Do credit cards represent shopping convenience, or a noose of debt? It depends on how they are used.
When credit cards were first issued, you had to either be seriously wealthy or amongst the top tier of salary earners in order to qualify for one. That your credit record needed to be more sanitary than an operating table went without saying.
Nowadays, these seemingly innocuous bits of plastic simply arrive in the post. And it is not only the banks who are issuing these cards, either. Clothing stores (e.g. Edgars), supermarket chains (Pick n Pay), medical schemes (Discovery), and even airlines (Kulula.com) are getting in on the act. Do not be surprised if you start seeing people carrying Kaizer Chiefs or Natal Sharks credit cards next!
Credit cards, used properly, can be good money-management tools.
Why are people switching to credit cards?
Increased credit card usage, sadly, is a reflection on the times that we are living in, since it is no longer safe to carry cash around. Credit cards generally provide increased security, in that once you have notified the issuer that your card has been stolen or lost, you are indemnified against any fraudulent purchases that take place after you have reported the loss.
In addition, whereas in the days of the first credit card, Diners Club, where acceptance thereof was limited to just 12 restaurants in the greater New York area, cards are now almost universally accepted. Merchants used to be reluctant to accept credit cards due to the high merchant fees charged, competition has driven these charges down, whilst at the same time, the cost of handling cash (cash-in-transit services, bank charges, etc.) has made the handling of cash more expensive.
Technology has also driven the increase in use, since credit card terminals and even cellphone-based card acceptance solutions make it far easier for merchants to obtain authorisation on transactions.
Finally, provided that the merchant has carried out the appropriate security checks (which is often no more than a verification of the cardholder’s signature, since the terminal automatically rejects cards that the bank has recorded as being lost or stolen), payment to the merchant is guaranteed.
When you compare the risks and handling costs around cash, not to mention the risk of a cheque bouncing, you will see that credit cards are fast becoming the preferred medium of payment. In time, cheque books are likely to become extinct.
How do credit cards work?
When you purchase a major item such as a car or a house, you would usually approach your bank for financing. Whilst this process has been streamlined somewhat in recent years, it still involves numerous forms to be completed, and waiting periods whilst the bank approves your application.
In the case of a credit card, this process takes place up front. Once your application has been approved, the issuer will set a credit limit and issue a card. When you use your card to make purchases, you are effectively drawing down against your credit facility.
Provided that you are in good standing with the issuer (i.e. your payments are up to date and your credit limit has not been exceeded), the bank will transfer the amount of your purchase directly into the store’s bank account, and raise a charge against you. With modern technology, the process at the checkout takes place faster than you can fumble through your change.
I keep hearing about this ‘55 days’ free credit’. Surely the banks don’t give you anything for free?
Despite the horror stories around credit card debt, a correctly-used credit card can be the cheapest form of banking available. This is due to the so-called ‘window period’ that the issuer applies to purchases – the so-called ‘55 days’ free credit’.
How this works is as follows:
- Your credit card issuer has specific cut-off periods each month, after which they will issue a statement to you. This cut-off date is normally around the middle of the month.
- You will then be given a period of time in which to pay your account – usually until the first or second week of the following month.
- Provided that you pay the account in full on or before the due date, you will not incur any interest charges.
But this amounts to around 25 days, you may ask. Whilst interest-free financing for 25 days is not bad, where do they come from with this 55-day story?
It works like this: Suppose that your card issuer has a cut-off date of the 15th of the month. Any purchases that you make on or before this date will appear on your statement for that month, and if you do not want to incur any interest charges, you will need to pay your account in full by the due date, which is normally around the 9th of the following month. This gives you 25 days’ interest-free credit.
However, any purchases that take place after the cut-off date will only appear on the following month’s statement. This means that, for example, a purchase made on the 16th of April will only appear on the May account, and payment will only be required on the 9th of June. Therefore, if you are close to the cut-off date, and can delay your purchase for a couple of days, you will get an extra month in which to pay – interest-free.
So why is credit card debt considered to be such a huge problem?
The previous question related to the disbelief that a bank would actually give its customers something for free. Actually, banks make an incredible amount of money from credit cards. This is partly due to the fee that is charged to the merchant who accepts the card, which ranges from 3 – 8% of the transaction value, depending on volumes and the type of card tendered.
However, the bulk of the money that banks make from credit cards is due to four of the dirtiest words ever to be found in the English language – ‘revolving credit’, and ‘budget plan’.
‘Revolving credit’ works like this: As already stated, if you settle your account in full each month, you will not incur any interest charges. However, the issuer will allow you to pay only a portion of this amount – the so-called ‘minimum payment’. This minimum amount varies between 5 – 10% of the amount due. You will however be charged interest on the balance outstanding, which can be at draconian interest rates – the average is around prime plus 8, which is 20% per annum at current overdraft rates.
It gets worse – for more expensive items, you can put your purchase on the so-called ‘budget plan’, which should rather be termed the ‘budget breaker plan’. This allows you to spread the payment over any period ranging from 6 to 36 months – with some issuers even offering 48-month plans. The interest charged is at the same draconian rates as for the revolving credit plan, and can result in huge amounts of interest being paid – particularly if you go for one of the longer plans.
The debt trap usually comes in when you have used your normal credit limit to the maximum, making only the minimum payments due. It usually happens when you see your credit card as an additional source of funds, rather than the banking convenience that it is supposed to be.
Suppose, for example, that you spend your entire limit of R5 000 in the first month, when you never had this amount in your bank in the first place. Having paid the minimum payment of R250 (assuming a minimum payment of 5%), the bank will then charge you around R80 in interest on the unpaid balance. This leaves you with only R170 available for the next month.
If this is part of a poor spending pattern that you have established, you will still want to spend R5 000 in the next month. Budget Plan to the rescue! I’m not exaggerating when I tell you that I have personally witnessed a family requesting the cashier to put a month’s worth of groceries onto their 12 month budget plan. I can understand paying off a refrigerator over 12 months, but food?
For such people, the only way out that they can see is enforced starvation for a year, or applying for another credit card. I have seen people with up to 10 credit cards in their wallets, using the cash advance from one card to meet the minimum payments on the others, thus ‘rolling’ cash between the various cards. The only long-term result is certain bankruptcy.
That’s horrible! Forget it – I’m never going to use a credit card!
For people who find themselves in the debt trap scenario, this is probably sound advice. For the average person, however, this would be like throwing out the baby with the bathwater. As seen above, using a credit card properly can provide you with unsurpassed banking convenience at a greatly reduced cost. The main proviso is that you pay the account in full each month.
Credit card companies often pay fairly decent interest on credit balances as well, so your card could be used as a savings account. Shop around, though, since you can often do better on a call or money market account.
Bear in mind as well that if you make cash withdrawals from your credit card account, you will pay interest from the date of the withdrawal to the date of payment. Such withdrawals should therefore be avoided, unless you have deposited surplus funds into your card (resulting in a credit balance). The same will apply to fuel purchases.
What other costs are there?
The only costs that you incur would be the annual card fee, which ranges from R100 for your basic card, to around R500 for the ‘fancier’ models, such as ‘gold’ and ‘platinum’ cards or those issued by Diners Club and American Express. However, even if you are at the upper end of the cost scale, there are very few banking products that will give you this convenience for under R50 per month.
You need to decide whether you actually need or want the so-called prestige of carrying one of the fancier cards. Whilst the limits on these cards tend to be higher, in most cases these limits depend on your creditworthiness and can often be negotiated without having to ‘upgrade’ your card. On the other hand, if you are a frequent air traveller, the increased insurance available on the higher-end cards may be worth the extra R30 or so such a card will cost you.
Most card issuers have some or other loyalty programme attached to their cards, such as frequent flyer miles or other ‘points’ benefits. In many cases, you will be charged an additional fee to belong to the programme (around R20 – R30 per month on average), and to be frank, most of them are of dubious value to the average cardholder.
Once again, if you are doing extensive travel particularly for business, or are in the type of income bracket where you are putting massive amounts of spending through your card, membership of such programmes may be of some benefit, but for the average person, their spend does not justify the amount of miles or points that you have to accumulate in order to get something worthwhile.
How many cards do I need?
For the majority of people, the answer is: One. There is little justification for you having half a dozen cards in your wallet, and all you end up doing is driving up costs and creating a reconciliation nightmare each month.
You can of course apply for a secondary card on your account. This is a typical arrangement for married couples, where both spouses have cards that are charged against a single account. A secondary card is normally much cheaper than having a completely separate account, although you would need to have a great deal of trust in the secondary cardholder’s spending habits, particularly as you will be held liable for the bill!
If you are in business, or your job entails a fair amount of travel, there may be merit in having separate cards for personal and business expenditure. Most people in this situation find it practical to have an ordinary Visa or MasterCard for their personal expenditure, whilst Diners Club or American Express cards are more popular choices for business. The reason for this is mainly due to the higher limits on the latter type of cards, as well as the increased travel insurance that such cards provide.