Chapter 3. Credit Cards

Some people view credit cards the way prohibitionist Carry Nation viewed alcohol: a hideous evil visited upon an unsuspecting and easily duped public.

It's true that credit cards have paved many a road to financial ruin. The soaring bankruptcy rate attests to that, as does the fact that millions carry credit card balances at rates so high that they would have been illegal just a generation ago. There's no question that some people would be better off without plastic. Many others would have a lot more cash in their pockets if credit card companies weren't so fiendishly creative at finding ways to snatch it away.

But just as most people can have a cocktail without ruining their lives, most people can handle a credit card or three. The oft-repeated statistic that Americans carry an average of $9,000 in credit card debt is actually bunk (more on that later). A large group of credit card borrowers (about 40% by most estimates) use cards solely for convenience, charging balances that they pay off in full each month.

Credit cards provide protections that simply aren't available if you pay by cash or check. The credit card company serves as a middleman if you have a dispute with a merchant, and it can even help you replace purchases that are lost, broken, or stolen. (If you have a gold or platinum card, check the benefits guide that came with it. Chances are you'll be pleasantly surprised at the perks you'll find.)

If someone steals your card or uses your account number without permission, you're typically not liable for a dime. (Most issuers waive the $50 fee they could legally charge.) Then there are all the rewards you can rack up with the right card—cash back, free flights, upgrades, hotel stays…even merchandise.

Credit cards can provide an important safety valve in a nation that's pretty much forgotten how to put aside a little money for a rainy day. If you don't have enough cash to survive a few months of unemployment—and two out of three households don't—you can live on your cards for a while until you land your next gig. It's not the best way to survive a financial crisis, of course, but it can work.

When people get in trouble is when they let credit cards tempt them into living beyond their means.

Some credit card issuers allow their borrowers to pay 2% or less of their balances each month. That means people can carry towering amounts of debt without really feeling the pain—at least not directly.

At 2%, the typical minimum payment on $5,000 of credit card debt is only about $100 a month. At 13% interest (which is about average as this book went to press), you would need 27 years to pay off the balance—and you'll wind up paying for everything you bought twice over when you count in the interest you've paid.

At a 19% rate, that same debt would take you 54 years to retire, and you'd pay for everything more than four times. (These figures are courtesy of Marc Eisenson, author of The Banker's Secret.)

Imagine paying for everyday purchases for literally decades. Every dinner you've long since digested, every toy that broke years ago, every household gadget or piece of clothing that's been donated to the Salvation Army—all paid for four times over.

Now, imagine that instead of sending that $100 a month to a credit card company, you invested it instead. Over your working lifetime, you could rack up a nest egg of nearly $350,000, assuming your investments earned an average 8% annual return.

That's a pretty steep price to pay for the “convenience” of not paying off your balance.

Carrying a balance also leaves you vulnerable to the many different ways credit card companies have devised to ding their customers, from rates that soar overnight to sneaky balance-transfer fees. (Again, you'll consider lots more on that in a minute.) If you don't carry a balance, you don't have to care when your issuer cranks up your rate—because you're not paying interest anyway.

Aren't there exceptions? You might have been led to think that any type of debt is okay, as long as you don't overdo it and you manage it correctly. But that's not true when it comes to credit cards.

Credit card debt is simply corrosive. Much of the time, it's ridiculously expensive, and even when it's not (listen up if you've received low-rate balance-transfer offers), it encourages people to spend more than they make, which is never a good financial habit to acquire.

People who play the balance-transfer shuffle—moving their debt from one card to another in search of low rates—do themselves a particular disservice. All those accounts can ding your credit score, as can moving money from one card to another with a lower credit limit. Do it long enough, and you may find that your score has suffered enough that the low-rate offers suddenly dry up, stranding you with a big debt on a card that's about to jack up its rate.

Playing the Balance-Transfer Shuffle The proliferation of 0% transfer offers has tempted a lot of people to play some pretty interesting games with their debt. Jonathan in Los Angeles bragged to me that he has plenty of money in his savings account to pay off his $5,000 credit card debt. But he'd been bouncing the debt from one 0% offer to the next while earning about 2% on his savings. Wasn't that smart? Not when you think about it. The 2% interest Jonathan earns translates into about $100 a year. Since he's in the 25% federal tax bracket, he loses $25 of that “windfall” to federal taxes and another $8 or so to state taxes. That leaves $67, or about $5.58 a month in “profit.” For that small return, he has to pore over each deal's fine print to make sure he doesn't get tripped up by some gotcha like balance-transfer fees. He has to make sure he gets every payment in well ahead of the due date, or he risks triggering a sky-high penalty rate. He has to know exactly when the offer expires and search out and secure the next offer in time. Jonathan could make the same “return” for a lot less effort by merely skipping his ritual latte-and-muffin habit one day a month, or by buying one less drink at the local watering hole. And he wouldn't be risking his credit score playing the balance-transfer game. Each new account he applies for dings his score; so does transferring a balance from a higher-limit card to a lower-limit one. Jonathan's been making matters worse by closing out the old accounts; closing accounts never helps your score, and can hurt it. If you decide to grab one of these low-rate teasers, watch the fine print. Credit card issuers increasingly are hiding tricks and traps in the fine print that are catching even veteran balance shufflers. Russ in San Antonio told this cautionary tale: “I am one of those who continuously rolls credit card balances to new cards before the teaser 0% interest term limit approaches. I have been enjoying 0% interest for several years. Within the last few months, something happened that has never happened before. I applied for a new card balance transfer. I was eventually approved. When I received my statement, my very first invoice included an 'over-limit' fee. “Just in case that did not immediately hit you, look at it this way. I apply for a card, not knowing the amount of the credit limit that will be granted. The card company transfers the balance amount I requested, but it makes my credit limit slightly less. The card company gets an over-limit fee along with a transfer fee. I did call the company, and they waived the over-limit fee, but it makes me wonder how many folks are paying without challenging something like that.”

Carrying credit card debt is not the norm in America, despite what we're frequently told.

Most Americans owe nothing to credit card companies, according to detailed figures compiled by the Federal Reserve Bank in its Survey of Consumer Finances. One quarter of U.S. households don't have any cards at all, and another 30% or so regularly pay off their balances in full.

Of the households that did carry a balance, the median amount owed was $1,900. That means half of the households with a balance owed more, and half owed less.

So where did we get the idea that the average American is $9,000 in hock? That idea is actually a misquote of a real but easily misunderstood statistic.

CardWeb.com, which tracks credit card trends, divides the total outstanding credit card debt at the end of each year by the number of American households that have at least one credit card (see Table 3.1).

Table 3.1. Credit Card Debt by Household

Year	Average Debt
1990	$2,966
1991	$3,103
1992	$3,275
1993	$3,646
1994	$4,301
1995	$5,213
1996	$5,875
1997	$6,247
1998	$6,618
1999	$7,031
2000	$7,842
2001	$8,234
2002	$8,940
2003	$9,205
Source: CardWeb.com

If you know anything about statistics, though, you probably know that averages can be incredibly deceiving.

Need an example? Imagine yourself in a room with nine friends—and two of those friends are Bill Gates and Warren Buffet. The average net worth of a person in that room would be more than $8 billion, even if the rest of you are flat broke. Gates and Buffet are so mind-bendingly rich that they skew the average.

A similar phenomenon seems to be happening with credit card debt. Most folks don't have any, and most of those who do don't have much. But a few folks have a lot, and that skews the average. (That and the fact that CardWeb's statistics include balances that are about to be paid off, as well as those that are carried month-to-month.)

The continued misuse of the CardWeb statistic does a real disservice to people with credit card debt because it can mislead them into thinking that they're the norm—that carrying debt on plastic is how you're “supposed” to live your life. Nothing could be further from the truth.

In fact, if you want to achieve financial independence one day—that is, if you ever want to retire or have enough money to chart your own course—you need to learn this lesson. While you're at it, teach it to your kids:

Pay off your credit card balances in full every month.

The only exception, as I've noted, is when you're experiencing a true financial emergency like a job loss. In that case, you'll want to preserve your cash.

Running out of cash before you run out of month isn't an emergency. That's just overspending. If you encounter that situation, go into savings overdrive to come up with the cash to pay your cards. Sell something. Eat beans and rice. Bike to work to save gas. Do whatever it takes to get in the habit of relentlessly, religiously paying off your credit card bill.

Of all the financial lessons my mother taught me, this was one of the most important. My mother was so dead set against paying credit card fees of any kind that when her Visa card first introduced an annual fee, she cut up the card and sent the shards back to the bank. (Within a few weeks she received a new card with the fee waived—and a letter of apology.)

Not owing credit card debt has freed me in so many ways. When I was first starting out, I had more money than many of my peers to save for retirement and spend on the things I enjoyed, including travel. When the newspaper I was working for in 1992 abruptly shut down, I learned that I had enough cash saved—and my expenses were so reasonable—that I could easily survive for a year without touching my retirement savings. While others panicked, I had the luxury of figuring out what I wanted to do next and even turned down a few jobs before I found the one I wanted. Now that's freedom.