How credit cards work (how to make it work for you)
I was still living in Nairobi. I saw an advertisement on TV explaining how convenient it is to own one. The ad was by one of the leading banks in Kenya. They were running two ads, one featured a lady and the other featured a guy. All celebrities or public figures.
As much as the ads were targeting young people and encouraging us to apply for the cards, my first impression was ‘this ain’t for people like me.’ They featured celebrities dining in expensive restaurants, using valet services, partying in flashy clubs and of course dressed in well-coordinated outfits that we only see in magazines and movies. They paid for all this using the credit cards.
So I learnt to dismiss the ads as soon as I saw them because clearly, I wasn’t the target market. If I was, it was an epic marketing fail.
Basically, credit cards in Kenya for me sounds like the kind of thing reserved for the rich or rich kids whose parents settle their credit card bill.
My suspicions were confirmed as I’ve heard a few well-off parents say that they give their kids a monthly allowance in the form of credit cards with a spending limit. A monthly allowance is another one of those things that people who grew up poor can’t relate to.
Fast forward to December 2019 when I had settled in Dubai.
Let me tell you guys!… here, the banks call you to offer you the cards! Well, that’s if you’re formally employed. I received more than 20 calls from different banks offering to give me a credit card. The reality here is totally different from my experience in Nairobi.
Credit cards vs debit cards
- A debit card is what a lot of us refer to as an ATM card. A credit card is a ‘loan card’.
- A debit card is linked to your bank accounts such as your checking account or savings account. A credit card is not linked to your account.
- While using a debit card, you spend money that belongs to you. The money is in your account. While using a credit card, you use money that belongs to the bank. They’re loaning it to you.
- If you make a purchase using your debit card, you won’t pay interest. If you make a purchase using your credit card, you will be charged interest if you don’t pay back before the due date. Remember it’s a loan. More on this later.
How credit cards work
When I moved to Dubai, I had zero experience on how credit cards work. Come to think of it, I had never heard any of my close friends, family or colleagues mention their experience with credit cards.
When I opened a bank account here, I got calls from banks offering me their credit cards. I always turned down these offers with a stern NO because of my fear of debt. This stemmed from all the books and videos I’ve watched about the dangers of credit card debt and how Americans are drowning in consumer debt. Most of these books offer data from USA.
Credit card numbers/statistics
Here are 3 worrying statistics from debt.org to consider before I explain how credit cards work:
- The average credit card holder has at least 4 credit cards.
- More than 189 million Americans have credit cards.
- The average credit card debt per household is about $8,398.
When you get a credit card from your bank, they set a monthly spending limit. This is the maximum amount that you can spend. You can also set your spending limit.
For example, my card’s spending limit is 3 times my monthly salary. This should already tell you how risky these cards can be. I literally have access to 3 times the value of my monthly salary. If you don’t have a grip on your finances , you can easily get trapped in debt. Which is what the financial institutions want because…they make money through interest rates!
The card has terms and conditions of use such:
This is for credit incurred through swiping and cash withdrawals. Yes, you can withdraw cash from your credit card. But it’s a catastrophic move (don’t even dare!) as the interest rates on this are up to 4% or more charged per day.
There’s a grace period, which is a specific number of days where the bank doesn’t charge you interest. If you don’t pay within those days, the interest kicks in.
There’s also a due date which is the date you are expected to pay what you owe.
These terms vary depending on the type of card you hold.
One thing to note is that a lot of people don’t read the document the bank gives you when the card is delivered. The bank also doesn’t give you accurate and specific information about the terms. This is a deliberate move as they’re in business and their aim is to make sure they earn as much money from you through the interest rates as possible.
That is not to say that you should write off the idea of applying for a credit card.
Application of credit cards
Since from my experience and research I have established that a lot of people don’t read the terms and conditions on their cards and a lot of people aren’t financially literate, here is a list of questions you should ask your bank before getting a card:
1. What is the due date?
My bank app shows me when my payment is due. It also shows the minimum payment due. This is an important date as missing a credit card payment means you’ll be charged a late fee, on top of your interest charge. The bank could also charge you a higher interest rate.
Late payments also affect your credit score and you risk getting reported to debt collectors and in extreme cases, you can get sued.
I know someone who missed their payment for one month. The bank immediately blocked her accounts.
2. How long is the grace period?
If you’re really good at managing your money and paying off your bills on time, the grace period is heaven for you.
Within this period, which is usually between 40 to 45 days for most banks, you won’t be charged interest. Which means that you’ll be accessing debt for free. But this only works if, by the time the due date comes, you don’t already have another balance you owe in your card.
This is the part that was really confusing for me about credit cards. I still don’t feel 100% confident about it.
I physically went to my bank to have the banker explain it to me. This was after I had already applied for one, had it delivered but I hadn’t activated it yet as I was still scared.
Let me tell you how the visit to the bank went…
First of all, he wasn’t very enthusiastic about explaining the process to me. I felt like I was being a nuisance yet I’m their customer. But I wasn’t shocked because if we get to know how credit cards really work, especially about the high-interest rates, then the banks will lose money.
I kept asking him to repeat because he was using jargons, remember this was my first experience with credit cards. And I didn’t want to get sucked up in credit card debt in a foreign country.
He drew the payment cycle on a piece of paper to explain my grace period and due date when I insisted on using a practical example. Yes, I’m a visual learner.
I concluded that it was too much work to keep tabs with the cycle. These institutions are deliberate about making this information complex and unavailable.
What is the difference between Minimum and Maximum payment?
Credit Card Minimum payment
A minimum payment is the smallest amount out of what you owe that the bank requires you pay each month. When you apply for a credit card, this is usually the default setting on your card, which is a dangerously low amount. It can be as low as 2%.
I learnt the importance of default options from one of my favourite books; Nudge by Richard Thaler and Cass Sunstein which I reviewed
My awesome friend had explained to me that before I start using my card, I should call the bank and ask them to change my payment method from minimum payment to maximum payment.
He literally saved my life. This is why I keep insisting that we should openly talk about money with our friends.
During that visit to the bank, I asked the same bank guy to make the change for me. He declined. He said that I should call customer care and ask them to do it…dude, I’m already physically here, and you want me to call customer service, which is a robot? Yeah, their customer service is a robot. I don’t know about you but it just doesn’t sit right with me to talk to a robot about my money. Human connection makes a big difference, you feel understood.
When I got my card, it had already been set that I’ll be making minimum payments. A decision that had already been made for me, default. The minimum payment required was 5% (or $27, whichever is higher) of the total spent per month.
Let’s use an example…(How Credit Cards Charge Interest)
If I spent $400 using my credit card in July, I’d be required to pay only $27 on the due date. 5% of 400=20, but $27 is higher as explained above.
Like I’d have been out there swiping my card left, right and center and sometimes mindlessly and all the bank requires me to pay is $27?! Nah, that deal is too good to be true.
What would happen in this case is that the bank would charge me interest of 3.25% per month on the remaining $373 debt.
3.25% of $373=12.1225
If I spent $500 more in August, I would owe USD 885.1225 (373+12.1225+500).
The minimum payment owed this month would be USD 44.27 (5% of 885.1225)
Then the magic of compounding would kick in …the 3.25% interest would be charged on the remaining amount (885.1225–44.27) which equals 840.85.
I hope you can tell that if you keep swiping your credit card and only making minimum payments, you will be stuck in debt for decades! You’ll keep losing money in the form of interest payments.
But of course, the bank will be elated to keep you in the debt cycle as they earn from a faithful client like you.
Because the minimum payments are tiny relative to the total bill, paying this amount just maximizes the interest payments over time. Credit card companies even make it hard to commit yourself to paying the card off in full each month. — Nudge by Richard Thaler and Cass Sunstein
Credit Card Maximum payment
This means paying your credit card debt in full every month. If you spend $400 in July, you pay $400. If you spend $700 in August, you pay $700.
If you do this, you won’t be charged interest. This is what I do.
People tend to be mindless, passive decision-makers. Credit card companies take advantage of this fact. Our choices depend on how ideas or problems are presented to us. Otherwise, why would you accept to pay $25 per month knowing very well you spent $500? They have presented the minimum payment as a relief to you while banking 18% (or more) in interest from you. — Nudge by Richard Thaler and Cass Sunstein
Watch this 3-minute video for an explanation of the deeper cycle of credit card debt.
Back to the questions you should ask your banker…
3. Is there a monthly and/or annual fee?
One of the reasons that convinced me to finally get a credit card was because my banker mentioned that they were offering a ‘Free for Life’ card. Since I don’t trust financial institutions, I had to confirm that with 3 people lol. And read the terms and conditions document that came with the card before signing to ensure that it was true.
Before getting a card, do yourself a favour and ask how much their monthly and annual fees are. Ask them if they have a card that doesn’t have these fees. If yes, pick that.
4. Is there a joining fee?
Yup, some banks charge you a joining fee. Which is crazy because they’re literally selling you debt. I wouldn’t sign up for such a card.
5. Which other fees are charged on the card?
A month after signing up for my card I learnt that there’s a 0.99% per month of the Credit Card outstanding insurance fee. They didn’t tell me this just like they don’t tell you about all other fees. And again, it was a default choice already made for me!
If I didn’t read and scrutinize my first statement, I would be charged this amount. I had to call my bank to enquire what that fee meant because I had no idea. They said that it was insurance just in case I lost my card. First of all, this is a safe city. Secondly, if I lost my card, all I need to do is go online and cancel/block it. Third, why didn’t you tell me about this fee?!!! I opted out of it.
There are many more fees such as late payments penalties, card replacement fees, above limit fee, foreign currency transaction fees (which cost them nothing but charge you for it anyway) etc that they will never tell you about. And most of the time, when they list the fees in their pamphlets or ads, they don’t mention that they haven’t included tax.
Ensure that you read, reread and understand the terms and conditions document that they give you. They include all fees and terms on it but because most people just live mindlessly and don’t read, we end up signing up for stuff we don’t understand.
How I use my credit card
This is where I issue a warning.
If you haven’t mastered the art of being financially disciplined through creating a budget that works and sticking to it for at least 6 months, automating your savings & investments, living below your means, saving for an emergency fund, and all other aspects of personal finance that we talk about here on The Wealth Tribe, don’t get a credit card.
Also, if you’re still stuck in other debts and you haven’t come up with a practical solution on how to pay them, don’t get a credit card.
You need to understand the basics and be financially disciplined first before making this move. As you can tell from the lesson on how the cards work, the institutions make it deliberately complex and don’t tell you about so many things. This means that it’s easier for you to get hooked and stuck for decades in this kind of debt.
But, there are many benefits of owning a credit card which I’ll talk about in my next article. For now, I’ll show you how I use mine.
1. I use my card to pay all my bills
I have a budget that I stick to. From my budget, I know where my money should be going every month.
I use my credit card to pay all my bills except rent.
By using my card to pay all my bills, I earn reward points which I can redeem at restaurants, or even convert them to air miles.
Using a card to pay for everything also eliminates the problem of having to look for change, looking for ATM machines to withdraw cash and always having a purse full of coins.
2. I make maximum payments every month
There was no way I was going to choose the default minimum payment option and end up stuck in debt for years and also enrich my bank through the crazy interest rates.
My bank app shows me the due date for my card every month. I ensure there’s always an equivalent of what I owe in my checking/debit account. All the bank has to do is deduct their money on the due date.
It’s all about making the card work for you.
3. My payments are automated
I don’t wait until last minute to ensure there’s money in my checking account to pay my credit card. I also don’t walk to the ATM machine or bank branch to make the payment.
There’s always an equivalent of what I owe in my checking account, all they have to do is deduct their money and send me a text message.
I noticed that if there’s no money in my checking account equivalent to what I owe a few days before my due date, the bank send me numerous reminders and calls me multiple times which is annoying. I hated those calls because it made me feel like I’m not in control of the process.
4. I only spend money that I have
I don’t spend more than I have in my checking account. If I want to pay $300 using my credit card, I check to ensure that I have the same amount in my checking account. And again, I stick to my budget because remember that credit card money is a loan! It doesn’t belong to you.
A lot of people use credit cards to buy expensive stuff that they can’t afford. This is mostly because the stuff is literally one swipe away.
If you do this while on the minimum payment, you’ll be stuck in debt for long. If you do it while on maximum payment, you won’t afford to pay it back on the due date. You might miss a payment in this case which has consequences such as late fee penalties and the bank will automatically start charging you interest on the amount.
5. I read my statements every month
For three months, I’d call my bank to ask them questions about any fees or concepts on my statement that I didn’t understand.
I’m all about being hands-on with my finances and taking control.
6. I don’t exceed 30% limit
My credit card limit is three times my monthly salary. That’s a load shit of money to have access to every month.
To ensure that I don’t lie to myself that I’m rich on other people’s money, I use the 30% rule. I don’t exceed 30% of my limit on any given month. I also learnt that this is a credit score hack.
Credit cards always mention the minimum payment you can make when you receive your monthly bill. This can serve as an anchor, and as a nudge that this minimum payment is an appropriate amount. Similarly, credit card limits, which are nominally in place to limit spending, may serve as high anchors that actually encourage spending. Credit card companies even make it hard to commit yourself to paying the card off in full each month. — Nudge by Richard Thaler & Cass Sunstein
7. I use it to grow my credit score
Maybe one of these days I will need a big business loan so it’s prudent to build my credit score in the meantime. Always be prepared.
8. I’m here for the reward points and discounts!
Yeah, I also want to dine in fine restaurants and fly to my dream destinations on a bargain!
Take time to understand how credit cards work and all the fees involved before you sign up. Keep talking to your friends and knowledgeable people their credit card hacks. Read books about it.
It’s a lot of information to process especially if you aren’t exposed to it like I was before moving to Dubai but you can learn anything if you give it time.
I still believe that I haven’t learnt everything about credit cards so please share your hacks with me and the community! Or leave a comment about something you’ve learnt from this article. See you on the next one!