Credit Cards: Another Primer

We talked about credit last post. Today we’ll expand upon it and talk about how credit cards work.

What are Credit Cards

A credit card enables you to make purchases using a credit line. It makes purchasing things super conveninent. Without one, you’d probably need to carry cash anytime you wanted to buy anything.

When you swipe your credit card, the credit card company effectively pays the merchant on your behalf. Because you’re using borrowed money (credit) to make that purchase, at the same moment you establish debt. This is reflected as a statement balance that you have to pay back. Paying back this balance consistently slowly forms one’s credit history over time.

This is the core idea behind credit cards.

Benefits of Credit Cards

Using a credit card offers several benefits. These include convenience, purchase protection, rewards/perks, travel benefits, and more.

However, building up your credit history is the most important in my opinion. Credit card companies work with credit agencies that analyze your habits to give you a credit score, taking into account factors such as payment history, credit utilization, length of credit history and more.

Why Do You Need Good Credit?

Put simply, being more financially trustworthy gives you finanical flexibility. Whether it be a getting approval for a loan or for renting at an apartment, good credit opens doors to opportunities and financial tools that aren’t as easily accessible to others with lower credit scores.

It enables you to “purchase things through trust”.

The biggest benefit of credit in my eyes getting access to better loan rates with higher chances of loan approval. For example, say you want to purchase a house. It’s unlikely you’ll have all the cash on hand to buy the house outright, so you’ll need a loan to cover the house beyond an initial down payment.

From a lender perspective, lending to someone with a poor track record is a shitty investment. They fear that they’ll never recover the lent amount. If they do agree to lend, they’ll want to mtigate the risk by increasing the potential reward - which translates to a high interest payment for the loan.

Conversly, from an investment perspective, possessing an excellent credit rating not only makes lenders more inclined to loan you money due to your perceived reliability as a potential income source, but it also results in better loan rates because your strong credit profile positions you to potentially attract multiple lenders from the market.

Credit Isn’t All Sweet: Understanding Its Drawbacks

While credit cards offer convenience, their effectiveness heavily relies on your responsibility and reliability in repaying debts. Missing payment due dates can result in accumulating high-interest charges, often surpassing the initially borrowed amount¹. This issue is prevalent in the United States, where consumers frequently overspend.

Opting for a debit card suits those prone to overspending and averse to borrowing money. With a debit card, you deposit money into an account that gets deducted when making purchases. However, using a debit card doesn’t contribute to building credit history due to the absence of borrowing.

It’s probably in your best interest to graduate to a credit card and build credit history eventually.

Conlusion

Hopefully you understand more about the nuances of borrowing money and see why using a credit card is super important especially for attaining enhanced finanical flexibility.

In future blog posts, we’ll discuss what credit card is optimal to get based on your spending profile.

1. You can conceptualize this as paying to spend your own money. Essentially, every delay in repayment means incurring extra costs. The duration between making a purchase and settling the balance with interest encapsulates the concept of the ‘time value of money’. Credit card companies capitalize on this concept to generate revenue ↩