Monday, May 2, 2011

Why Credit Cards?

This post will primarily be about what is a credit card and how you can use one to make money on the money you spend.  I will go over credit card reviews in the next post most likely, but you can look at some credit card comparisons here.

A lot of college students actually don't use a credit card, or at least a lot of my friends do not currently own one. Yet I believe a credit card, used wisely, can actually be one of the best ways to make some money back.  Nowadays with the rewards programs offered by many credit card issuers, it is easy to make back 1-5% back on your normal purchases and you are essentially getting paid to spend what you normally spend.  For those of you who have a savings account (which I'll go over in a later post), this means even more potential earnings since you delay payment of your purchases by a month or more which allows your cash to earn interest in the bank.

First of all, what is a credit card?  A credit card is a plastic card with a magnetic stripe which you can use at most businesses.  You have some credit with an issuer, let's say $500.  Essentially, when you make a purchase with your credit card, the company giving you credit promises to pay the business you are shopping at and then bill you at the end of the month for the total purchases you make, up to your credit limit of $500.  Why would a company offer to pay for you?  Credit card companies make money through two main sources: interest on late payments and fees charged to merchants.  You usually get a grace period of around 25 days after you are billed to pay the amount you spent that month, and if you pay it in full before the grace period ends, there is no interest charged.  If not, then whatever balance you have not paid off will accrue interest (usually 10-20% which can add up, so make sure you pay your bill in full every month if you do decide to get a credit card).  Also, if you swipe your card at your local grocery store for $10 worth of groceries, the store actually only receives perhaps $9.50 and the last fifty cents go to the credit card issuer and the credit network you are with.  There may be a minimum fee along with a percentage, which is why a lot of stores often have a minimum purchase requirement to be able to use your card.

Why should you use a credit card?  The first reason many people start getting a credit card, especially when they are in college, is to start building up a credit score.  This credit score, called a FICO score after the company that handles the process, is a measure of how risky a person is with credit.  It is used for other credit cards, car loans, mortgages, etc.  The main metrics used to determine your FICO score include your credit card payment history, the length of your history, amount of debt you currently have (in proportion to your total credit limit), new credit you have recently opened, and the different types of credit you have.  The score itself is between 300 and 850 and normally determines whether you qualify for loans and other forms of credit above, as well as how high of an interest rate you will be charged.

The second reason is to be able to afford things you normally wouldn't be able to (and not have to carry around a lot of cash all the time).  By using a credit card, you could buy something you wouldn't be able to afford until next week when your pay check arrives.  Although I use my credit cards the same way I do cash, there are some people who forget about how much they spend in a month and often go overboard.  However, if you use a credit card the same as you do cash for necessary purchases, you can actually make money off the rewards you get back, which brings me to the third reason.

This is probably the most overlooked reason since many people underestimate how much 1% on how much a person spends in a year really is.  It can easily get up into the hundreds of dollars a year for essentially buying the same things you would buy normally.  And, depending on how you manage your credit cards, you could end up earning back 5%.

So to sum up, getting a credit card at any age is important to start building your credit history, to have the option to spend more than what you actually have, and to earn cash back for almost no extra work.  Especially as a college student, it is important to learn how to become fiscally responsible and manage your personal finances.  Of course, the critical note to remember is that credit cards can be very dangerous without full control over your spending habits.  Many people fall victim to spending more than they can afford just because it is available and they don't have to worry about paying it until later.  If you do get a credit card, only spend what you have the cash for and make sure you follow a budget (I'll talk about a budget in a later post and how it shouldn't be as much of a restriction as it should be a guide).  In the end though, credit cards are the logical first step toward personal finances, and I would strongly recommend getting them.  Hopefully, this post has shown why they are important and you can read a future post to decide how to pick which card is right for you.

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