Money and You: Course Notes

Credit cards are the most prominent example of a “revolving” loan. When you are issued a credit card, the issuing company is agreeing to give you a loan up to a set dollar amount called a credit limit. Unlike an installment loan in which you have to use the borrowed money for a set thing (car, house, education, etc.), a revolving loan gives much more freedom to what you can use the borrowed money for. Also unlike installment loans, paying off the balance of a revolving account does not close the account, you can continue to borrow up to your credit limit.

There are other kinds of revolving loans. Payday and other personal loans are usually revolving loans. Just like payday loans, credit card loans have many dangers, such as high interest rates and a very easy path to amassing too much debt. However, when used responsibly, credit card loans present a much better option for making purchases than other revolving lines of credit.

The main benefit of a credit card is being able to make purchases without needing to carry cash with you. Of course, personal checks also fit that bill, but fewer and fewer places are accepting personal checks. Of course, online shopping is very difficult without a credit or debit card.

The economics of credit cards is somewhat complex, but it can be helpful to know some of the monetary motivation for their existence.

First, let’s talk about payment card companies. In the United States, the payment card industry is dominated by four companies: Visa, Mastercard, Discover, and American Express. These companies collect, store, process, and transmit all data related to debit cards and credit cards. So, these companies are data-storage companies. In terms of making loans via cards, some payment card companies do this themselves (such as American Express and Discover). Others have “member banks,” that use the payment card’s data services to issue loans (such as Visa and Mastercard).

All payment card companies make money via fees. Have you ever been to a store that charges higher prices or a purchase minimum price when paying with a credit card? This is because payment card companies charge a fee to businesses for their services. Payment card companies charge different amounts, which can cause businesses to only use certain companies. Visa and Mastercard generally charge lower fees, which is why many small businesses do not accept Discover or American Express cards. Fees are often percentage based (1.5%-3.5%) along with a per-transaction fee ($0.10 - $0.80). Historically, businesses set their prices uniformly to account for these fees. Some businesses have begun offering lower cash-only prices to be more competitive (gas stations, for example). Some cards have fees that are paid by the cardholder, called annual fees. Lastly, member banks that use payment card services pay a fee for those services.

Member banks (and payment card companies that are their own banks) make money via annual fees and interest. Not all credit cards have annual fees, but all will have interest. The interest rates on credit cards tends to be very high (usually 15%- 30%). Given that home and auto loan interest rates are about 6%currently, credit cards can generate a massive profit for these member banks. However, you do not have to actually pay any interest on credits card. We’ll explain how soon.

To get a credit card, you need to apply for one. As mentioned above, a credit card is the mechanism for a revolving line of credit, meaning that it is a loan. As with all loans, you need to apply for it. You apply for a credit card via a member bank (or the payment card company itself if it is its own bank). The biggest member banks are companies such as Chase, Capital One, Bank of America, Citi, Wells Fargo, etc. Smaller banks can issue their own credit cards, but usually don’t. Smaller banks do usually issue debit cards, which still require the services of a payment card company.

As with any loan, applying for a credit card usually requires a credit check. (If a credit card issuer doesn’t require one, it is likely a very scammy and dangerous card.) Depending on what services and benefits come with a particular credit card (which we’ll discuss soon), credit card issuers may restrict approvals to people with sufficiently good credit history.

When you are approved for a credit card and have one, you are ready to make purchases with it. When you use a credit card at a business, whether in-person or virtually, you are actually requesting your credit card issuing bank to give you a loan for that purchase amount. The request is automatically transmitted to the issuing bank, which will very quickly determine if you will get the loan to pay for whatever it is you’re buying. In making this decision, the issuing bank’s computer will look at whether the purchase will exhaust your credit limit, where you are making the purchase, and the amount. There are a variety of reasons for a transaction not to be approved, but most are. If you exceed your credit limit or the purchase requests seems out of character for your buying habits, the transactions may be denied. You can always call the banks if you think the purchase should be approved. (For example, if you travel far away from home and use a credit card, the bank may think your card was stolen and just needs to be told that it is indeed you making the purchase.)

Once you have made a purchase using the borrowed money from your credit card issuer, you have taken out a loan for the purchase amount. Like any loan, you have to pay it back, and your loan will accumulate interest. We will go over interest in a later week. For now, just understand interest as essentially the cost to you for borrowing money. The higher the interest rate, the higher the cost.

Unlike an installment loan, there is not a set schedule in which you pay off your loan. The bank will determine what is called your minimum payment amount. The minimum payment is the absolute smallest amount you have to pay monthly to pay off your loan. How much the minimum payment is depends on a few factors, but it is mostly determined by how much you owe the bank in total. You can absolutely (and should) pay more than the minimum payment each month.

Here is the thing about minimum payments. Paying only the minimum payment on a credit card will lead you to never paying off the loan. You’ll just accumulate more and more debt through the high interest rates. So, it is generally in your best interest to pay more than what is minimally required.

If you are wondering why anyone would use a credit card if the loan interest rates are so high, I have an important fact about every credit card in the U.S.

Here is why and how. By law, every credit card issuer has to allow a grace period. Every credit card company has a monthly billing cycle. All purchases made with a credit card in one monthly cycle are treated as one big loan, essentially. For purchases in one billing cycle, the actually terms of the loan (interest) cannot kick in until the end of the grace period, which is usually 3-4 weeks. If you pay off your credit card balance before the end of that grace period, the bank cannot charge you any interest at all.

So, if you pay off the full balance of your credit card every month, you will never, ever pay a single penny in interest.

If you are responsible with a credit card and only make purchases you have the money for in your personal savings account (or cash), then paying off your credit card each month is easy. First, most banks let you choose which day of the month your bills are due. Many people choose the 1st or last day of a month. Second, you can set up automatic payments so that the credit card issuing bank withdraws whatever you balance is each month (rather than a set dollar amount). By setting up automatic payments, you don’t have to worry or think about credit card debt or interest.

While eating dinner with your significant other’s family, your SO’s father mentions that he’s never owned a credit card. He explains that because of the high interest rates on credit cards, it’s always cheaper to pay everything by cash and check. Is he correct? Explain your answer in a few sentences.

Beyond the convenience of credit cards, some issuing banks offer other perks. Essentially, the issuing banks expect (on average) to generate a lot of profit via interest. There is also a great deal of competition for you and your potential to pay interest. So, some card issuing banks offer incentives for choosing their cards. These benefits vary wildly. A “cash back” card will essentially return a small percentage of a purchase amount to you. (1%-5%, depending on the card and location of purchases. Most are around 1.5%these days.) Some cards offer discounts on certain products via agreements they make with companies. (For example, Marriott may offer a discount on hotels if the purchase is made through your credit card bank in exchange for the bank advertising Marriott to you.) Some cards offer services such as travel planning, event ticket buying, stream service membership, etc.

Cards that offer these additional benefits many not be a simple add-on service. Cards that offer benefits are more likely to charge annual fees. You have to make a decision as to whether an annual fee is worth it. Some benefit-bearing cards to not have any annual fee.

Unfortunately, the better the benefits of a card, the more scrutiny is used in determining if you are eligible for the card. That is, some cards require you to have sufficient high credit to be eligible.

For those just entering the credit-card benefit world, I tend to suggest finding a cash-back card that does not charge an annual fee. If you pay off your balance every month, you never pay interest, but you do still get the “cash back.” This combination essentially makes your purchases cheaper.

There is an upper bound to how much you can purchase with a credit card. Your credit limit is the most your card issuing bank is willing to loan you. One common misconception is that a credit limit is the most you can spend per purchase. That is incorrect. A credit limit is the most you can purchase in total. If, either by a purchase or interest, your credit card balance reaches your credit limit, your are “maxed out.”

In general, credit limits are tied to a few key factors. Your credit rating, annual income, loan balances, and other assets will determine what your card-issuing bank will set as a credit limit. For your first credit card, credit limits are often $500 or $1,000. Credit limits can be much, much higher for those with good credit and large incomes.

Credit limits are very malleable. Often, your card bank will change your credit limit automatically. In times of economic downturns, banks often lower credit limits as a form of risk management in case many of their cardholders lose the jobs. In times of economic booms, banks may increase credit limits. If a bank determines that you do not use much of your credit limit each month, it may lower your credit limit. If you make purchase close to your credit limit or have amassed a large credit card balance, the bank may increase your credit limit to encourage more spending.

Automatic credit limit increases can be a bit of a trap, particularly if you are carrying a balance month to month that accrues interest. It is in the best interest of the credit card bank for you to amass credit card debt while making the low monthly payments. Particularly for people with a spender money personality, increasing credits limits can encourage poor money management and exacerbate debt issues you already have.

Fortunately, you can often request changes in your credit limit. In particular, requesting a lower credit limit is easy. If you find yourself making too many purchases with your credit card each month, requesting a lower limit may help keep spending down. On the flip side, you can sometimes request a limit increase. This can be helpful as you get older and start making more money and making more purchases. Requesting a credit limit increase usually requires approval and will consider factors like current credit balance, purchase history, and income.