In the world of personal finance, credit cards have a fairly mixed reputation. Conventional wisdom states that they are best avoided as they enable people to get into problematic debt very quickly. However, there are strong arguments that credit cards are advantageous for people that can manage their repayments in a timely manner.
What is a credit card?
A credit card is a financial product offered by lenders that enables a person to borrow money to pay for goods and services. As with any loan, the lender makes money by charging the borrower interest on the balance that remains unpaid.
Credit card users can set up a direct debit from their current account to repay their credit card in full each month. This is crucial because credit card providers charge high rates of interest - around 20% a year which is typically charged at the end of every month unless the balance has been completely repaid.
Credit cards can offer users (often significant) benefits, depending on how you use them, but as with any kind of borrowing they can also present a serious risk if you fail to pay back what you borrowed on time.
Benefits of credit cards
Rewards
A lot of credit cards reward users with points if they use their credit card to make purchases. These points can then be used at select shops, airlines or even given as cashback. If you use a credit card to make a lot (or even most) of your purchases, these points can add up to a significant amount each year and some people put these rewards towards holidays.
Credit card protection
Purchases made with a credit card are automatically subject to payment protections offered by the card provider. This means that if you make a purchase that turns out to be faulty, defective or fraudulent, you are able to contact your credit card provider for a refund (provided that the purchase is over £100 and less than £30,000). Therefore, making larger payments on a credit card (rather than a debit card, which does not offer this protection) can provide an extra layer of security.
Risks associated with credit cards
Future income
Like any form of debt, credit card debt must be repaid. For many people, this can mean using future income, such as next month’s salary, to repay amounts borrowed. This always carries a level of risk because we can never be entirely certain what our future outgoings will be, which means there is a risk we will be left short. Therefore, it’s a good idea only to use credit cards when you already have the money to pay for the item or services that you are purchasing; this means that you will gain the benefits of using a credit card without restricting your future income.
Interest
As mentioned above, credit cards charge rather high interest rates. However, credit card providers often offer introductory rates of as little as 0% for a particular period. This runs the risk of getting customers used to spending on a credit card and losing track of when the introductory rate expires, potentially leaving borrowers open to hefty interest charges. Therefore, if you do sign up for a credit card with an introductory rate, make sure to repay any amounts borrowed prior to the introductory period ending.
What about credit ratings?
A final point to mention about credit cards is that they can impact our credit ratings. A credit rating is a measure used by banks to gauge a person’s creditworthiness (i.e. their ability to pay back a loan) and is a factor they will take into account when deciding on whether to approve a mortgage, for example. On the one hand, if someone is late in making credit card repayments then this will negatively impact their credit rating; however, if someone uses a credit card properly and makes their repayments on time, this may improve their credit rating.
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Before taking out a credit card, it’s important to ensure that you have considered the financial responsibility associated with them. All debt carries risk and with their rather high interest rates, credit cards can be particularly risky. However, for people that are confident that they will have the cash flow to meet their credit card repayments on time and the discipline to keep on top of repayments, the rewards and payment protection that credit cards provide can be valuable.