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Credit Cards - A Necessity and a Potential Evil
Credit cards are useful and often necessary for making hotel reservations, buying something online, renting a car, and even getting the best exchange rate when traveling abroad. They offer the convenience of buying something now and paying for it later, and they give you the security of being able to get a refund for damaged or defective products.
While useful in many ways, credit cards can be very costly to you if you opt to carry a balance from month to month. The real damage comes when people choose to make the minimum payment each month. Consider the following example.
Imagine you have a credit card with a balance of $2000. It has a typical annual interest rate of 18%, and a minimum interest of 2%. If you make the minimum payments each month, it will take over 30 years for you to pay off the balance in full. And, you will repay $4931.15 in interest. This means that a $2,000 purchase in this scenario actually costs a total of $6931.15!
Whenever possible, pay your bill in full. When that isn't possible, be sure to pay more than the minimum monthly payment. For example, if you were to pay $40 a month, every month, on the same balance of $2,000 (rather than reducing your payment as the balance declines), you would reduce the number of months you pay on this debt from 370 to 94 months. You would reduce the amount of interest you pay from $4,931.15 to $1,724.47.
Most people don't intend to charge too much on their credit cards, but life happens. Before they know it, their balance is higher than they want it to be. They find that they cannot pay off the balance each month.
Then, as the debt and payments become overwhelming, payments are missed and a vicious credit cycle begins: fees are added, rates are increased and it becomes even more difficult to meet your obligations. And your credit scores plummet.
If you have found yourself in this situation, rest assured, you are not alone. However, you must take immediate action to start righting the ship before you go under permanently. A common thing that many people do to try to fix the problem actually leads to more trouble down the road.
Many people who have balances on multiple credit cards will consolidate their debt by transferring their balances all to one single card promising a low rate. In itself, this isn't a terrible thing. But, here's where the problems creep in.
Most people make two big mistakes at this point. First, most people continue to make small payments on the one card, often close the required minimum. Though they're paying less in interest each month, they're still not paying down the balance fast enough.
The second mistake involves your actions with the leftover credit cards from which the balances were just transferred. The only correct thing to do with these cards is to leave them open, with a $0 balance on each of them. Do not use them again. Do not close the accounts.
If you continue to use them, you are running up a huge balance in conjunction with the new card that has the consolidated balance from your old debt. If you close the accounts, then your credit score will actually decrease! It seems counter-intuitive, but credit scores are based in part on a ratio of your credit balances versus your credit limits. So, if you close those credit card accounts, you are decreasing your overall credit limit and making your ratio appear dangerously high on your credit report.
Countless credit card users are shocked when they find out that closing their credit card accounts has actually hurt their scores. They feel that they are doing the responsible thing by closing the accounts, but the truth is that credit reports give high scores to people who show a responsible use of credit - not a responsible lack of use. In other words, your credit score will increase over time when you show a $0 balance on a high credit limit. That's responsible use of credit. It shows that you can maintain credit without getting yourself into trouble.
For the sake of your credit score, and for the sake of your own wallet, the key to healthy credit card use is to pay down the balance as quickly as possible. Credit cards can cause a world of pain for people, because the minimum payments lead to long debt cycles. However, credit cards are a necessary evil as they make life much simpler for consumers. The key is proper management.
About the Author Chris Esposito specializes in home renovation loans with CM Direct, Inc. As a nationwide lender, they provide home improvement financing across the country, including the FHA 203(k) home rehab loan program. To learn more, visit www.DirectRehabLoans.com, or call (877) 876-3688.
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