Monday, November 5, 2007

Credit Cards – Useful tools, or evil debt traps?

Most finance books and blogging gurus that I’ve read seem to hold the opinion that the best way to get out of debt is to chop up all your credit cards.

They have a good point.

Many people find it difficult to control their spending if they have access to easy credit. My grandmother has never had a credit card. She’s terrified of them. My in-laws got rid of theirs after digging themselves into a financial hole which is still threatening to eat them alive (the fact that their elderly days may be financially strapped is something that often weighs heavily on my mind, but that’s a tale for another day).

If you have difficulty treating purchases on credit cards as real money, or if you’re prone to impulse buying, then this is certainly a valid strategy, and will no doubt help you immensely.

My problem is I tend to do the opposite. Cash that’s in my wallet has already left my bank account, so I tend to think of it as already spent. I therefore have very little difficulty parting with it. Purchases going on my credit card increase my balance, and end up detailed on my paper statement. An ATM withdrawal of $100 is just an ATM withdrawal. A purchase of $97.96 from VideoGamesRUs goes down in the annals of family history as the waste of money that it is.

I tend to view our main credit card as a tool. It’s a no fee MasterCard that has a 18.97% annual interest rate. We pay off the full balance every month, since I'd rather swallow paint thinner than 19% interest.

While my husband was in school and I was working a crappy retail job, I must confess that we weren’t always able to pay off the full balance with cash on hand. For that we had an unsecured (since we had no assets) line of credit with an interest rate of about 7%. Once we were both working, it took us about 6 months to pay off that line of credit.

Used the way we do, our credit card gives us a 30-day interest-free loan every month. It also provides us with 1% back in groceries. In the past we’ve tended to cash that 1% out during the summer for the expensive meats we love to barbecue. This year we’ll probably store up the credit and use it to buy baby supplies. I’m thinking the 40-odd diapers people say you go through the first week would feel slightly better if they were free.

In addition to the free groceries, I also like the credit card because it provides immediate mergency funds when necessary. Now, I would never suggest that you rely on a credit card for your source of emergency funding. That's not smart at all.

What I'm saying is that a credit card allows you to instantly pay for emergency needs while maintaining a slightly less liquid true emergency fund.

For example: We have just over $5000 in an account set up for emergencies. It's in a high-interest savings account currently making 4.3% interest. Unfortunately, while I can instantly transfer money to it from my chequing account, it takes 24 hours to get it back out again. This means that if I needed to access that money in order to remove my car from a ditch, I'd have to wait a day.

Not helpful.

However, with my credit card, I pay the nice tow truck driver when I need him. Then, when the credit card bill comes, I transfer the funds from my emergency savings account to my chequing account, and from there to Mr. MasterCard.

Note that in order for this to work well, you need to pay the balance on the credit card off in full every month. Otherwise you're being charged an astronomical rate of interest while you're paying the nice tow truck driver. Talk about adding insult to (hopefully) metaphorical injury.

In addition to our main MasterCard which has my husband as the primary cardholder, we have a much smaller Visa in my name. This is because I discovered a few years back that I had no credit rating. That was a thrilling moment, let me tell you.

When my husband and I were first signing up for our accounts and credit we put the chequing and savings accounts in my name primarily and the MasterCard in his. It was an arbitrary decision and seemed fair. A little while later we had an offer for a line of credit which came in his name. Because money was tight while he was in school, we accepted.

Three years ago I applied for a separate credit card because I intended to start my own hobby business. I was only applying for a $1000 credit limit, so imagine my surprise when my bank turned me down.

I couldn’t understand it. I’d occasionally paid a bill a bit late, but nothing had ever gone into arrears for longer than a couple of days. We always paid at least the minimum due on everything, none of our cheques had ever bounced. Why on Earth couldn’t I get a little bit of credit?

It turned out I couldn’t get credit because I hadn’t had any in my name for over seven years. I was the secondary cardholder on the MasterCard, and while any failure to pay would reflect badly on me, I didn’t benefit from my husband’s (i.e. my) good record of payment. A good history of writing cheques was meaningless, only a bounced one would affect my rating. My student loan wasn’t large enough and hadn’t been in repayment long enough to be meaningful.

My first thought when getting this information remains unprintable.

My second thought was to panic because I knew that in a year or two we’d be looking at buying a house and if I had no credit history that was going to be difficult.

The bank I tried first is a good online firm for the most part. They give relatively high interest rates on savings, they have no-fee chequing accounts. They’ve saved us a lot of money. They are, however, completely inflexible. Because everything is done online or by telephone, they adhere to strict formulas and rigid schedules about who qualifies for what. There’s no wiggle room. They wouldn’t help me.

Our line of credit is through a brick and mortar bank. I decided to call them next. They were remarkably more helpful, but even so I had to have my husband co-sign my $1000 Visa card with them. As the sole breadwinner at the time, it was unbelievably grating, let me tell you.

It all worked out in the end. I now have a credit rating. We successfully acquired a mortgage last year and it’s in both our names. My husband is still the primary holder of our large MasterCard. I still hold the smaller Visa. We regularly pay everything with the MasterCard so that we earn the free groceries, and so our expenses are easier to track. I put one to two purchases on the Visa monthly to keep it active and to show that I can regularly pay it off. We have no need or desire to have any other credit cards.

I understand why cutting up all credit cards can be the best solution for many people, but you might consider having at least a small one to maintain your credit rating if you can practice discipline. You can always ask your lender to reduce your credit limit to $1000 or even $500, so that you can never dig yourself too deep.

Just remember to ignore all the other ‘great’ offers you’ll likely receive in the mail once you have a good credit rating.

November 10th Update: Guess who called me last night to offer me a $15,000 credit card?

If you guessed the bank that turned me down three years ago when I begged them to give me a $1000 credit limit after having been a customer for four years, you'd be right.

Now, guess who had me laughing uproariously in their ear? Go on. Guess.

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