People live in an electronic world where purchases are regularly made with a swipe of plastic through a little machine. It’s easy, convenient and simple. It can also be a recipe for disaster. When you use cash for a purchase, you can only spend the money in your hand ensuring you don’t spend more than you can afford to pay, with a credit card the temptation to spend money you don’t have is high and your financial health can suffer as a result.
Credit cards are a very useful tool and in some circumstances it is preferable to use a credit card rather than cash or a debit card, which is similar to cash but has the ease of an electronic credit card. When making online purchases for example, where cash is not taken or there is an element of risk, a credit card can reduce risk as some offer insurance on purchases and if a transaction is in dispute (your card is used unlawfully for example) there are more options available to you to get the situation resolved.
That being said, the inherent risk to your ongoing financial health is higher with regular use of a credit card than any other method of payment.
A credit card is a line of credit and when used for a purchase, interest is calculated on the amount charged. This means any purchase made using a credit card costs you more than the purchase price. Some credit cards have an interest free period that means no interest will be charged if the full balance is paid each and every month. This seems to be a good thing and many people take advantage of this, using their credit cards for everything and then paying the balance in full every month. The problems occur when something happens. Perhaps other expenses were higher than usual or there is a sudden reduction in or loss of income, the full balance cannot be paid and interest is charged.
The average credit card interest rate on cards with balances is 12.78% as at Q4 2011 according the Federal Reserve G.19 June 2012 report on Consumer Credit. Since this figure is an annual rate and interest is calculated on average daily balances at a daily rate, it works out to 12.78% divided by 365 or 0.035% per day which doesn’t seem very much until you start to look closely.
If your average daily balance is $100 and your APR is 12.78%, you will pay $1.05 in interest for the 30 day statement period (APR/365 x average daily balance x 30 days) if you don’t pay the balance in full by the due date. If you are late with that payment due to unforeseen circumstances mentioned above, you will also pay a late fee which varies but let’s say it’s $25. So one missed or late payment means you now have to pay $126.05 for a one hundred dollar balance. Now at this point the issuing bank may also adjust your credit card interest rate to a higher “default rate”, meaning that your interest rate could jump up considerably during the next statement period. If you were already having trouble meeting your payment, a new interest rate of 26% APR isn’t going to help matters.
Consider that the average credit card debt carried by households with credit card debt is $15, 956 (from creditcards.com) and it starts to look very frightening. The monthly interest payment alone on an average daily balance of $15, 956 at the average rate of 12.78% APR is $167.60. Credit card debt can seriously impact your financial health with just a small change in your existing financial circumstances.
So the questions arises, is using a credit card ever a good idea?
Unless you have the money available to pay the balance charged on the credit card and do so immediately, the logical answer would be no. It’s too easy for unforeseen circumstances to arise and throw you into a debt spiral. However, judicious use of a credit card can be of great assistance in an emergency.
What constitutes an emergency is different for everyone however a good outline is as follows. An emergency would be an unexpected yet foreseeable event. Such as vital car or household repairs, job loss or a medical situation. The situation is unexpected in that you could not predict when it would happen but it was foreseeable in that you could reasonably assume that at some point your car, or home would require repairs, medical treatment may be required or a job loss may occur.
In this type of emergency, hopefully you have been preparing for it with your emergency fund, saving money to see you through the unexpected eventualities of life. When the incident occurs, however, you may not be able to draw cash or write a check and so use a credit card to cover the bills. The money you need, the cash to pay the bill is available just not readily. A credit card in this situation is a godsend.
Perhaps you have almost what you need to pay the bill. For example, you have $1200 to pay for necessary house repairs caused by a storm but the bill is $2000 and although insurance will pay the balance you have to wait for payment. Using a credit card may give you more time, up to an extra 55 days (the interest free period on some cards) to wait for the insurance payment. In which time, you will also earn the funds to pay the remaining balance if the payment is delayed longer.
If an emergency occurs and you don’t have an emergency fund to cover all or at least most of the expenses, using a credit card can be a disastrous course of action. You may create more problems for yourself, adding financial stress and worries to an already stressful situation. Other steps should be considered first, such as making payment arrangements with the hospital or medical facility which do not charge interest instead of charging Doctor’s bills to a card.
If a situation arises where you have no other options available to you, perhaps you are stuck in a foreign country and need to buy a ticket home to get out of a bad situation, a credit card can be a lifesaver, interest charged is of no consideration in such circumstances. Understanding how the cards work, and what you will charged, can help you mitigate long term financial damage caused by carrying debt on a card.
Credit cards can be a useful tool in your financial tool box, but like all tools, they require knowledge, preparation and understanding before use. With all their convenience and accessibility, credit cards can have serious consequences when used unwisely yet judicious use can give you peace of mind in an emergency situation. Despite this, nothing gives greater peace of mind than some planning and preparation.
Establishing an emergency fund and consistently contributing to it will stand you in better stead than relying on lines of credit as a sole means of covering emergencies.