Love ‘em or hate ‘em, the fact of the matter is, credit cards are a way of life. That doesn’t mean they’re all that good, nor are they all bad. They make spending effortless, blurring the line of how much money you have and how much you can spend. And eventually lending your way into debt. This begs the question. How should you use a credit card without falling in the debt trap?
Credit cards are a useful tool in helping you manage your money and building your credit score at the same time. And depending on the type of credit card, you even get to use the benefits attached to the card. Your credit card could also help you get good rates for when you want to buy a house or a car.
Although these benefits are great, having a credit card can put you in a serious financial disposition if you don’t manage it properly. From penalty fees, a crippled credit score to a lawsuit with creditors. Dealing with credit card debt is by no means a cup of tea. You’ll end up making debt on debt, further reducing your chances of financial security. Getting out of this debt spiral is mentally and physically draining.
So, how do you use a credit card, the smart way?
Credit vs Debt
Credit means that you have money available to borrow. When you use your credit card you purchase things with money that belongs to the creditor. The creditor pays for your purchases and you repay what you’ve borrowed. Generally, creditors will have a limit on the card, preventing you from borrowing more than you can handle.
Credit means that you have access to money that you don’t owe, debt means that you owe money. When you don’t pay your credit amount on time on time, you end up making debt.
Should you have a credit card?
Are you even adulting the right way without a credit card? Putting the accomplishment aside, should you have a credit card? A credit card is an exciting piece of plastic, that comes with a great deal of responsibility.
We all know that credit cards have serious consequences that can be damaging in the long-term. But, use it the right way and a credit card can open doors for you.
Think about how a credit card will affect you before you sign up.
Advantages of a credit card
A credit card comes with a revolving line of credit. That means it’s raining credit in your back pocket. But, it comes with its restrictions, the account has a credit limit attached to it.
Having a credit card allows you to have a sense of financial freedom. Now you have access to some money if you need to fix your car or if you have some medical bills to sort out. Even if you have a big enough savings account to take care of those bills, the benefits attached to a credit card may be worth the swipe.
The benefits will depend on the card that you have, you could earn cashback rewards, airline miles, discounts and so on.
One of the best benefits that come with a credit card is that it helps you improve your credit score. As you use your credit card your payments are reflected on your credit history. As long as you keep paying your bills on or before the due date, you’ll be doing wonders for your credit history. To maximise on this, keep your credit utilization – the difference between your credit balance and your credit limit – as low as possible. You want to aim for a credit utilisation rate of 30% or below.
Remember, the longer you have an open account and use your credit card smartly, the better your credit score will be.
Disadvantages of a credit card
As awesome as it is to have a credit card, they come with significant risk. Because most credit cards are not backed up by any form of guarantee, creditors can’t collect their unpaid debt. To put in place some form of security, creditors charge higher interest rates than any other unsecured loan. And to make things worse, the interest rate on a credit card is charged daily.
Creditors know that these high-interest rates are damaging to our wallets. So they offer us an interest-free period, which usually lasts for 55 days. If you use your credit card smartly, you could essentially never pay interest. But, if you don’t pay in full, the bank will start charging you interest for every day you don’t settle your bill.
Interest rates attached to credit cards can be as high as 20% in South Africa. That can damage your financial situation if you’re not careful.
Understand how your credit score works
Your credit score is made up of various parts, each affecting your score differently. According to FICO, your credit score is broken up as follows:
- Payment history (35%)
- Amount owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
These percentages represent the importance of each category, which determines how your score is calculated. However, these categories may vary from person to person.
A general rule of thumb is to remember that late payments will reflect negatively on your score, while making payments on time, will raise your score.
Use a credit card the smart way
Your credit card is directly linked to the major credit bureaus. So, if you use your credit card smartly, it is one of the fastest and easiest ways to rebuild or build a good credit score.
How do you build a good credit score using your credit card?
- Avoid piling up on credit cards
The rewards attached to credit cards can make it very tempting to signup to new cards. While there’s nothing wrong with having more than one credit card, you are however dealing with more risk.
Having multiple credit cards could mean that you’re more tempted to make purchases. You may even forget to make the repayment on your latest purchase. This will only hurt your credit score. On top of that, every time you open a new account it is reflected on your score, which can also negatively affect your score.
So second guess the next credit card before opening the account. If you don’t need a second credit card, don’t get one.
- Pay in full and on time
One of the biggest factors that determine your credit score is whether you make your payments on time. Missing 1 payment can impact your score significantly. And to make matters worse, it will reflect on your score for 7 years, even if the negative stain has faded away.
To avoid missing any payments you can schedule, or debit order your payments. That way you always pay on time, every time.
- Use it like a debit card
One of the biggest factors that get people in serious debt when using a credit card, is that they don’t keep track of their spending.
Using your credit card like a debit card means that you know exactly how much you can spend and pay in full by the time the bill comes. The more you focus on spending within your means, the easier it will be to spend what you can afford and avoid paying high-interest rates.
- Keep your balance as low as possible
The second biggest factor that determines your credit score is the ratio between your debt and your available credit. This is known as the credit utilisation ratio. This simply tells banks how much credit you’re using in relation to your credit limit.
For example, you can have a credit limit of R10 000. If you use R5 000 of that, half of your limit, your credit utilisation ratio will be 50%.
Good practice is to keep your credit utilisation ratio at 30% or below. Of course, the lower the better. But if you want to use your credit card the smart way, pay off your balance in full, and avoid paying any interest.
- Keep your old accounts open
Creditors can start predicting your lending behaviour the longer you have an account. And the longer you use your account responsibly, the better your score will be.
Avoid opening and closing accounts after short periods. Every time you open or close an account it is reflected on your credit score. Short-lived accounts can look bad and drop your score significantly.
- Choose carefully
If you’re only starting out or if you’re rebuilding your credit score, getting good deals are highly unlikely.
Even applying for credit cards when you’re unlikely to be approved, can damage your credit score. Creditors do background checks when you apply and record your application as well. If your application has been denied you’ll be negatively affected.
Make sure that your credit score is in good enough shape before applying for a credit card or even a store card. When you’re ready to start applying, make sure you apply to the card that meets your needs.
Using your credit card the smart way
A credit card can be a great tool to help build your credit score. But, it can be your worst nightmare if you’re not smart about how you use your credit card. If you’re not careful it can damage your credit score to a point where it’s almost impossible to build up again.
Be honest with yourself and evaluate whether you are responsible enough to own a credit card. If you smartly use your credit card, you’ll be on your way to healthy credit score.
If you have too much debt and are struggling to pay it off, you may be over-indebted. Get your free, personalised, non-obligation assessment today.