Credit Cards - Our Foibles and Failings

The sage Meredith Whitney wrote of the next great failing of this financial crisis today in the Wall Street Journal - credit cards! And while I agree with most of her article in the macroeconomic sense, I think every household needs to have a credit card that makes common sense.

Credit cards can be the downfall of any undisciplined individual. First, recognize that the money you spend using a credit card is an unsecured loan. A financial institution/card issuer has extended to you, the borrower, an unsecured line of credit. That's different than a car loan or a mortgage because in the case of a car loan or a mortgage you have put up collateral to support the unpaid balance. If you default on a car loan or a mortgage, the financial institution comes and takes that asset back to help offset the balance of the loan you can not repay. In the case of a credit card, the card issuer is not going to come to your home and raid your closet for the clothes you bought using the credit card you did not repay. That's why credit cards cost so much.

What is that cost? The issuer charges you fees and interest in order to offset the risk that you might not pay all of your charges back. Essentially, the issuer is extracting a little bit of money for you each month that ultimately is used to offset the balance you can not repay in the future. The card issuer has assessed your credit risk by checking your credit bureau, verifying your employment and your income and through credit models, and the card issuer has decided how large of a credit line to extend and what rate of interest to charge. The card issuer has also reviewed that same credit bureau analyzing the other credit cards you have and have had, looking at the largest balances you have had on these cards and your repayment history. Do you pay on time, habitually late, etc. The card issuer has also reviewed the kinds of credit lines you have - do you have lots of store credit cards, do you shop at luxury retailers, do you have lots of gas cards, etc.? And there is a trade-off - a larger line of credit might be more expensive than several smaller lines of credit. And late fees and annual fees are part of that credit model too.

Second, recognize that the merchant you visit is also paying the card services like Visa, Mastercard, and Discover a fee per transaction for the privilege of accepting the particular line of credit card and for processing the payment. While the merchant probably recognizes that without accepting credit cards, certain customers will not frequent his store, the merchant is also passing that cost on to you, the customer. Now we are talking pennies per transaction but that allows Visa to run adds to encourage folks like us to run up transactions on our credit cards.

Finally, know that statistically very few people are in huge hock to the credit card companies. Rather, most consumers have lots of credit cards but rarely are borrowers actually living off of their cards and rarely are borrowers fully maxed out on all of their credit cards. Most borrowers have one or two credit cards they use most often and those cards have certain benefits that accrue for usage. But these same cardholders rarely pay their balances off in full, every month throughout the year. And if a paycheck stops coming in or hours are cut at the job, some of these same cardholders will increasingly roll-over their balances.

Ms. Whitney does a wonderful job in her Opinion article today of discussing the impact the recent congressional legislation will have on the average credit card borrower. Credit card issuers are increasingly pulling back lines of credit extended to regular borrowers like us for fear that the economic recession will continue and/or deepen causing more stress among their cardholders. The unique feature favored by credit card issuers is the ability to re-price the risk in their credit card portfolios over time. In other words, a credit card issuer can change the conditions of your credit card agreement on the fly, with little notice. The card issuer can cut your credit line, raise your interest rate, add a fee, impose fines and fees, and generally make your life miserable and complicated for what you may perceive as just a simple late payment. In fact, the card issuer is constantly monitoring your credit and the credit of the cardholder pool it manages and the issuer is constantly looking at small, seemingly insignificant factors for possible stress or increasing risk. If it sees you have opened another credit card account and just paid them late, they may believe that you are becoming overextended and at higher risk for default. They'd better extract more interest from you are gain a fee or reduce your line. They don't want to be the last issuer standing, holding the bigger balance when you do default (if you do). The recently legislation Ms. Whitney discusses will halt the issuer's ability to re-price risk and as she so aptly surmises, the card issuer would rather not issue you the card than issue you a card it can not later re-price.

So, how do you manage credit cards?

First, never charge more than you can afford to pay off each month. If your pay is erratic, you need to be more vigilant in managing your monthly charges to some sort of minimum expected monthly pay amount. You never want to pay monthly service charges (interest) or a late fee. The actual cost of such is typically very high and repeated failures to pay the entire balance each month results in paying interest charged on top of interest. Effectively you will vastly overpay for that item or items you just had to have!

Second, use websites like bankrate.com and constantly check to see that you are using the credit card with the best possible interest rate and the lowest (or no) fees. If your card program has perks, make sure that you really can use the airline miles or the cash-back program. If you have to carry a balance, always seek the program with the lowest possible rates. It may also be hard to switch from one card program to another if you are carrying a balance. You will probably have to work with the card issuer directly and that issuer will want to be certain that the card they issue to you is not incremental. They may want to use a cash advance to pay off the card you intend to replace.

Now, be careful when you close credit card accounts. Your credit score can actually go down if you close too many credit lines. It is actually better to charge on your credit cards and pay them off in full each month. But do not charge your credit card all the way up to its limit each month, even if you are able to pay it off each month. That will drive someone looking at your credit bureau report to conclude that you are apt to overextend yourself. It is advantageous to have several credit cards that you charge modestly on each month and make sure you pay every one of them off each month in full. That will enhance your credit score. If you find it difficult to manage multiple credit cards, take a few of your open credit cards out of your wallet and store them in a safe deposit box or lock them in a home safe. The open credit line will be reflected in your credit score but you won't be tempted to use all of your cards.

Finally, it is also helpful to use credit cards that have due dates at different times during the month. For example, I use 2 cards pretty much exclusively each month. Each carries a reward that I use. One comes due at the end of the month and the other mid-month. That helps me even out my cash flow and time my payment due dates with my paydays. One is a miles card and typically awards bonus miles at gas stations and groceries each month. The other is a broader travel rewards card that we use for car rental rewards and for some airline credits. I use it at the pharmacy, the dry cleaner, for some business expenses, and other mail order purchases.

Credit cards are a necessity for most in today's society. While the shift away from the days of cash and checkbooks and to credit cards and debit cards has been accomplished, Ms. Whitney highlights several concerns that might cause a bit of a shift back toward more of a cash society. Prudent use of your credit cards will be a necessity for maintaining your credit card relationships through this period of economic hardship - and even prudent management is no guarantee that the credit card issuers will want to maintain that same relationship with you.

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