Thursday, 31 March 2011

Should you get a credit card?

by Rob d'Apice
There are three and a half reasons to get a credit card:
  • Value creating - yes, credit cards can make you money; they return value to you through reward program points (eg Frequent Flyer).
  • Income advance - the interest free period on most credit cards means that you can spend part of your next pay packet interest-free; effectively a cash advance on your salary.
  • Emergencies - credit cards are an instantly available loan available to cover an unexpected and significant expense (eg medical bills, car repairs, etc.)
  • Ease of use (the half reason) - Visa and Mastercard are accepted almost everywhere, and are super easy to use.
(The astute reader might notice I've left off a probably the biggest reason: buying things you can't afford.  I want to spend this post delving into the more ambiguous credit card motivations, but, to be clear, this is a bad idea.)

One of these reasons is a good one; the remaining two and a half aren't.  Let's start from the bottom up.

The (two and a half) bad reasons

Ease of use 
What? Getting a Visa/Mastercard to use on the internet, when travelling overseas, etc, because they are more reliable and more widely accepted than EFTPOS, cash, or cheques (haha cheques).
Why is this a bad reason? Visa and Mastercard debit cards are available with almost all banks.  This gives you credit card functionality that draws from your savings account, like a superman EFTPOS card.  No need for attached credit account.

Emergencies
What? Keeping a credit card tucked away, just in case something bad happens.
Why is this a bad reason? This is arguable, but I see three clear reasons not to do this.  One, an 'emergency' credit card can be very quickly maxed out when buying that macbook pro suddenly becomes an 'emergency'.  Two, even if you have a sudden need for cash, credit cards are a terrible source of funding - the interest rate is very high.  You'd be much better off with a personal loan, or better still, a loan from a family member (you could offer them an attractive interest rate that is much lower than a credit card, and - shameless plug - you could even use dapShare to track the loan).  Three, as a friend of mine suggests, it is much more financially prudent to proactively build an emergency savings fund (of say, $1,000), and have that fund earn interest, than take out a $1,000 loan at a 20% interest rate.

Income advance
What? Buying that macbook pro now because you can afford it when you get paid at the end of the month.
Why is this a bad reason? There's clearly a bad smell about this kind of spending behaviour.  The logic is fairly plain: if you spend all your income before you get it, then what will you live off between then and the next pay day?  The likely answer is: your credit card.  This creates a rolling paycycle debt that doesn't go away quickly.  In theory, this purchase is as an interest free loan; in practice, it's a never-ending and amorphous debt that you probably want to avoid.

The (one) good reason

You guessed it (to be fair, it was pretty obvious) - they can make you money.  This sounds a bit ridiculous, and for good reason: credit cards make banks a lot of money, so how can that be good for me?

Credit card companies make their money in several different ways: an annual fee, a merchant fee they charge to retailers that is a % of each transaction, and interest charges on outstanding balances.  Interest charges are the biggest component of their revenue, but they still make money when a customer spends money via the merchant fee, even when the customer pays off their credit card balance straight away.  They can then return some of their revenue back to the customer through reward programmes.

On top of this, the reward points you get from your card are not taxable income, even if they are generated from work-related expenses on your card, as per a 1997 ATO decision.

Not everyone can make money from a credit card. In fact, whether you can earn money from your credit card depends on two key factors:
  • Spend per month: how much you would spend on the card, including any work-related expenses you could put on the card and then reclaim from your employer; and
  • Outstanding balance: how much debt you have that is currently accruing interest (ie outside the credit card's interest free period, which is generally somewhere between 30-60 days)

Four types of credit card users

If we combine these two factors, we end up with four types of credit card users:


We all know how Charlie Sheen uses his credit card - like a Winner, of course!  He would spend a lot on his card each month (hookers, drugs, etc.) and pay it all off before he's charged interest (because he has roughly a zillion dollars).  The worse place to be is highly debt laden with very little spend on the card, what I call the 'Shopaholic Mum'.  If you're the Shopaholic Mum, get rid of all your cards and consolidate your debts into a lower interest loan.

This may seem like a trivial insight: of course it's better to spend more and pay less interest.  The real question is: at what point does it make sense to get a credit card?  When will it begin to pay you, instead of you pay for it?  Well this next chart is a little more revealing (and a little more boring):


Basically, you want to be in the green zone, and the more green the better.  If you're in the red, credit cards aren't for you.  Two examples:

  • You have no credit card debt, and expect to pay off your card every month - therefore your average outstanding balance = 0.  You spend roughly $2,000 on the card every month.  This puts you on the cusp of the first and second green bands; expect to get about $200 worth of reward points over the year.  Yes, you're winning.
  • You have a $2,000 credit card debt that isn't going away.  Every month, you spend (and pay off) $1,500 on your card.  This puts you in the second red band, probably costing you around $300 net per annum.  Get out.
Obviously, this is a bit simplistic.  First, I prepared that chart using just one card type (the no annual fee American Express Frequent Flyer); it will inevitably look quite different for each card.  Second, in reality, there are a few other ways credit cards return value (eg extended warranties, free travel insurance, bonus points) and there are other costs we haven't discussed (late fees, additional cardholder fees, etc.).  Dealing with these complexities is where Prosple comes in, so stay tuned.

So, what have we learnt?
  1. If you are spending (or could be spending, if you had a credit card) more than about $1,000 per month on a credit card (including work expenses), it could be well worthwhile to get a credit card, if you avoid any interest charges.
  2. If you are considering getting a credit card for another reason, think hard about it.  It may make sense in your circumstances, but be aware it may come at a cost to you.
  3. Having an outstanding credit card balance greater than (say) $1,500 is not good.  Consider cutting up your card, and getting a personal loan to cover the balance, or get a new credit card with a low interest rate balance transfer.
  4. However much you win, you'll never win as much as Charlie Sheen

7 comments:

  1. Dear Dap,

    I bought a Macbook Pro on my credit card and now I have a $1500 debt that I can't pay off. Can your advice be retrofitted onto debts already incurred? If so, I'll put it on dapShare.

    Love,

    Toad

    ReplyDelete
  2. Dear Dap,

    Also, does Dap himself do personal loans?

    Love,

    Toad

    ReplyDelete
  3. Dear Tom,

    Thank you on your short note, and congratulations on your first investment!

    Shame that it's a depreciating asset and is borne from the absurdly high interest rates of a credit card, though.

    If you want to get rid of that debt though, then maybe worth checking in with a UK bank to see if you can get a lower interest loan - or better still, transfer the debt to a card with a 6 month low interest balance transfer window. Yeah?

    Talk soon,

    dap

    ReplyDelete
  4. Hey Dap,

    The reason why I got a credit card...
    For years I have had a visa debit card linked to my st george savings account, and I never saw the need to get a credit card.
    Then one day I went online to book a flight with Tiger airways, and there was a 'verified by visa' step as a part of the card security check. This step required me to put in my st george internet banking password, which I have for my debit card, but for some reason it didn't work.
    So I went into a St George bank to find out what the problem was, and they basically said that websites that use verified by visa don't take debit cards. Next thing I knew they'd offered me a credit card as a solution for this.
    SO, i'm not sure if this is still the case, or if it's the same for mastercard, AMEX etc... but for me, this was my main consideration for getting a credit card.
    What do you think?

    Em

    ReplyDelete
  5. Weird Em, your post got marked as Spam for some reason - only just uncovered it now.

    The St George website seems to claim that Verified By Visa comes with its debit card:
    http://www.stgeorge.com.au/personal/bank-accounts/transaction-accounts/visa-debit-card/

    So it sounds like either things have changed since you got a credit card, you were conned or you had incompetent staff helping you out.

    ReplyDelete