Financial Literacy: Credit and Debt Management

Credit Cards: Benefits, Risks, and Management

Credit Card Rewards and Perks

• Points System: Many cards offer rewards, such as earning three times the points on purchases.

• Travel Cards: Often recommended, particularly cards like Alaskan Air, which help users build miles and achieve preferred customer status.

  • Benefits: Preferred seating, complimentary upgrades to larger legroom, indicating advantages for loyalty.

Advantages and Disadvantages of Credit Cards

• Advantages:

  • Financial Stability: Properly managed credit cards can signal financial stability.

• Disadvantages:

  • Temptation and Overspending: The biggest drawback is the temptation for immediate gratification, leading to overspending.

  • Consequences of Non-Repayment: Failure to repay a credit card loan results in:

    • Creditors pursuing payment aggressively.

    • Intrusion into personal life (e.g., constant calls to the individual and family, as was more common in the 1990s and 2000s).

    • Significant mental and emotional toll on individuals and spouses.

    • Impact on Relationships: Financial problems are a major cause of stress in household life, comparable to infidelity in terms of their potential to strain or break partnerships. They can either strengthen a relationship by working through it together or tear it apart due to overwhelming pressure and inability to meet financial obligations (e.g., mortgage, after-school activities for children).

Types of Credit

• Closed-End Credit:

  • Definition: A fixed amount of credit extended, paid down over time with regular installments. Money repaid cannot be reused.

  • Examples: Car payments, mortgages, installment agreements with contractors (e.g., a $15,000$ job paid at $1,000$ a month until zero balance is reached).

• Open-End Credit (Revolving Credit):

  • Definition: Credit that can be continuously used up to a certain limit, and the amount paid down becomes available to borrow again.

  • Primary Example: Credit cards.

  • Historical Overdraft Protection: Banks previously offered overdraft protection (e.g., $250$ to $1,500$) on checking accounts, clearing checks even with insufficient funds. However, due to individuals perpetually remaining in negative balance and banks finding it an unprofitable business proposition (e.g., JPMorgan), this service was largely discontinued.

Credit Card Statistics and Usage

• Prevalence: Roughly $70\%$ of households carry one or more credit cards.

• Convenience Users: Approximately $35\%$ of all credit card users pay their balance in full every month, primarily using cards for convenience and tracking expenses rather than borrowing.

Specialized Card Types

• Co-Branding: Linking a credit card to a specific business (e.g., Alaskan Air card) or organization (e.g., fraternity-branded cards) to offer specific points or benefits.

• Smart Cards: Modern cards with embedded chips for tap-to-pay or slot insertion, enhancing security and convenience.

• Debit Cards vs. Credit Cards:

  • Debit Card: Uses your own funds directly from your checking account, serving as a cashless way to access your money.

  • Credit Card: Uses the bank's money, which is essentially a short-term loan that must be repaid.

• Stored Value / Gift Cards (Prepaid Cards):

  • Description: Cards with a preloaded monetary value for specific or general use.

  • Problems:

    • Time Limits/Expiry Dates: Funds may expire if not used by a certain date (e.g., nine months, one year, two years).

    • Retailer Bankruptcy: The value of the card can become worthless if the issuing retailer goes out of business.

    • Loss of Value: If forgotten or unused, the money is lost to the consumer, and the retailer keeps the funds. Encouraged to use them quickly.

• Travel and Entertainment (T&E) Cards:

  • Examples: American Express, Diners Club, Carte Blanche.

  • Characteristics: Primarily for business travel and entertainment expenses. Historically, balances must be paid in full each month, although some American Express cards now offer revolving credit options. Accepted worldwide, but are not designed for gradual repayment.

• Mobile Commerce: Using smartphones for purchases via digital wallets or stored credit card information.

• Home Equity Loans (HELs) and Home Equity Lines of Credit (HELOCs):

  • Concept: Utilizes the equity built in a home (difference between market value and outstanding mortgage, often inflated by real estate appreciation, especially for baby boomers).

  • Benefits: One of the few loans with tax-deductible interest, reducing the after-tax interest rate.

  • Structure: Can be set up as a one-time installment loan or a revolving line of credit (HELOC).

Protecting Your Finances and Credit

• Safeguarding Personal Information: Never give out sensitive information (e.g., Medicare numbers) over the phone unsolicited.

• Credit Card Security:

  • Treat credit cards like cash; know their location at all times.

  • Immediately freeze a lost or stolen card online and notify the issuing bank/company to prevent unauthorized use and obtain a replacement.

  • Protect credit card numbers similarly to how you would your Social Security Number.

• Record Keeping: Always request a receipt for credit card purchases (physical or emailed) to track transactions effectively.

• Monitoring and Reporting:

  • Regularly review monthly bank and credit card statements (online or physical) for accuracy.

  • Notify the issuer promptly of any lost or stolen cards, or billing errors. Rapid reporting is crucial.

  • More than two electronic payment mistakes in a year from a single company is considered problematic and warrants investigation (e.g., a company breach not disclosed to customers).

Assessing Loan Affordability

• Debt Payment to Income Ratio:

  • Formula: $(\text{Monthly Debt Payments}) / (\text{Net Monthly Income})$

  • Guideline: Should ideally be less than $20\%$ of your monthly take-home pay. Lenders will examine all debt payments (rent, mortgage, credit cards, auto loans, etc.).

  • Example (Exhibit 6.3): A net monthly income of $2,136$ and total credit card/auto loan payments of $426$ results in a ratio just under $20\%$ ($426 / 2,136 \approx 0.199 \text{ or } 19.9\%$).

• Debt to Equity Ratio:

  • Formula: $(\text{Total Liabilities}) / (\text{Net Worth})$

  • Guideline: You should never be