Ah yes, the mighty credit card. The backbone of the American consumer complex.
We are all so familiar with this magical piece of plastic, yet so few of us really understand how credit cards work.
And that’s a problem. Because while credit cards can be incredibly empowering, and I love using them, they can also be incredibly dangerous, if not used responsibly.
Today, we’re going to dive into the fundamentals of how credit cards work.
We’ll be comparing credit to debit, reviewing the benefits of credit cards, and finally, we’ll discuss the all-powerful credit score, including how you can find yours and how you can boost it.
So if you find the topic of credit cards scary or confusing, stick around, because we are about to demystify things for you.
Credit vs Debit
Let’s begin by discussing the “credit” part of credit cards.
“Credit” is just a fancy name for borrowing.
If you read financial news, you might come across terms like “Credit Markets”, which refers to all kinds of debt, from corporate bonds, which are loans issued to corporations, to treasury bills, which are loans made to the government.
Credit card debt is just another type of loan, in this case a loan issued by the credit card company to a consumer, such as you or me.
So when you make a purchase with your credit card, you’re not paying any money upfront. Instead, you’re asking the credit card company to spot you the money and you’ll pay them back when your credit card bill is due.
This means your credit card statement is just a long list of IOUs to your credit card company. And if you don’t pay them back on time, which you should always do, they’ll charge you interest, which we discuss in depth in a separate lesson.
Now, let’s contrast credit cards with debit cards.
A debit card is much simpler. Debit in this context means to “subtract from your bank account balance”. So when you make a purchase with a debit card, you’re paying money on the spot.
Once you swipe, the payment processor verifies you have enough cash in your bank account, and then it instantly debits the purchase from your bank balance.
If you don’t have the cash, the purchase will simply fail. Be careful though, because some debit cards do allow “overdrafting”, which is essentially a short-term loan with ridiculously high interest. Avoid overdrafting at all costs.
But the key here is that, with debit cards, your payments happen in real time, whereas credit cards allow you to buy things without actually paying for them upfront.
And if you pay off your credit card on time, you’re essentially getting a free loan. This is great because a dollar today is worth more than a dollar a month from now. That’s very empowering.
But with great power comes great responsibility. People frequently take advantage of these “mini loans” to buy things they can’t afford. And this can get them in a lot of trouble when it comes to paying the bill.
If you don’t have the cash to pay your bill, the credit card companies will start charging you interest, and that gets expensive fast. Credit card companies love when that happens because they make money on your interest payments.
So a good rule is to never spend more on a credit card than you can pay off at the end of the month.
The Other Perks of Credit
In addition to getting a free loan, credit cards come with a variety of other perks.
Foremost among those is fraud protection.
As we already discussed, when you purchase something with a debit card, you pay on the spot. So, if a fraudster gets a hold of your debit card number and goes on a spending spree, your money is gone instantly, and it’s very hard to get back.
By contrast, with credit cards, you don’t pay the money upfront. Sure, you still have to pay your bill eventually, but you have a window of time to review your statement, and if you see something that doesn’t belong there, such as a fraudulent charge, you can dispute the charge before you pay.
Debit cards also provide direct access to your bank account through an ATM or online. If someone gets a hold of your pin number, they can steal your money before you have a chance to stop them.
With a credit card, that risk is much lower. Credit cards aren’t linked directly to your bank account and most won’t let you withdraw more than a small sum in the form of what they call a cash advance.
So think of a credit card as an additional layer of security between merchants and your bank account.
That alone should be reason enough to use a credit card. But the perks keep coming.
Many credit cards include all kinds of other automatic protections like car rental insurance, travel insurance, and other purchase protections. The higher end cards also include things like priority lounge access at airports and concierge services for restaurants and travel.
And of course, most credit cards include some kind of points or cash back system, both of which can provide a meaningful return on your purchases if you use them strategically.
How Do Credit Cards Profit?
Now at this point you’re probably wondering, if these credit card companies are giving me free loans and showering me with perks, what do they get out of this? Where’s the catch?
Well don’t lose any sleep over those poor credit card companies. Because they’re doing just fine. And to be clear, they’re not poor at all.
We’ve already discussed how they make money by charging interest on late payments. They also charge for all kinds of other services, like balance transfers (which is when you transfer your debt from one card to another) and cash advances (which is when you use a credit card to withdraw money from an ATM).
But an even larger stream of income for credit card companies is from the transaction fees they charge the merchants you buy from.
When you swipe your card, that merchant is typically paying around 3% of your purchase to credit card companies to provide that convenience. That’s one of the reasons why some shops don’t allow credit cards. Or they might charge you a 3% surcharge to cover the fee.
Finally, as with most “free” services these days, credit card companies also make money selling your personal data. They typically do this anonymously, but that’s still valuable to data brokers, and it’s something you should be aware of if you are concerned about your privacy.
Your Credit Score
Another fundamental concept when it comes to credit cards is your credit score.
Your credit score is essentially a measurement of your trustworthiness as a borrower. People with higher credit scores are more likely to pay their credit card balances on time, whereas people with lower credit scores are more likely to default on their credit, meaning they never pay it back.
Your score is calculated independently by a few large credit agencies who know way more about you than you realize.
These agencies consider all kinds of factors when they calculate your score, including how much debt you have outstanding, how much credit you have access to, how consistently you pay off your debt, and to a lesser degree, the length of your credit history (i.e., how long you’ve had access to credit). They even look at the diversity of your credit sources, including things like student loans and mortgages.
They roll up all of this data into a single score that credit card companies use to determine how much credit to give you and what type of credit card you qualify for. The higher your credit score is, the more credit they’ll offer you, and the more perks they’ll tempt you with.
They like big spenders because they generate large merchant fees for the company, so the more they think you’ll spend, the more they’ll try to win your business.
If you’re wondering what your credit score is, it’s really easy to check. And it’s totally free. My go-to resource is CreditKarma.com, which does a nice job summarizing everything related to your credit score in one nice dashboard.
Whatever service you use, you should never have to pay to see your credit score. Those days are long gone.
Also, make sure you trust the authenticity of any service you get your credit score from, because in the process of getting your score, you’ll need to disclose a lot of sensitive personal information.
If that info falls into the wrong hands, you put yourself at risk of being hacked, or worse, having your identity stolen.
Use Credit Cards Wisely
So as I’ve hopefully made clear by now, credit cards are a phenomenal resource. They provide a powerful layer of security between your bank and the merchants you buy from, and they offer a wealth of rewards (along with free short-term loans).
Just remember that credit cards are not without their risks.
You must use them responsibly to get the most value out of them. Under no circumstances should you use them to buy more than you can pay for. And take care when researching your credit score because that personal data is precious.
When all is said and done, I strongly recommend using a credit card. Just make sure you’re smart about how you select your credit card, which we discuss in detail in another lesson.
What Do You Think?
Now that I’ve shared my thoughts on the benefits of credit cards, I’d love to hear your thoughts. What do you love about credit cards? Are there any other drawbacks you can think of?
Share that with me and the other Wealth Stakers in the comments below.
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With that, I bid you adieu, and happy Wealth Staking!