We recently wrote about 5 things to know about paying off a credit card. We recommend that clients pay off their credit card debt and start using cash more often.

However, we acknowledge that credit cards offer valuable features and benefits. Certain risks can seriously harm your credit score, report, history, finances, and overall financial well-being. Always inform yourself and take responsibility when using a credit card.

Introduction to Credit Card Risk

Navigating the Credit Card Landscape

Credit cards have become a fundamental part of financial transactions in our lives. They offer convenience and flexibility but also come with inherent risks. The world of credit cards is complex, and navigating it requires an understanding of how credit cards work.

This introduction aims to shed light on the potential dangers associated with credit card use. Before using a credit card, users should carefully read the terms and conditions set by the card issuer. The ease of swiping a credit card can often mask the financial credit risk that comes with it.

In this article, we'll provide you with the foundation for understanding the importance of responsible credit card use and set the stage for a deeper exploration of the specific risks involved with a credit card. As we dive into the world of credit cards, remember that knowledge is power, especially when it comes to financial tools that can have a lasting impact on your credit report and financial health.

On-Going Credit Card Debt

Breaking the Cycle of Minimum Payments

It’s no secret that a credit card is designed to never be paid off. Missing payments on your monthly credit card statement is the worst thing you can do to your credit report—but only making the required minimum payment is a close second. If you only do the minimum payments on your credit card, your debt will take much longer to pay off and you’ll incur more interest charges along the way.

Check out this post on our blog “The Dangers of Paying the Minimum on Your Credit Cards”; the scenario described in the article, paying the minimum payment of $28 toward a $1,424 debt means 12 years to pay off your credit card, and $1,238 in interest paid—that almost doubles the cost of the debt.

If you miss payments or are late with a monthly payment, the late fee is typically $35, which is more than the $28 minimum required. These kinds of repayment structures make even relatively small debts take decades to repay.

This article goes in-depth about the dangers of making minimum payments. Always assume that you aren’t using the credit card at all while paying down the balance. That’s rarely the reality; most people continue to use their credit cards, and if you’re making only minimum payments, your overall debt is growing rather than shrinking.

Credit Scores and The Damage on Credit Report

The Impact of Misusing Credit Cards

In our recent article, Top 5 Things to Know About Paying Off a Credit Card, we cover some of the benefits of credit card use, and how building a great credit report with a good credit score is key.

In the article, we talk about the importance of understanding credit reports, credit history, credit scoring models, the three major credit bureaus, credit utilization rate, credit score ranges, and the impact paying off your credit card does to your credit reports. The opposite, therefore is always true; misusing them can have negative consequences on your credit score and credit reports.

If you miss payments or pay past the due date, even by a day or two, your credit score can take a serious hit. Even credit behavior that is not negative can have an impact; getting a balance transfer, opening a new account—these things can be a red flag to lenders, employers, landlords, and others who might access your credit report.

There are even some actions, like closing an open credit card account that might seem very responsible. However, closing unused accounts can lower your credit score and, depending on the drop in your score, could impact your ability to get the best terms and rates on loans like mortgages or auto loans.

High Costs High Costs of Credit Cards

Deciphering Interest Rates and Fees

Credit cards aren’t a free product by design. It might be possible to get by without paying anything extra, but only if you get a card with no annual fees and you pay off the balance in full before the grace period ends every month. That’s very difficult for most people.

First off, there is an annual fee, which is more common these days, and you’ll pay that annual fee no matter how much you use the credit card. Credit cards with extra benefits and perks are much more likely to carry an annual fee.

Then there’s interest. Any time you don’t pay off the balance in full before the grace period ends, you’ll be charged interest, and if your interest rate and balance are high enough, your payments might be paying as much or more in interest than in principle.

To calculate an example using $2,500 in debt with a 19% interest rate and pay the minimum monthly payment of $50. This debt takes 9 years to repay and costs $2,493 in interest. So the $2,500 spent initially is nearly doubled by the time the balance is paid off.

Finally, there are other fees, like late payment fees, or balance transfer fees, and cash advance fees. Most of these fees are charged for things you shouldn’t be doing in the first place (like paying late or getting a cash advance), and they can significantly add to the cost of credit over time.

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The Trap of Overspending

The Psychological Aspect of Credit Card Use

Credit cards are convenient, and that’s a good reason to have them. But they can be too convenient, and lead people to spend more than they would or should.

If you’re faced with an impulse purchase that you really want, but don’t have the money in the bank, it can be very easy to swipe the card and buy the item today. We rationalize that we will pay off these purchases soon, but the truth is, we shouldn’t be buying things we can’t afford. Just because credit cards make it possible for us to make a purchase, that doesn’t mean we can truly afford it.

People also have a psychological tendency to compare a purchase to their available credit card balance rather than the cash in their pocket. If you have $100 in cash and you want to purchase something for $50, it’s painful to spend cash because that would take 50% of the money you have on hand. If you have a card with a $5,000 credit line limit, the $50 is only 1% of the total credit utilization rate.

We forget that we don’t have $5,000; it's an illusion created by credit card issuers. So people will tend to buy things with credit that they wouldn’t buy if they were required to spend the cash they have.

This is something our clients on a Debt Management Plan learn; they must live on a cash basis while on the plan, so they are far less prone to overspend while we help them reduce their credit utilization rate and cut their debts.

The Fine Print

Unpacking Terms and Conditions

Credit card agreements are notorious for their fine print, and the terms often give the creditor the right to close the account or change terms (with proper notice given to the consumer). The Credit Card Accountability Responsibility and Disclosure Act of 2009 (CARD Act) reduced penalty fees and made the cost of credit cards clearer to consumers.

Some cards come with 0% introductory rates, but the fine print will specify when that rate expires, and how much you’ll pay if you don’t have the initial balance paid off before that time.

Other tricks include changing the category of purchases that will generate a reward. One month, you might get rewards for grocery spending, while the next you get rewards for spending at restaurants. But even these rotating benefits might be riddled with exceptions—is the café in your grocery store considered a restaurant or grocery purchase? What about buying groceries at a big-box retailer?

Read the fine print to make sure you know how to redeem your credit card rewards—some credit cards will let them sit; they're waiting, and you’ll never get the bonus unless you proactively redeem them. And if that redemption method is buried in fine print, you might never claim the rewards you’ve earned.

Credit cards can be a good thing, and most people should strive to have a card and use it responsibly. Credit cards come with dangers, and each one of us have to be careful when using credit cards.

Dangers of Credit Card Use Summary

1. Perpetual Debt: We discussed how credit card issuers can lead consumers into a cycle of endless debt through minimum payments and high interest rates. The solution lies in paying more than the minimum due and keeping a close eye on your credit utilization rate, crucial for maintaining a good credit score.

2. Credit Damage: Misusing credit cards can severely impact your credit history, as reflected in your credit report. To mitigate this credit risk, timely payments and responsible credit line management are essential. Regularly checking credit reports from credit bureaus helps in identifying any discrepancies and understanding your credit score ranges.

3. High Costs: We explored various costs associated with credit cards, including annual fees and interest rates. To avoid these high costs, it's advised to choose cards with lower fees and to understand the terms of balance transfers and interest rates thoroughly before account opening.

4. Overspending: The ease of spending with credit cards can lead to budgeting issues. Setting spending limits and adhering to a budget can control this risk. Awareness of your spending habits is key to preventing debt accumulation.

5. The Fine Print: Understanding the terms and conditions of your credit card agreement can save you from unforeseen charges and complications. This knowledge is vital in making the most out of your credit card benefits while avoiding potential pitfalls.

Building a Healthy Credit Future

To conclude, the journey of using a credit card responsibly is centered around understanding and managing your credit risk. Building credit requires a strategic approach – from selecting the right card with favorable terms, like a lower annual fee and interest rate, to managing your new account effectively. Remember, a good credit score opens many financial doors and reflects your credit health.

Whether you are building credit from scratch or managing existing credit lines, the key is to stay informed and proactive. Regular monitoring of your credit score and report, understanding the implications of balance transfers, and managing your credit utilization rate are all part of this process. By making informed choices and using credit cards wisely, you can harness their power to your advantage while avoiding the pitfalls that come with uninformed use.

The journey of credit card use is not just about spending; it's about smart financial management. By understanding the risks and employing the solutions discussed, you can ensure that your card is a tool for financial success, not a trap leading to financial strain.

Anyone who has struggled with credit cards can reach out today for confidential debt counseling. We’ll help you create a budget designed to remove your debts and get you on the road to financial freedom.