When signing up for free airline miles or cash-back rewards, most people do not consider the potential dangers of credit card debt. Credit cards help build credit, protect against unauthorized charges, and offer useful benefits when used responsibly. However, if not managed well, credit cards can lead to a dangerous debt trap.
How do credit cards work?
Credit cards let people borrow money and pay it back later.
“For the most part, using credit cards and understanding how credit card companies work are pretty straightforward,” said Todd Ossenfort, Chief Operating Officer of Pioneer Credit Counseling. “Just remember, you are expected to pay back any money you spend when the monthly statement comes.”
People can choose to pay back the full amount each month or pay a minimum amount of the balance due.
When paying off the full credit card bill each month, credit cards can help people build good credit. They may also offer perks, such as mileage awards, cash back or other rewards.
On the other hand, if you choose to pay just the minimum payment, only a small portion of your payment goes toward your debt. Most of your payment will go to paying interest. Since credit cards carry high interest rates, it can take a long time to pay off debt when only making the minimum payment.
If you miss a credit card payment, then the bank can charge you interest on top of the original payment owed. If this happens repeatedly, the interest can grow significantly or “snowball,” meaning you will owe more and more each month. People refer to this as a debt trap, and it can hurt your credit score.
How do credit card companies make money?
Credit card issuers are banks and credit unions that allow you to borrow money from them based on certain terms and conditions. Issuers make their money from interest and fees charged to cardholders.
Credit card issuers often pair with a network company, like Visa or MasterCard. Network companies authorize and process credit card transactions. They earn money from transaction fees paid by businesses that accept credit cards.
Most of credit card issuers’ revenue comes from interest charges on credit card balances. High interest rates on credit card balances are the biggest cause of ongoing credit card debt for consumers.
Fees also generate revenue for the credit card companies. Some common fees include annual fees to use the card, cash advance fees, balance transfer fees and late fees.
Where people get into trouble with credit cards
“In today’s world, using a credit card and having access to credit is practically a necessity. Online shopping, purchasing an airline ticket or renting a car all require a credit card or debit card,” said Ossenfort.
Credit cards can be helpful and have positive benefits. So, where do people go wrong and get into trouble?
1. People get into trouble when they think of credit cards as free money.
“The first part of the problem is failing to recognize that the sheer convenience of using credit cards can produce a sense of complacency – as if no money was borrowed or spent,” said Martin Lynch, FCAA President and Compliance Manager/Director of Education at Cambridge Credit Counseling Corporation. “When you use a card, you’re actually borrowing money that must be repaid.”
2. Carrying a credit card balance can become very expensive.
“The other part of the problem is carrying balances for more than a few months, at most. A credit card can carry you through an emergency, but it’s best to only carry balances for the short-term [or not at all],” urged Lynch.
“The pitfall that we see people get caught up in is overuse and not being able to pay off the entire balance of the card when that credit card statement comes,” said Ossenfort. “If you’re not able to pay off the entire balance at the end of the month, that $6 cup of coffee becomes very expensive.”
3. People don’t realize credit card balances affect their credit scores.
“Many people don’t realize the connection between the balances they’re carrying and their credit score,” said Lynch. “The larger your balances or the more you owe, the greater the negative impact on the credit utilization portion of your score.”
According to Lynch, 30% of a FICO score comes from how much money a person owes.
Ways to prevent and escape credit card debt
1. Create a budget and live within your means.
“The best way to responsibly use a credit card is having a monthly budget and sticking to it,” said Ossenfort. “There are many online tools available for setting up a monthly budget, and a great resource is FCAA’s website.”
Lynch agreed. “The number one thing all credit counselors recommend is to create an accurate budget to identify where every dollar is going.”
2. Pay down any outstanding credit card balances.
“Next, create a reasonable plan to pay down your card balances, making temporary reductions in other areas of your budget, if possible,” said Lynch. “If there are no other reductions you can make, that’s the time to talk to an FCAA member agency.”
3. Reach out to certified credit counselors for help with your debt.
“It’s never easy admitting you may be struggling with credit card debt, but it’s far more common than a person thinks,” shared Ossenfort. “Reaching out to an accredited FCAA agency and going through a free budgeting session is a great way to start. The certified counselors are compassionate and non-judgmental. They can assist you with setting up a budget and make recommendations on how to get out of debt.”
“Our counselors can review your options and determine if a debt management plan could help you break the cycle of debt by allowing you to pay off your balances at reduced interest rates,” said Lynch.