The Misconception of Credit Card Debt

Note: When I started writing this post I didn’t think it was going to get as in depth as it has. As such, I recommend you take a paper and a pencil and jot some notes on the issues I discuss here. The world of credit and credit cards can be a scary thing, but if you break it down, it’s actually not that complicated. Convoluted, yes, but not complicated. I’ve tried to make things as simple as possible, but I can only do so much: your brain has to do the rest. I trust you’re an intelligent individual, or else you wouldn’t be reading this, so put on your thinking caps and start reading!

A few days ago, someone over at 9Rules Notes asked about the best financial advice others could offer to someone coming out of college. Some of the answers were traditional, some where a bit “out there”, but the one that caught my eye was this one:

Get one credit card (one!) to build credit, but pay off every cent before you get charged a penny of interest.

She goes on to talk about a few items I not only totally agree with, but have started to live and swear by (treating savings and investments as fixed, monthly expenses; treating yourself once in a while). But it was the statement quoted above that really caught my eye, since it highlighted a misunderstanding of the purpose of credit and credit cards. (This is not to say that the author doesn’t understand these, but it does speak of a somewhat limited view of credit which tends to limit the available financial options at the disposal of most individuals.)

Most people think of credit cards as money they can borrow when their funds run low. They also think of credit as something that builds up over time if you take care of your bills on time. While both of these statements can be true (depending on your particular situation), they miss the point of the entire credit score and credit card system.

By the way, before we start, remember this: credit cards are not there so you can spend extra money. They’re meant as short term tools for investment, primarily for business. If you can appreciate and understand this statement (and I hope that by the end of this post you will) you’ll soon realize that credit cards may be one of the most useful tools at your disposal. If you don’t understand this statement, then yes, for the love of God, “get one credit card (one!) to build credit, but pay off every cent before you get charged a penny of interest.”

The Basics of Credit

Your credit score is nothing but the rating financial institutions use to rate how much money they can safely make off of you. Why do I say this? Think about it this way: because letting you borrow their money is an investment for them, which may have a return ranging anywhere up to 32% a year. (If you’re the one lending the money, and therefore receiving the benefit, then this is called “Return on Investment”, or ROI for short. If you’re the one being lent money, and therefore paying the interest, then this is called an “Annual Percentage Rate”, or APR for short.)

Here are a few examples of how your credit — the measure used to determine how good of an investment you are for them — can go up or down.

  • If you borrow $2000 on a credit card with a $5000 limit and you pay it all off within a year (with all payments being made on time), then your credit score will increase because the company knows that you (a) will borrow money and (b) are good about paying it back in a timely fashion, with interest. (Remember: the higher your APR, the higher their ROI). You’re tagged as a good investment for them.
  • If you never borrow any money and always pay everything in cash, then your credit score will neither go up nor down. In fact, it won’t exist. You will find it hard to get a loan when you need it because you’re what’s called a “ghost” in the system. In other words, you don’t have a credit rating at this point and they don’t yet know whether they can trust you! (This really ticked me off when I first discovered it: I had always made it a point to pay for everything cash, then when I went to get a car loan I couldn’t do it because I had no credit!)
  • If you borrow $2000 on a credit card then don’t pay even the minimum payments, you’ve just told the financial institutions that you cannot be trusted. Even if you do make your payments, unless they’re on time, the companies will tag you as someone who doesn’t deliver the returns on investment in a timely fashion. This makes you a risky investment, and as a result your credit score goes down, since they might make money off of you, but they may also lose money on you. You’re tagged as a bad investment for them.
  • You have a credit limit of $5000 spread over two credit cards ($2500 each). You max them both out on things like going out to dinner and taking care of miscellaneous expenses, and buying yourself some new furniture that you really shouldn’t be buying. You start paying off the minimum payment at whatever interest

Side Note: Interested in Interest? By the way, ever wonder why interest is so high on your statement? I mean if it’s 21% interest, why is more than half your minimum payment going to the principle?! Interest is calculated as follows:

  • taking how much you owe (say, $10,000),
  • dividing that into, say, 50 months, or 2% increments (so $200 each — your monthly payments, so a more common number is 60 months for cars),
  • figuring out the total annual interest on the entire amount ($2,100 is 21% id $10,000),
  • then dividing the total interest by the number of months in a year (12, so $175),
  • then adding the monthly payments ($200) to the interest payments ($175),
  • and herein we arrive at your total monthly minimum payment: $375, almost half of which is being paid to interest.

If it takes you 3 years to finish paying for this, then this means the companies are making not just 21% on 10,000, they’re making 21% on $10,00 (the first year), 21% on $7,600 (the second year), and 21% on $5,200 (the third year). (Yes, the clock on interest is reset every year, and the interest payment is based on the current amount owed. This is why interest doesn’t go down during the year itself unless you refinance.) Since your payments for the principle were based on the number of months in which you agreed to pay it (and for credit cards I believe the industry standard is 50 months, though this number may be well over 100 months, depending on the card and your situation), the principle statement either stays the same or goes up, proportionally as interest goes down. This is why you get car loan payments of $400 a month on a stead basis, but the principle/interest ratio changes over time.

If you don’t get all this just yet, don’t worry: finish reading this article, then come back to this part. Read it a few times if you have to. Heck, write it down and make up a few examples of your own based on this, but make sure you understand what’s going on with your interest.

So wait, what other evidence is there to support the claim that a credit score is all about them making money off of you?

Have you ever wondered why it was that companies would (a) charge you to view your own credit score, and (b) lower your credit score every time you checked it? (If done often enough, checking your credit score can cost you up to 20% of your total credit score!) It’s because they benefit when you’re left ignorant. What if something happened where they made a mistake on your credit score. Suddenly all your credit card rates rise and you have no idea why! You finally check your credit (which lowers your credit score even more), notice that there have been four checks supposedly bounced in your name (we’ll call this a system error, not identity theft, for simplicity’s sake), and call them to tell them that this is an error on their part. After all is fixed, your credit card rates come back down, so the banks are making less money off of you! Sure, you’re a safer investment, but now they’re competing with other companies which want your business because you’re trust worthy, and so your APR drops to meet the competition. Things would be so much easier (for them) if you weren’t so trustworthy. After all, then you’d be stuck with them, right?

(Of course, it can get nastier than that: some banks will tell you “well that’s just too bad” and keep your rates sky high for someone else’s mistakes. But that’s another subject for another time.)

Only after years of outcries from consumer groups did the government step in and tell credit companies to provide one free credit check per year. To keep their businesses going, the companies capitulated to the demand, but just barely.

Hopefully now you understand the purpose of the credit score. One of the ways to use this knowledge in order to make the score higher (especially if you don’t have a lot of credit) is to take out a credit card and borrow $500 to buy something (or to PayPal some cash over to norb@gnorb.net). Pay it off slowly for a few months (twice the minimum payment is good), then after 3 or 4 months, pay off the whole thing. Do that a few times to show the companies that you’re not frivolous in your spending, and that you can be trusted with money. Later on, when you’re considering buying a car or a house (provided you don’t have the money to buy them cash; yes, people do it all the time) your credit score will reflect that you are a good investment for them a trustworthy custodian of money, and you’ll be able to get a lower APR. (Remember, it’s all about competition for them: they’re competing with other financial institutions for your business. The free market works both ways. Be comforted in this, you do have some power, but it’ll take some work.)

Now, I’ve been talking about the consumer’s point of view, which doesn’t really help you unless you want to spend money. But what if you want to make money? Can you really make money using credit cards? In short yes. In fact, this, my friend, is when the real power of the credit score and the credit card come in to play.

Side Note: How do Investments Work?Now, all this time I’ve been talking about companies investing in you and how this is all part and parcel of your credit score, but you still don’t know how investments work. “I’m not a company,” you say, “I don’t have a stock market ticker symbol!”

Remember: financial companies research you like you research a stock. (Even better, actually, since your finances are a lot more transparent than those of a Fortune 500 company).

An investment is simple: you give Person X money so that he can do whatever he wants to with it, then when he comes back to you he says “Your money grew at this percentage rate, so here’s your money back and some more!” When you buy stocks you’re doing the same thing, except you don’t know what your percentage return will be. When a company gives you credit money, they’re doing the same thing (investing in you) , except they know how much their return will be, since it was part of the agreement.

You invest money in something hoping that it’ll grow, that your money will work for you instead of you for it. If you do you research then your chances of losing money are much less than if you don’t do your research. Same thing with financial institutions: your credit score is basically how they rate you as an investment. A high rating means you’re a good, safe investment. A low rating means you’re not a very good investment. To cover their losses, they’re going to demand a higher return on investment from you if you’re a risky investment, which is why your interest ratings and credit card APRs are so much higher when you have bad credit.

The Credit Card: Your Silent Business Partner

I was listening to a speaker on a television program not too long ago talking about how he buys and sells real estate. Of course, he was trying to sell his own real estate system, so he started talking about the almost mystical “no money down” techniques he uses to buy real estate. Ever wonder what those real “no money down” techniques involve?

Allow me to burst the bubble: there’s always money to be put down. There’s always money to move around. How much money comes out of your own pocket and how much comes out of someone else’s is what determines the real “no money down” situation. While there are a number of ways of looking at this (partner investments, owner financing, down payment assistance programs, etc.) the most common “no money down” technique involves using credit cards.

Now, before you get all uppity and self righteous about how stupid people would have to be to use credit cards to pay off real estate (or any business, for that matter, something I’ll discuss later), let me make another shocking, bubble bursting statement: it’s actually a pretty smart idea, and to an extent, this is why credit cards were created in the first place. Here are few very simplistic examples:

  • You see a house for sale for $150,000. You know for a fact that the houses in this area sell for $300,000 (even in a down market), and that it would take only $15,000 to fix, so you decide to buy the house: you want to either fix it and profit, or flip it for an immediate profit. The down payment on this house is $15,000, which you don’t have. Here are some options:
    1. You find a partner who will give you the $15,000, plus he’ll fund the fixing of the house (another $15,000). You do the work, he puts down the cash. He’s asking for 30% of the profit, however, in addition to his $30,000. If you sold the house for $300,000, then your profit would be $150,000, 30% of which would be his, in addition to his initial investment. In short, this means that out of your $150,000, $75,000 would be going to him (his original $30,000 plus 30% of the profit, or $45,000). Total profit to you: $75,000.
    2. You decide to use a credit card (or multiple — it doesn’t matter for this example) with an APR of 21%. You try to flip the house, but no one buys it, so you finish fixing it up, paying the next $15,000 with other credit cards at the same APR. You’re able to sell the house for $285,000 in 6 months. Your gross profit is $135,000. Presuming you paid 21% interest for 6 months on $30,000, your grand total to pay the credit card companies is about $37,000 (I’m using round numbers to be clear; mathematicians, please don’t stab me with your protractors). Your net profit is then $98,000.

    Which is the smarter choice, the partner, or the credit card? (In either case your ROI is not really measurable because you never actually invested anything. Now, this won’t always be the case, but if someone else is funding this much into it, expect to pay a good percentage. The advantage of a partner is that if for some reason the house didn’t sell for two years, then yes, you would end up owing more to the credit card companies. But for business investors (and not speculators) this is seldom a problem. Business investors and business owners who know their business know how to manage these kinds of risks. (And in real estate, the rule of thumb is that you make your money when you buy, not when you sell: if you can’t run the numbers and know you’ll come out profiting, you shouldn’t get into that deal. But I digress. Remember also that you shouldn’t use credit cards to put the down payment on a property which won’t produce income for you. For that, go and get yourself a down payment assistance (DPA) loan.)

  • You own a business selling jewelry. You’re about to put on a sales show. Last time you were at a show, you sold out of your jewelry before the end of the show, costing you sales. Based on past response, you decide you need to spend $35,000 (wholesale) in pieces, which you expect to sell (if all of them sell) for a total gross profit of $135,000 ($100,000 net profit). Right now, however, you don’t have $35,000, and you can’t pull out a business loan (for some strange reason I won’t explain). You decide to use your credit card and buy the jewelry. The show, one month later, is a total success, and while you don’t sell out of your pieces, you still make $120,000. After you pay the credit card, you still have made $84,400 in profit (with the rest going to the credit card, $35,000 for principle and about $615 going towards interest), and to take care of the left over stock, you sell it for 50% off the retail price, which still makes you a small profit.

In both of these cases, credit cards were used to make money. Sure, you paid interest, and the interest rates could be considered high, but what would have been the cost of NOT using the credit card? In the first case, it would have forced you to lose over $20,000 in profit money, while in the second case it would have cost $85,000!

In neither of these cases were credit cards used for consumer expense, they were used for business expense, and as such were making money for both the credit card company (in the form of interest) and the business person. This is the classic win-win situation. This is also the original intent of credit cards, to extend and make convenient general lines of credit. Furthermore, they allow financial institutions to make standing loans which accrue interest for them every time they’re tapped. In fact, think of a credit card as a general loan, which you can use for whatever you want. The loan amount is your credit limit for that card, and you can get another loan by simply getting another card. The higher your credit score, the more they’ll trust you with since they know that you can be both trusted with the money, and that you’ll make money for them. In short, you’re a good investment.

The question, as far as you’re concerned, is what you use those loans for. Do you use them to buy a television (and therefore pay for the television AND for the interest, or you use them to invest in a business that will give you an ROI (therefore making more money than you’re paying out)? Do you use them to help yourself, or do you use them to hurt yourself? (This, by the way, is where money management comes in. I’m not talking about the software, I’m talking about the discipline.)

The mistake most people make is to think that credit cards are there so they can buy things now and pay them later, or they can buy expensive things and pay them over time. While this is true, treating credit cards like this is like treating a fever by trying to bring the fever down, instead of by resolving the root cause of which the fever is a symptom: it signifies a misunderstanding of its actual purpose. Believing this is how you hurt yourself.

OK, I Think I Understand… but Not Really

Alright, with everything we’ve covered, I’m going to show you how you can use credit cards to make money. Before I tell you any of this, however, remember that you’ll probably need at least OK credit to do this. Also, you’ll need to be extremely disciplined. If you’re not, for the love of Visa, don’t even try it.

Suppose you have a credit card (we’ll call it CC1) with a $3000 credit line and a 13.99% Annual Percentage Rate (APR). You get offered another card by another company. This card has no transfer fees and a 0% interest on transfers for the 12 months (we’ll call this CC2). Here’s a simple way you can make some money with it: Open up a high-interest savings account with the bank of your choice (we’ll presume the ROI is 5% on this account). To open this account, do a cash advance from CC1 to the savings account for $3000. Apply for CC2 and immediately transfer the $3000 balance from CC1. When you get CC2 (and unless you have bad credit, you probably will), CC2 will have a $3000 balance at 0% APR for the next year. (Note that you’ll still need to pay the minimum monthly payments.) The $3000 now sitting in a bank will earn you 5%. This means that at the end of the year, you’ll have made $150 (actually more, since interest is compounded), all without spending one dime. This is what’s called making money with other people’s money (OPM). Right before year’s end, take the $3000 from the savings account and pay your credit card balance, pocketing the rest. (And yes, taxes will have to be paid on that money, but think about it: how much work did you really put in for that? Was it worth it?)

Of course, this example runs with fairly small numbers as far as the credit game is concerned, but it’s OK: the principle is what matters here. If you’re smart, credit (and credit cards) allow you to borrow money from one entity in order to make money for yourself. In the long run this is in their best interest because it means that they can capitalize on your skills to make money: they lend the money, you do the work, you walk out with the bulk of the cash. Sound like a good deal? It is, if you’re careful and understand these principles.

 

6 thoughts on “The Misconception of Credit Card Debt

  1. Gnorb! How could you stab someone with a protractor ? Perhaps you meant a compass? 🙂

    I disagree somewhat with the idea that “Your credit score is nothing but the rating financial institutions use to rate how much money they can safely make off of you”

    The lower the credit score the greater the chances of that person defaulting on the loan. Credit card companies make money on interest and lose money when people don’t pay back.

    So, people with a lower credit score = riskier investment for them. With a riskier investment comes a higher return to offset the losses. If the riskier investment’s return was the same as the safer investment you would just invest in the safer investment.

    So, back to “how much money they can safely make off of you”. Let’s say your going to become a CC company and you have 100 applications with an average score of 750 (good) and 100 applications with an average score of 575 (bad).

    You’re going to obviously charge the 750’s a lower rate than the 575’s, but that doesn’t mean you’re going to make more money of either one. I.e. I can charge 750’s 10% and end up, after losses, making 9.75%. I can charge the 575’s 18% and end up , after losses, making 7%.

    Charge either of them too much and they’ll go somewhere else. Charge either of them too little and you’ll lose money.

    At the end of the day, regardless of score, the “The free market” / competition is going to determine “how much money you can safely make” not the score. 🙂

  2. Elio: Thanks for the response. Just a few notes;

    From the article:

    To cover their losses, they’re going to demand a higher return on investment from you if you’re a risky investment, which is why your interest ratings and credit card APRs are so much higher when you have bad credit.


    From your response:

    So, people with a lower credit score = riskier investment for them. With a riskier investment comes a higher return to offset the losses. If the riskier investment’s return was the same as the safer investment you would just invest in the safer investment.


    So we’re basically saying the same thing here. Now, for another issue:

    From your response:

    You’re going to obviously charge the 750’s a lower rate than the 575’s, but that doesn’t mean you’re going to make more money of either one.


    You’re right. However, the person with the higher score is more likely to get you your money back on time than the person with the lower score. The rate for that person is lower for that reason and because of the free market: if the costs of keeping a person with a 750 score happy are lower, then companies can afford to give them better rates, and this is where the market comes into play: people are always vying for your business. To get your business they’ll offer the services at a lower price, although the price they set is the highest they can that the market is willing to pay. Fewer people are going to want to give you business if you have a lower credit score (so there’s less competition for your business, with limits your options and allows them to raise their rates accordingly). Combined with the higher cost of doing business with that kind of population, rates have to go up so they can keep whatever profit margin they’ve set as their goal (for example, 10% quarterly profits). The lending institution may not make more money from either one, but you’re likely to make more (on time) from the person with the higher score. In the end, this leads to lower cost of business, which leads to a higher profit margin for them.

    The free market and competition how much money they can safely make, but the score is in the end just a metric which they use to grade how good of an investment lending you money is. The better the investment, the more money they can make off of you safely.

    By the way, trust me, I meant protractor. Those things have sharp edges, especially the metal ones!

  3. Just wanted to say that I thought your article was really informative and explained A LOT of the misconceptions and never-before-known facts about credit cards. Great stuff!

    PS. I agree with you about the protractor!

  4. Gnorb, I still remember that note–wish I had known that it had resulted in a post earlier! 🙂 That’ll teach me to check your blog more often. Good stuff–way to flex that credit knowledge muscle.

  5. Guess I was one of those who believed credit cards were for buying stuff you needed. This is very informative.

    However, it does strike me as being a real problem if you cannot get your credit score without it costing you points. The last time my husband and I got our “free” report, it did not contain the actual “credit score” at all though it was promised. We did this with three companies. SInce we have no idea what our score is, we have no idea if it went down either.

    One more thing. Who benefits when you can’t get a credit card because of those same reasons as not being able to get a house, car, etc.? Certainly not us. How does one build that illusive credit score if they are not allowed to get credit for anything in the first place? Too many people have that problem.

    Thank you. This is informative.

  6. Hey Jaz:

    Until I actually started attending a bunch of “Zero down” real estate courses the correlation between credit cards, credit scores, and percentages didn’t really make any sense to me. It’s when I finally got it through my thick skull that credit cards = loans that I finally put it all together.

    As for your credit score, any time you do a hard check on your credit report your score goes down. There’s a law which says that credit companies (the big ones, like Equifax) are supposed to provide you with one free credit report per year, but I don’t know of its effect on your credit score per se, nor if they give the actual score to you (I though they did), instead of just a report to make sure you don’t have any fraudulently open accounts.

    As for getting the score itself, there are two things you can do. The first is to inquire about a bank loan. Yes, it’ll lower your score (it’s a hard check, not a soft check) but you can ask to get your number right there. PITA, I know, but it’s the only SURE way I know how to get it. The second way may be to go here and sign up for this service (it’s offered by LendingTree.com), but I’ve never used it myself, so I can’t recommend it. Your mileage may vary.

    As for you not getting credit because of the reasons above, that depends. See, the credit companies are looking for 2 things: either to make money, or to not lose money. They make money by giving you an APR which will cover your operating expenses, plus a certain percentage, for profit. (This operating expense takes into consideration how likely it is others in your credit score level are to default. The higher the percentage you get offered, the riskier you’re considered to be.) If they consider you too risky they just won’t lend you money, thereby ensuring that they won’t lose that money, at least not with you. They’ll either give that money to someone else, or invest it in some other way.

    (Here’s a fun fact: companies only expect to get a certain percentage of what they lend out back anyway. What they can’t collect themselves they sell off, for pennies on the dollar! Ever hear of countries buying debt (like China, for example, which keeps buying American national debt)? People can do that, too! Let’s say Alice owes Visa $3000. Visa hasn’t collected in 3 months, so they sell off the debt (“pass it to debt collectors”). Bob decides to buy Alice’s debt, but instead of paying Visa $3000, he pays $1000. He hires CollectorCompany to bug Alice to get back his money. Eventually she pays and CollectorCompany gets a certain percentage of whatever Alice pays back. For example, if Alice calls the company and says “I want to negotiate my debt. I can pay you $2500, but not the whole $3000,” Bob can say “Sure!” and make a profit of $1500 (minus CollectorCompany expenses) or he can say “No! Pay the whole thing!” to which Alice may say “I declare bankruptcy!”, leaving Bob with $1000 lost. Visa, CollectorCompany, and Bob have to cut their losses, and Alice now has 7 years of a bankruptcy to deal with. A good time was had by all. To find out more about buying debt, check out CreditMaxTeam.com. You can buy debt off on a per zip-code basis, I think. Not sure because I haven’t done it myself (yet), but having friends in that industry, I’ve learned how it works.)

    One side note: if you’re rejected for credit for any reason you’re entitled to a credit report to find out why. This won’t include your score, though.

    By the way:

    How does one build that illusive credit score if they are not allowed to get credit for anything in the first place?

    You borrow from the mob.

    Just kidding. However, this is a phenomenal question. In fact, it’s one I know just about everyone has had. The only real way to do this is through a pre-paid credit card. Here’s how one works: You give Company X $500 of your money. Company X then makes that money available to you via a credit card (with a $500 limit, or however much you deposited). Then, any time you use that money, you pay a certain percentage rate (13%, for example) on that money until the amount is repaid. (The interest is theirs, by the way, it doesn’t enter your account.) Eventually, when they see you can handle paying the card on time — especially since THEY didn’t have anything at risk — your credit score will go up and you’ll be able to start borrowing again.

    Frankly, I think that whole idea is genius: you give me $500 to invest however I please. Then, I let you borrow it, but only if you give me more money as payment for letting you borrow your own money. I make money either way. Seriously makes me wonder about starting a credit card company!

    Here’s a trick I recommend, which requires discipline, but will help you get on track quickly: take out one of these credit cards and put your total amount of monthly bills in it. Then, pay all your bills with that card. Make sure you pay that card immediately, before a penny of interest accrues. Do that for a few months and watch your credit score start to rise. You can jolt it by leaving small amounts to accrue interest (say, $200), but make sure you pay at least the minimum payment. You’ll build up your credit in no time. (If you already have cards you can do this anyway to both build up your credit and, if you have a rewards card, to collect your rewards by just paying your bills!)

    Again this takes some discipline. Then again, if you don’t have enough discipline to do this, then for the love of God, shred your credit cards and never ever ever look at one again.

    Remember, the system’s not there to help you, per se. It’s there so they can make money work for them. (I recommend you read the book Richest Man in Babylon to see this in action.) You just happen to be the vehicle they choose. As a consumer, this sucks for you, since all you’re doing is spending money. As a business owner or investor (which requires a shift in mentality) this is great, since you can borrow money for business ventures left and right, and so long as you pay everything back in time you’re good: they’ll let you borrow more money so you can make them (and, oh yeah, yourself) more money. They get theirs, you get yours. Of course, as a consumer, this option’s not all that available to you.

    Hope this helps a bit more.

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