The Credit Card Trap

Nothing has a greater capacity to derail you financially than getting swallowed by a credit card black hole of debt.

The original purpose of the credit card was to offer the consumer a convenient way to pay that didn’t involve carrying around a lot of cash. A credit card is great to have on hand in an emergency, such as a unexpected and/or expensive car repair when you are travelling. Unfortunately, most people don’t have enough spending room left on their cards to cover an emergency. They have used them as an extension of their paycheck, failing to understand that credit cards are high interest loans and not their spending money.

Financial institutions that provide credit card services, earn $billions in interest and fees collected from uninformed consumers. They have aggressive big-budget advertising campaigns that highlight all the perks, bells, and whistles of a particular card, leaving all the negatives (the traps) they are required by law to disclose, lost somewhere in the fine print.

The amount of credit card interest and fees that many people pay, could fund their retirement. Proceed cautiously and arm yourself with all the details of a particular card before jumping in.

There are three dimensions to credit cards, length, width, and debt.

The Minimum Payment & Compound Interest Catastrophe

Minimum payment may sound self explanatory, but if people really understood the meaning and consequences, they would never make a minimum payment again.

The chart below shows what can happen when something is purchased on credit and only the minimum payments are made on it. You end up paying more than double for every purchase you make by dragging out the payments over years. For simplicity sake, the purchases have been divided into 10 categories of $100 each. The calculations assume that you are making all payments on time, because if you miss one or are late making it, there will be additional  interest and fees to be paid.The minimum payment terms from RBC Visa for this example, which is $10 plus all interest and fees. An interest rate of 19.99% (compounded monthly) has been used in the calculations, but many cards compound their interest daily, which would increase the dollar amounts shown in the chart. Unit costs have been rounded so they may not calculate to the exact total cost.

Take note of the following:

  • If you buy 10 items at $100 each, and make the minimum payment, only $1 a month is going towards each purchase.
  • If you only make the minimum payment on your $1,000 balance, it will take you 100 months, or 8.33 years to pay it off ($1,000 credit card balance divided by $10/month minimum payment = 100 months).
  • If you don’t make any payment at all, the interest and fees will be added to your balance and you will start paying interest on your overdue interest. You can’t charge over your credit card limit, but the financial institutions certainly can. The late payment fees and higher interest rates charged on overdue accounts are brutal.
  • If you live in a jurisdiction that doesn’t have consumer protection regarding minimum payments, make sure you ALWAYS add all interest and fees to your payment.
  • The chart below is using a minimum payment of $10 a month plus all interest and fees. If your credit card minimum doesn’t include the month’s interest and fees, the cost per unit could be astronomical.

15 Credit Card Tips:

 
  1. Credit cards are nothing more than high interest loans from the bank. Treat them as such with a plan to repay as quickly as possible.
  2. Pay off your credit card debts first, as they have the highest interest rates and fees.
  3. A credit card can be a great option for emergency funds, IF you can keep it free and clear to use when you really need it.
  4. Change out of control cards to a ‘payment only’ option, and ALWAYS pay at least the minimum required plus any interest and fees.
  5. If you feel you can only make minimum payments, try adding an extra $10 or $20 whenever possible.
  6. Too many cards will get most people in trouble. Few people need more than one or two – start getting rid of one card at a time.
  7. Overpaying the total amount you owe on your credit card, will help build your credit score.
  8. If you have trouble with spending and debt, steer clear of all advice telling you to use your card for all purchases to get maximum points, cash back, etc. It only works if you are financially disciplined, never late with payments, and are knowledgeable on how credit cards work (all the ‘fine print’).
  9. If you are serious about getting out of debt, shop around for a line of credit or personal loan that offers the best interest rate. Pay off as many of your highest interest cards as you can with this loan and cancel those credit cards. You can save thousands of dollars a year in interest, and the loan has a structured repayment plan that could have you out of debt in 7 years or less.
  10. Transfer high interest credit card balances to cards with lower interest rates, only if there are no penalties for doing so, and if you are getting rid of the high interest card.
  11. Leave your credit card at home if you are an impulse buyer.
  12. It is never a good idea to simply stop paying off your card balances. This lack of financial responsibility will come back to bite you in the future when you are turned down for a car loan, mortgage, or a loan to start a business. See the free debt/credit counselling links in this module.
  13. Look for a card that doesn’t penalize you for late payments by hiking your interest rate through the roof. 
  14. Get only what you need for a credit card – the lowest interest, lowest fees, and no surprises in the fine print.
  15. Cutting up a credit card doesn’t get rid of the account. Be sure to cancel it with the card company so you don’t keep getting charged monthly or annual fees.

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