Credit Cards: Beneficial Tool or Financial Obstacle?

The economy has turned a corner and you know what that means: pre-approved credit card applications are headed to a mailbox near you. I've shredded a few just this week, though not every application should be completely ignored. As a former credit card industry professional, an amateur economist and a credit card holder myself, I know it is important to weight the pros and cons before deciding to have a credit card and which card to have.

Perhaps the biggest "pro", and the reason there are more than 1 billion active credit cards in the United States alone, is that credit cards allow us to smooth our consumption over time. For Americans with irregular incomes, a credit card may be the tool of choice for evening out their expenditures-- they can still spend on the low-income months and pay off their debts in the high-income months. Or, if we expect to make more money in a year or two, we can benefit from our expected raise now by using a credit card that can be paid in full when our income is increased.

Credit cards also allow us to pay large purchases over time. I've used a credit card to purchase a new computer, a refrigerator, a new bed, etc. In each case, I had the option to pay over time for something I could not afford up front. In addition, each of my credit card purchases earned rewards that ultimately decrease the cost of whatever I'm buying.

Another positive of any major credit card (Visa/Mastercard/Discover/American Express) is the ability to dispute charges you may not have made. This feature secures cardholders against fraud, identity theft and unauthorized use. This feature also works on debit cards issued by Visa or Mastercard, so long as you choose "credit" as your method of payment.

In short, credit cards allow us to smooth our consumption, pay for large purchases over time, earn rewards that ultimately save us money, and be protected against thieves and con-men. In order to make a good decision about credit cards, however, we must consider the costs along with the benefits.

The most direct costs of a credit card are the fees and interest associated with your card. I have made it a practice never to pay a fee of any kind on my cards-- I don't sign up for cards with an annual fee and I'm careful not to be late, make telephone payments or go over my limit. The best way to avoid interest is to pay off the balance, so I am careful not to use my credit card for anything that will take more than 3-6 months to pay in full. As often as I can, I pay the card off in full as soon as I have made a purchase-- this captures the security and rewards benefits without costing additional interest.

Because of interest and fees, credit cards can make a purchase much, much more expensive and can take a very long time to pay off. Making minimum payments at the average 14.65% interest rate, for example, a balance of $2000 would take approximately three years and an extra $500 to pay in full. If you were to default on that account to 26-29% interest, it would take four years and an extra $1600 to pay that same balance. Before deciding to stretch out payments over several years, credit card holders should ask, "Is worth an extra $500 to me to have this now? An extra $1500?" If the answer is "no", you may be better off saving for what you want and paying cash instead.

Left unchecked, the interest we pay to smooth our consumption may turn into a heavy burden. Credit cards allow us to instantly have what we want, which can hinder our motivations to save and pay for what we have purchased-- but debts will always come due. If we're spending because we are expecting a raise, we should consider how we'll pay off our credit cards if that raise doesn't come or if it takes longer than we thought it would. If our income is up-and-down, what will we do if we have three or four or five down months in a row? Because life is unpredictable, credit cards can pull our dreams off track or delay what we want most when things don't go according to plan.

Weighing the pros and cons of credit cards reveals that this form of payment carries a great deal of risk. Credit cards can be a beneficial tool or a significant obstacle to reaching our financial goals, depending on how well we use them. Limiting the number of cards you own to one or two is an essential way to manage the risk involved. That is exactly why I recommend you do what I do when you get a pre-approved credit card in the mail: head straight for the shredder.