So far everything has been quite clearly positive or negative to your finances. Money in the bank earning interest gis helpful. Paying off the interest on a mortgage is not helpful (though buying the house can be good over the long-term!)
Credit cards are a different story. They are either positive for your finances, or a very big negative. And the exact same card can be either, depending upon how you use it.
If you’re in High School, you may not need this information for a little while: Unless you prove you have income, you can’t get your own credit card until you turn 21.
The positive credit card case: Paying off your balance each month
Let’s take a look at one credit card: The Citi Double Cash Card. This is not an ad. But it is the most straightforward card I could find. You get 2% cash back on every purchase, and there’s no annual fee. The structure is a little weird: You get 1% cash back when you buy something, and then another 1% when you pay your bill. But if you pay off your balance every month, it’s more or less the same as getting 2% cash back.
Let’s look at the positive case first. You get your credit card, and you make a purchase for, say, a $100 college textbook. You put your credit card into the reader (chip first!) and sign somewhere that you agree to pay Citi for this charge.
Citi is a giant bank, and they have just done something incredibly nice for you. They have agreed to give the merchant some money, and decided that they will ask you to pay them back sometime in the future. And, they’ve even agreed to give you back $2 (2% of the purchase price) once you do pay them back.
They’re going to give you some time before you have to pay them back; this is called a grace period. You only get a bill once a month, and so the length of the grace period varies based on where you are in your monthly billing cycle. If you’re at the end of your month, you may “only” have a 21-day grace period; that’s the legal minimum. (Citi’s grace period minimum is actually 23 days.)
Your billing day can be any day of the month; this way credit card companies can stagger their outgoing and incoming mail.
If you buy something at the very beginning of your month, you don’t have to pay them back for the rest of the month plus 23 more days. That means Citi is paying you 2% for the privilege of holding on to your money for an extra 53 days or so. It’s a fantastic deal.
Why are the credit card companies being so nice? They aren’t, of course. In our example above, you bought a $100 textbook. Notice I didn’t say “Citi pays the bookstore $100” because they don’t. Credit card companies take a cut of the sale, called interchange. They may only pay the store $97; they give you $2 and keep $1 for profit.
As long as you only buy what you can pay for when the bill comes, credit cards are fantastic. The store might wish you paid with cash, but everyone else comes out ahead.
The negative credit card case: Carrying a balance
You bought that $100 book, and now a few weeks later your bill is due. Unless you pay the full $100, bad things start happening. Immediately. First, the bank starts charging you interest on your $100. Second, your grace period disappears. Now, and new purchases have a 0 day grace period; you start paying interest on any new purchases right away.
What’s the interest rate? Well, you don’t find out until you get your new credit card in the mail. It will be somewhere between 13.99% and 23.99%. (Imagine taking out a mortgage and not knowing the interest rate!)
You can see some of the fees and interest rates here.
We’ll look at this in more detail in the next lesson. But there is a minimum payment amount set by the credit card company. This minimum payment works much like the mortgage payment: It’s enough to pay off the interest that was charged this month, plus a small bit of the principal.
If you don’t pay at least this minimum amount each month, your interest rate soars to the “penalty” interest rate, which can be up to 29.99%. There’s also a late fee of up to $40 that kicks in if you miss more than one minimum payment.
In the mortgage lesson, we ended up calculating that you pay equal amounts of interest and principal at an interest rate between 5% and 6% or so. Now your interest rate is a minimum of 14%. That $100 book will cost you well over $200 if you just make the minimum payments.
And at the minimum payment, paying off your book purchase will take almost as long as paying off a mortgage! Let’s look at an example in the next lesson.