When signing up for free airline miles or cash-back rewards, most people do not consider the potential dangers of credit card debt. Credit cards help build credit, protect against unauthorized charges, and offer useful benefits when used responsibly. However, if not managed well, credit cards can lead to a dangerous debt trap.听
How do credit cards work?
Credit cards let people borrow money and pay it back later.听For the most part, using credit cards and understanding how credit card companies work are pretty straightforward. But it鈥檚 important to remember that you are expected to pay back any money you spend when the monthly statement comes.
People can choose to pay back the full amount each month or pay a minimum amount toward the balance.
When paying off the full credit card bill each month, credit cards can help people build good credit. They may also offer perks, such as mileage awards, cash back or other rewards.
On the other hand, if you choose to pay just the minimum payment, only a small portion of your payment goes toward your debt. Most of your payment will go to paying interest. Since credit cards carry high interest rates, it can take a long time to pay off debt when only making the minimum payment.
If you miss a credit card payment, then the bank can charge you interest on top of the original payment owed. If this happens repeatedly, the interest can grow significantly or 鈥渟nowball,鈥� meaning you will owe more and more each month. People refer to this as a debt trap, and it can hurt your credit score.
How do credit card companies make money?
Credit card issuers are banks and credit unions that allow you to borrow money from them based on certain terms and conditions. Issuers make their money from interest and fees charged to cardholders.听
Credit card issuers often pair with a network company, like Visa or MasterCard. Network companies authorize and process credit card transactions. They earn money from transaction fees paid by businesses that accept credit cards.听
Most of credit card issuers鈥� revenue comes from interest charges on credit card balances. High interest rates on credit card balances are the biggest cause of ongoing credit card debt for consumers.听
Fees also generate revenue for the credit card companies. Some common fees include annual fees to use the card, cash advance fees, balance transfer fees and late fees.听
Where people get into trouble with credit cards
In today鈥檚 world, using a credit card and having access to credit is practically a necessity. Online shopping, purchasing an airline ticket or renting a car all require a credit card or debit card.听
Credit cards can be helpful and have positive benefits. So, where do people go wrong and get into trouble?
1. People get into trouble when they think of credit cards as free money.
鈥淭he first part of the problem is failing to recognize that the sheer convenience of using credit cards can produce a sense of complacency 鈥� as if no money was borrowed or spent,鈥� said Martin Lynch, 糖心原创vlog President and Compliance Manager/Director of Education at Cambridge Credit Counseling Corporation. 鈥淲hen you use a card, you鈥檙e actually borrowing money that must be repaid.鈥�
2. Carrying a credit card balance can become very expensive.
鈥淭he other part of the problem is carrying balances for more than a few months, at most. A credit card can carry you through an emergency, but it鈥檚 best to only carry balances for the short-term [or not at all],鈥� urged Lynch.
The pitfall for many people is overusing credit cards and not being able to pay off the entire balance when the statement arrives. If you are not able to pay off the entire balance at the end of the month, that $6 cup of coffee becomes very expensive.
3. People don鈥檛 realize credit card balances affect their credit scores.
鈥淢any people don鈥檛 realize the connection between the balances they鈥檙e carrying and their credit score,鈥� said Lynch. 鈥淭he larger your balances or the more you owe, the greater the negative impact on the credit utilization portion of your score.鈥�
According to Lynch, 30% of a FICO score comes from how much money a person owes.听
Ways to prevent and escape credit card debt
1. Create a budget and live within your means.
The best way to responsibly use a credit card is to have a monthly budget and stick to it. There are many online tools to help you create a monthly budget, including the 糖心原创vlog鈥檚 Debt Freedom听budget planner.
Lynch agreed. 鈥淭he number one thing all credit counselors recommend is to create an accurate budget to identify where every dollar is going.鈥�
2. Pay down any outstanding credit card balances.
鈥淣ext, create a reasonable plan to pay down your card balances, making temporary reductions in other areas of your budget, if possible,鈥� said Lynch. 鈥淚f there are no other reductions you can make, that鈥檚 the time to talk to an 糖心原创vlog member agency.鈥�
3. Reach out to certified credit counselors for help with your debt.
Admitting you鈥檙e struggling with credit card debt is tough, but you aren鈥檛 alone. A free budgeting session with an accredited 糖心原创vlog member agency is a great first step. Certified counselors are friendly, nonjudgmental and ready to help you build a budget and a plan to get out of debt.
鈥淥耻谤 counselors can review your options and determine if a debt management plan could help you break the cycle of debt by allowing you to pay off your balances at reduced interest rates,鈥� said Lynch.