Credit Demystified – Chapter 1, Section 3: Credit Cards

Purchasing with a credit card, on the other hand, is a very different animal.

Whereas with a debit card you signed a permission slip for the merchant to take money from your bank account, with a credit card you’re signing a promissory note with a banker (from now on referred to as The Banker). You’re saying, “Hey, look Banker, lend me a little money, will ya? I swear I’ll pay it back at the end of the month.”

With a debit card, if you run out of money and you try to buy more groceries, usually your card will be rejected. Sure, it’s a little embarrassing to be holding up the only cashier on duty with 20 frustrated and hungry people behind you and your purchase won’t go through so you have to decide whether to put back the veggies and fruit or the pretzels and ice cream but, hey, at least those veggies and fruit won’t make you go into debt. Right?

But let’s pretend, for the purpose of this exercise, that money is not an issue. Let’s pretend that whether you’re paying with debit or paying with credit you’ve got the cash to back up the purchases you’re making. The point here is to understand the operational differences between credit-backed and debit-backed purchases.

So, what’s happening when you use a credit card? When you apply for and open a new credit card account you’re agreeing to a whole bunch of fine print — the terms and agreements. Basically, what it boils down to is that you borrow money from The Banker and if you don’t pay it all back when it’s due, The Banker gets to charge you interest. And if you pay late or miss a payment, The Banker gets to add fees and fines to the interest charges. Plus — and The Banker is really salivating now — as we just learned, The Banker gets to charge you compounding interest on your purchases, the interest, the fees, and the fines. Holy cow!

You’re probably wondering, why the heck would I want to use a credit card?! That’s a very valid question. And it’s one I’m not going to definitively answer because I believe deeply that the choice between debit and credit is one that individual consumers need to make for themselves. But I also believe that it is a decision that should only be made once the consumer has all of the facts and fully understands both the advantages and disadvantages of each option.

So, here we go. Here’s how credit cards work:

– You go to the grocery store and buy $100’s worth of groceries.

– You pull out your credit card and Poof!, out pops The Banker (wearing sleeve protectors and a visor, naturally).

– The Banker pulls out a substantial wad of cash and pays the merchant on your behalf.

– Then The Banker pulls out a little notebook and pencil, flips to the sheet with your name on it, and notes, “Joe Schmoe – Kroger grocery store – $100.”

– At this point the cashier’s done and you put your credit card back into your wallet at which point, Poof!, The Banker disappears.

– A few days later, you go out for a new pair of running shoes and pick out an awesome pair of Nike or New Balance or Adidas (or whatever – your favorite footwear company here). Once again, you pull out your credit card and….

– Poof! The Banker pops out of thin air, pulls out that massive wad of cash again, peels off $150, pays the merchant, makes a note on your page in The Notebook: “Joe Schmoe – Runner’s Roost – $150.” Then, like before, Poof! – gone again.

And so it goes. For about a month (we’ll get into that soon), The Banker keeps a running list of all of the times you called up the Credit Card Banker-Genie. At the end of that period, The Banker rips the Joe Schmoe sheet out of The Notebook and creates a new, blank Joe Schmoe sheet. Next The Banker tallies up everything on the sheet, everything you charged to your credit card over the past ~30 days, and sends you an itemized bill.

Up to this point, you haven’t spent a dime of your own physical money. But now the day of reckoning is upon you. You have been spending money you did promise The Banker that you would pay upon receipt of his bill. It is, as they say, time to pay the piper (or The Banker, in this case).

Advantages

Making purchases with a credit card has several advantages.

1. No one is directly touching your money. Not only is the merchant not reaching directly into your cash funds, it’s The Banker’s cash that is being used to pay the merchant.
2. Due to the timing of dates and billing cycles, your money sits in your bank account for an extra 30-60 days. Interest rates have been in the tank for nearly a decade now but there was a time when a healthy bank balance could earn an appreciable amount of interest. It’s not inconceivable that leaving your cash in your bank account for an extra month or nearly two could be just another way to learn to leverage your money.
3. One of the biggest advantages to using credit is fraud protection. [We just covered this in Section 1.2 – Debit Cards.] Remember the story about my daughter and the $800 that it took her bank 30 days to return when someone used her debit card fraudulently? Well, I had a similar experience except it was my credit card that was used fraudulently.
   While our two stories are very similar, they’re also quite different.
   • One day I received a text alert on my phone from my credit card company saying they’d detected suspicious activity on my card and I should call the fraud department — which I did immediately. The customer service agent named a store, a location, and a purchase amount that clearly was not mine. The agent then read a list of charges, starting with the most recent and working backward, on my account. I verified that all but that most recent one — the one that triggered the fraud alert — was mine. And that was that. The fraudulent charge was deleted from my sheet in The Banker’s notebook. It did not appear in the list of transactions online nor was it included on credit card statement.
     
   For anyone not floating in cash, the difference between the stories demonstrates the significance of the impact of a fraudulent debit charge and a fraudulent credit charge. In my case, the cash never left my possession. Unlike my daughter, and anyone else who has been the victim of debit card fraud, I did not have to wait 30 days to get my money back.
4. As I mentioned earlier [in Section 1.2 – Debit Cards] and as illustrated above, not only are the impacts of fraud less inconvenient in the case of credit card fraud, but the long-term repercussions are also more favorable. Credit card companies are more vigilant in detecting fraud. They’re more likely to shut down your card and stem the flow of fraudulent funds. And your overall liability is lower in cases of credit card fraud than in debit card fraud.
5. While all of the advantages of credit cards are, well, advantageous, I’ll admit that the rewards are my personal favorite. We’ve all seen them: cash back, double points, revolving bonus rewards for shopping at Kohl’s or buying gas.
   I prefer cash back cards but I know others really like the points they earn. Last year I earned over $1,200 in cash just by using my credit card — and that was pure gravy because I didn’t pay any fees or interest (plus all of the other advantages listed here).
6. A lesser known, and lesser used, but significant advantage of credit cards: the added consumer protections. The fine print is different with each card but many cards offer extended warranties on electronics purchased with their card including theft or accidental damage. Did you know that if you buy a digital camera to take on vacation and a thief runs off with it, your credit card covers that? If you rent a car with a credit card, you can likely skip the outrageous insurance fees because most cards provide coverage for that. I’ve even got a card now that offers price adjustments if an item I buy is sold elsewhere for less money within a certain timeframe. Note: make sure to check the fine print on each card to see the terms and conditions for these extra card benefits.
7. Last, but certainly not least, responsible credit card use is one of the fastest, easiest, and most efficient ways to improve your Credit Score.

Disadvantage

Credit cards have many advantages but let’s not gloss over the big disadvantage of credit cards — one can get oneself into a big ol’ hot mess of DEBT. One day you’re doing fine and the next you find yourself in a $10,000 pit of debt with no idea of how to get out.

Additional Consideration

Before we close out the Credit Card discussion, I have one last bit of information that may or may not impact your future decisions regarding debit and credit card usage: the costs incurred by merchants depending on your payment method.

Merchants pay higher fees on credit card transactions than they do on debit card transactions.

The difference in fees charged is not as significant as it once was but it does still exist. The increased number of competitors in payment processing has helped bring fees down considerably. Not each credit card company charges the same fees (American Express is notorious for charging merchants higher-than-average fees) and not all merchants are charged the same percentage by the same payment processor (larger retailers can negotiate for lower fees where smaller, cottage-industry merchants don’t wield that sort of power).

If you’re a consumer who makes an effort to buy locally or you choose to support independently-owned stores over chain stores, the difference in fees might influence your choice of payment method. Or not. I believe it’s a personal choice to make. I strive to find a balance between convenience and social-conscience that works for me given my particular circumstances and values.

To recap

Making purchases with a credit card is like paying for your purchases with the bank’s money—at least temporarily. Payment to the bank isn’t due until from between 25 up to 55 days after the purchase was made. Many cardholders earn cash or point rewards for card purchases. If your card is used fraudulently, you are not held responsible for those charges and your maximum liability, if assessed at all, is capped at $50.00. Many credit cards offer additional member benefits on the products purchased with the card such as extended warranties and insurance against theft or damage; other member benefits include rental auto insurance or price adjustment guarantees. And responsible credit card use can help build or repair your credit. However, it is possible to go deep into debt with credit cards.

next >> Section 1.4: Overdrafts & Overdraft Protection