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, and how you can always check a credit score for free. 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.