We’ve been told our whole lives that in order to be a financially responsible adult, we need to build credit, and in order to do that, we need to have a credit card.
But does credit really matter as much as people tell us it does? And, is having a credit card really worth taking on the financial risk of debt? Here’s how to avoid making the same debt-burdened mistakes of past generations, and embrace the new financial technologies that make it possible for us to avoid risky business.
It’s been nearly a decade since the 2008 recession, and if you’re like me, you probably had to watch The Big Short at least twice to figure out what the hell went wrong. But, regardless of the depth of your financial or economic knowledge, most of us can agree that lending money to people who are at risk of not being able to pay it back isn’t the smartest idea.
And based on the most recent reports from the Federal Reserve, Americans are now carrying a record amount of outstanding revolving debt, also known as credit card debt. At $1.021 trillion, it’s beat the previous high set back in April 2008. Which means we’re setting ourselves up for yet another economic disaster if we don’t curb our addiction to charging up those credit cards.
Credit cards are risky business
Most of us signed up for our first credit card because we were told that we’d need it to build credit, or in case of an emergency, or so that we could rent a car (as if we’re constantly in need of renting cars). But, given that America’s current household debt load is $12.73 trillion, most people are one fender bender, surprise diagnosis, or Black Friday sale away from not being able to make their minimum monthly payment obligations, let alone paying off the balance in full.
With credit card interest rates between 15 to 23 percent, for some people, minimum payments alone could be hundreds of dollars. Studies find that you’re likely to spend 12 to 18 percent more when using a credit card, rather than when you pay with cold, hard cash. This overspending tends to cause people to focus only on the benefits of the product in order to justify, or even ignore, the cost.
It’s not just that you’re damaging your personal finances, but this behavior has a pretty negative effect on your psychological and mental well-being too. According to consumer psychologist, Ian Zimmerman, the propensity to indulge in impulse purchases is related to anxiety and unhappiness, which is only exacerbated by the inevitable financial problems that follow.
The average consumer is more likely to get themselves into a financial hole using a credit card, then get ahead. So, what are the alternatives?
Building credit without credit cards
It’s true that most lenders look at your credit score, largely determined by your credit history, to determine whether to approve you for a mortgage, personal loan, or car loan. But just because that’s the most common way to get approved, doesn’t mean it’s the only way. Many lenders will also look at other factors when considering you for a loan, known as the Five C’s:
1. Character
Lenders evaluate factors including how long you’ve been at your current job, your current address, and how long you’ve maintained a level of stability with your financial obligations, including paying bills, student loans, car lease payments, etc.
2. Capacity
Lenders will examine your debt-to-income ratio, meaning, will you be able to meet all your other debt obligations and bills while also paying back the loan you’re applying for? This is largely be based on your current income.
3. Capital
This refers to your net worth—how much you own minus what you owe. So, this is where owning your car outright, having some money in savings, and maybe even some investments can serve you well, even if you don’t have a credit card or a credit score.
4. Collateral
Collateral is any asset that you own that the lender could potentially take ownership of, in the case that you’re no longer able to pay back the loan.
5. Conditions
Some lenders will evaluate other conditions related to your ability to take on a loan, such as if you’re self-employed, live in a lower income neighborhood, or even the state of your local economy.
Your credit score isn’t the be-all-end-all of whether or not you get approved for a loan, either. In fact, you can qualify for a mortgage even if you pay off all your credit cards and loans in full, and never use your credit card again. Eventually, this will bring your credit score down to zero, essentially clearing your credit “slate”.
At this point, lenders will then look at those Five C’s, and if you’ve had at least two years of full-time employment at the same job, and have a strong down-payment of at least 20 percent, lenders will underwrite your mortgage.
“Rewards” with expensive strings attached
Lastly, we all know people who swear by the travel or cash-back rewards that keep them holding on to their credit cards for dear life. Unfortunately, some of the cards with the most rewards offerings often require consumers to spend anywhere between $3000 to $5000 within the first three months to qualify for large sign-on point bonuses. Additionally, the cards with the best rewards often carry the highest annual fees, anywhere from $100 to a whopping $550. Not to mention they also tend to have higher interest charges than lower end credit cards with lesser rewards and perks.
You’d have to spend at least $3000 to $5000 a month on a card charging that amount to justify the rewards, let alone the interest charges that could incur if you were carrying a balance. Unless you’re a frequent business traveller, the added risk and cost just to have rewards points is not worth the occasional airport lounge access.
Also, with advancements in financial technology and products, you can now earn points by using your debit card. Apps such as Drop link to your debit card, granting you points which you can redeem for discounts and freebies at approved retailers. So, if it’s points you’re after, perhaps look for alternative options that don’t charge you an annual fee, interest charges, and penalty fees while you’re busy “earning” points.
Of course, some people can handle paying their credit card balance in full every month, never getting charged interest, and maintaining control of their spending on a credit card. It’s just that according to the stats, most people can’t.
Let’s not repeat the mistakes that led up to the 2008 recession. If you’re someone who feels like you’re playing with financial fire, do some research and consider ditching the credit cards, before you get burned again.
