Mismanaging your credit cards can result in lasting financial difficulties – especially if you have big goals with your money – like buying a home or car.
Let’s explore three of the most serious credit card blunders.
1. Leaving Debt on Your Card
Leaving a balance on your credit card from month to month is a big no no. Why? It’ll damage your credit score. A high credit score is required to be approved for a mortgage or car loan. The higher your credit score, the lower interest rate you’ll receive on a loan.
One of the biggest elements that determines your score is your utilization ratio. This is merely a term for how much debt you’re in. If you leave a balance on the credit card — and only pay the minimum payment instead of the statement balance — you’re now in credit card debt.
Let’s say you have a $3,000 credit limit on your credit card. That means you can charge up to $3,000 worth of expenditures on your card. For the sake of this example, if you have a $2,000 balance on your credit card, your utilization ratio is 66.6% (2,000 divided by 3,000).
That’s rather high. A good rule of thumb is to keep your utilization ratio at around 30% or less.
So let’s say you were able to pay off half of your $2,000 balance. Your utilization ratio is now 33.3% (1,000 divided by 3,000). While you’re still in debt, at least this is a little bit better of a utilization ratio.
Had you paid off the entire balance, your utilization ratio would be zero, which is a good sign. It means you don’t have any debt, so your score will likely increase over time.
And don’t forget about all the other things you could be doing with this extra money you were throwing away in excess interest charges.
2. Throwing Money Away on Interest Payments
Let’s take a step back and focus on some credit card basics.
When you charge something on your credit card, you’re not paying for the item with your own money. You’re using the bank’s money. You have to pay back those funds or face some hefty financial consequences. At the end of the month, you’ll receive a statement with a ton of numbers on it.
From the $5 lattes you purchased over the past month to the $10 salads you spent during your lunch break. Even the $75 pair of jeans you may have splurged on – it’s all there.
Next, you’ll see the “statement balance” – this is just the sum of all of your expenditures on the credit card for the month. Then you’ll have the “minimum payment.” This is typically much less than your statement balance – it’s usually a small percentage of the balance, say 2%.
The exact calculation isn’t important. What is important is that you are aware of the dangers of only paying the minimum payment. The minimum payment sounds tempting because it could be as low as $35, even though your statement balance may be close to $1,000.
If you fail to pay anything but the “statement balance,” interest charges will kick in. Chances are, the interest rate on your credit card can be as much as 25%.
Let’s take the example of someone with a $2,000 balance on their credit card that has a 25% interest rate.
Interest rate: 25%
Minimum Payment: $20
Years to pay off debt: 50
Total interest expense: $32,000+
A $2,000 bill turns into a $32,000 one? This is a perfect example of the power of compounding interest — working against you.
Now what if you tripled the minimum payment? You would then be out of debt in under 5 years and pay under $1,500 in interest expense.
3. Allowing Your Credit Card to Sink the Rest of Your Finances
What do we mean by this?
You don’t want your credit card to become an expense – like another cell phone payment.
To further illustrate the negative impacts of leaving debt on a credit card, here’s another scenario to keep in mind. You come across an incredible laptop that’s $500, but discounted half off. You score it for $250. Sounds like a great deal right? It probably is.
You then use your credit card to buy the laptop and when the bill comes for $250, you only make the minimum payment.
If the interest rate on your credit card is 25% and you only pay the minimum payment of $20, online interest calculators suggest it will take you a little bit more than 12 months to pay off this balance and you’ll pay over $40 in interest charges.
So all of a sudden, that $250 laptop now costs you almost $300. You still scored a good deal on the laptop, but not as good of a deal.
Plus, this is just one item, think about if you applied this mentality to a host of different expenditures throughout the month. You’d be giving up a large portion of those sales and coupons.
The dangers of only paying the minimum payment on your credit card stem beyond just the increased interest costs.
Need another example?
The S&P 500, an index that includes 500 stocks (typically large companies), rose over 9% in 2016. Remember how we talked about the thousands of dollars you were throwing away on interest charges?
If you put that money into your 401(k), a Roth IRA or even a brokerage account with an exchange traded fund that tracks the S&P 500, you would have grown your money and made profits.
In summary, there are a host of reasons why you should be paying more than the minimum payment on your credit card. You’re essentially robbing your financial future – thank to all the extra money in interest expense you’ll pay.
Now there are plenty of people who can’t afford to pay off their balances in full – and that’s completely understandable, especially if you’re unemployed or working through another financial struggle. But if you’re merely splurging on items you can’t afford, that’s where the financial calculus fails to make sense.
One important rule of thumb to follow: if you can’t pay off your credit card balance in full each month, don’t use your credit card. Pay for the item in cash instead.