Credit cards can either be a blessing or a curse. Your understanding of how they work, how credit card companies make money, and what benefits you can get from them largely determine which they will be for you.
You might already know this, but just in case, here’s a quick rundown on how credit cards work...
Very simply, a credit card allows you to buy something at a store, restaurant, online, or any other place that accepts them without any cold hard cash changing hands.
When a purchase is made, two things happen. Money is sent (electronically) from your credit card company to the vendor on your behalf. And at the same time you make a promise to your credit card company to pay them back for your purchase. Essentially, it’s a short-term loan that is “free” as long as you pay it back on time.
This is great because it’s super convenient, and you might even get rewards for the purchase towards travel, cash-back or other benefitsOther benefits include things like fraud protection, car rental insurance, price protection, extended warranties, and more.. And if you keep your promise and pay them back on time, you can get a boost to your credit score (your financial reputation).
Now that we’re all on the same page about the basics of credit cards, it’s important to understand how credit card companies make money.
They wouldn’t provide all of these great benefits for nothing… right?
As a credit card company, they take on risk every time a transaction happens. If you decide not to (or can’t) pay them back, they will have lost that money. So how do they make money?
Credit card companies rake in the dough in two different ways.
They make a small percentage (typically about 1.75%) of every transaction they are involved with. Depending on the bank, this can account for up to half of their total revenue, but it’s typically less than that.
For most companies, the majority of their revenue comes from interest payments. These payments come from people who don’t pay back the credit card companies on time or in full, which is the main way you can get in trouble with credit cards. Depending on the deal you agree to, they can charge you anywhere from 13% to 23% per year on any unpaid amount.
There are some other ways that these companies make money, but these are the two main ways they are compensated for the risk of people not paying them back.
You might be wondering at this point, “How many people are actually in credit card debt?”
Nearly 40% of all households1 in the US are charged interest due to credit card debt. So, you’re not alone if you are in this boat.
Even though this is a fairly common occurrence, not making full payments on your credit cards can be a recipe for disaster. It will increase the amount you pay for your purchases due to interest charges, and can really hurt your financial reputation (your credit score). In addition, you run the risk of entering into a debt spiral, where you owe more and more without being able to catch up on your payments.
Use the tool below to understand more about how costly paying off only part of your credit card balance can be.
Have some credit card debt you’re serious about paying off? Learn about some great strategies we’ve put together to pay off your debt here.
After reading everything above you may be thinking to yourself, “Ok... but what should I do?”
It’s totally your choice.
Choosing not to use a credit card (or cutting up your current cards) is totally fine. We would still suggest using a debit card for the same convenience of not having to carry cash. And understand that you are leaving some of the benefits of a credit card on the table. The most significant of which is building your credit. If this is the case, we would strongly suggest making a plan to build your credit score in other ways.
If you choose to use credit cards, that’s great! Use them responsibly and you will get all of the benefits (rewards, convenience, boosting your credit score, fraud protection, etc.) without the risks. But there are a couple recommendations we think are important to keep in mind if you go this route:
No matter your decision about credit cards, Previsio is here to help. While credit cards are an aspect of your financial life, we like to consider the whole picture. In addition to giving you insight into your credit card use and strategies to pay off debt, we work with you to create a lifestyle plan. Think of it as a way to live your best life right now, while we help you plan for the future. Interested?