additional sales are also generated because customers can purchase goods and services immediately and are less inhibited by the amount of cash in hand or in their bank accounts.

Transactors vs. Revolvers

Credit cards give you thousands of dollars’ worth of perks.?However, this only works IF YOU PAY YOUR BILL ON TIME.?I am a transactor, i.e., I pay my credit card bill in full by the due date every month.?I do not carry a balance from month to month therefore I do not pay interest or late fees.?The only way credit card companies make money off of transactors is by cross-selling them other financial products and from the fees paid by merchants on each transaction the transactor charges to their card.

The opposite of a transactor is a revolver—a consumer who carries a credit card balance from one month to the next. ?Revolvers as a group are a major source of revenue for credit card companies because they pay interest on their balances.?But individual revolvers who accumulate large balances and then become delinquent on their debt can cause creditors to lose money.

I strongly advise that you all join me and pay your credit card bills in full and on time every month.?However, this is not easy! ?You have to be extra vigilant.?You have to be super disciplined.?Do you really need that new mobile phone??Do you REALLY need that huge HD TV??As you think about this, remember what we said about good debt and bad debt.

Bad debt is usually debt that won’t make money for you.?In other words, if you used debt for consumer purchases, it’s bad debt.?If you used debt to buy an asset that depreciates in value, that’s bad debt.?Good debt is debt used to invest in yourself or in an asset that appreciates over time; debt used for productive use, such as investing or business growth.?Debt used to finance an education that helps you to land a higher paying job or a mortgage to buy a home that should appreciate in value.

Remember Halik and Gunderson’s advice “Never borrow to consume. Use your own cash resources for consumer items, such as furniture, clothing, and vacations, and only borrow for productive assets and resources.”?Remember that credit card debt is the worst type of debt, unless of course you are desperate enough to borrow from a pay-day lender or you buy consumer items like furniture and appliances on hire-purchase.

Therefore, as you look at all the very attractive sales and the fear of missing out (FOMO) takes hold; as you feel the pressure to get that special gift for your significant other or favorite child—STOP and ask, do I have the money to pay this off when the credit card statement arrives??If you don’t have the money saved, please remember that the interest rate that will be charged on any balance will be greater than 20%.?And this is likely to increase as Central Banks around the world raise interest rates in the fight against inflation.?Therefore, paying the minimum amount due is NOT good enough!!!?Don’t succumb to the temptation to borrow on your credit card.?DO NOT LIVE A LIE!!!

Suze Orman advises “One of the most disrespectful and powerless ways to live a life is to live a lie, and when you are mired in credit card debt … you’re living a lie.?You’re presenting to the world as your own possessions, things that do not belong to you, things that you cannot afford.?If your debt is carefully hidden … you are not only living a lie but also putting your loved ones’ financial lives at risk.?You are being dishonest about yourself and your future, because juggling credit card debt today jeopardizes all of tomorrow’s dollars.”

Ideally, you should have planned and saved so that you can afford the ‘gifts’ to yourself and loved ones without having to resort to using ‘bad debt’.?However, if you still cannot resist the temptation, you should use your credibility and credit history to approach your bank or credit union for a loan.?The interest rate should be much lower and the payments much more affordable.?This method of financing these impulse purchases, while bad, are much better than credit card or hire-purchase debt.?However, this should be a LAST RESORT.?You should plan and save for these types of purchases.

Cheers, Nigel

Nigel Romano, Partner, Moore Trinidad and Tobago, Chartered Accountants