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How Do Credit Cards Work?

Liz's advice, on finance, credit, frugal living practices, & anything monetary, is from the 'school of hard knocks,' research, & experience.

Do Credit Cards Increase Spending?


Credit Cards Equal Temptation

Many people ask: "Do Credit Cards Lead to Unnecessary Buying?"

The simple answer is yes, credit cards allow people to make unnecessary purchases: it is built into the whole concept. Simple answers, however, do not always tell the whole story.

Why is that? Credit cards make impulse purchases much easier to justify or rationalize. Even people who are normally careful can think, "Well, just this one time; I'd like to get this item, but I don't have the cash with me right now, and I won't have time to make another trip later." They assure themselves that they'll take that money and add it to their checking account in order to pay off the item with the rest of the monthly bill.

Sometimes, people with extraordinary will power are able to do just that. Unfortunately, it is not true of the majority of people. Call if human nature, if you want. Maybe it's that old desire to 'keep up with the mythical "Joneses."

Over the course of history, people have been shown to have a very acquisitive nature. Wars have been started countless times by the desire to acquire ever more, be it goods or territory.

Credit Is Not Free Money

As anyone who has ever held a credit card knows, credit is not offered for free. There is interest charged on any balance not paid in full each month. If you are organized and disciplined enough to manage this feat, congratulations! You are in the minority. If the majority of people did this, there would be no credit cards--the companies would go out of business.

Credit card companies make their money by charging interest on the balances held past a single month's time. No carryover balance, no income for them. By law, they are not allowed to charge interest on less time than a single calendar month. (Interesting, though, that their interest rate "disclosures" account for "average daily balances.")

Therefore, it is in their best interest to keep their customers perpetually in debt. Very few credit cards maintain a low and reasonable interest charge. True, they may start out offering a "low introductory rate," to hook you in, but when that intro period has expired, watch out! You may be in for a shock to see how high the new figure is! Miss a payment or two, or be late with a payment, and watch that rate skyrocket into double-digits in the high twenties!

If you are not careful, you can easily get in over your head to the point where you can no longer afford to pay off the balance in full each month. The credit card companies just LOVE this. This is where they make their money. They absolutely hate customers who faithfully pay off in full each month, because they have then given a loan of free money!

The Real Cost of Credit

An informal observance of the habits of nearly all the major credit-card companies reveals a very interesting practice which holds the potential for personal financial ruin. Namely, if you make your payments on time, you will probably get a letter congratulating you on your excellent payment record, and as a result, "reward" you with an increased credit limit.

This is not a "reward," it is a trap! The more credit you are allowed, the greater the temptation to "just this once" buy something you may have to pay off over a couple of months or longer. That's the foot in the door for the card issuer! Manage to pay off that balance, and/or keep up with at least your minimum payment, and before long, you'll get another "reward" letter, increasing your limit still more.

At this point, it is has become really easy to take advantage of all this extra "free" money. Charge that hotel room; that weekend getaway; that airfare; the tickets to a concert or big-name auto race. You'll pay it off, next month.

Yeah. Sure...said the spider to the fly. That's just what the card issuers want you to believe, and according to widely available statistics, the majority of people do fall into their web. The more you charge, the more you are allowed to charge. It is a deadly circle dance.

Somewhere in the backs of our minds, we all know perfectly well that this is not "free" money. We know it must be repaid; that it is essentially a loan. Yet, in the majority of cases, much to the glee of the credit card companies, this basic fact gets ignored. We treat these cards as if they are extra money, and use them for purchases which we cannot actually afford.

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Put a slightly different way, many people use their cards as a means to increase their standard of living. This means that the money they have left after paying all of their normal bills (housing, insurance, transportation, utilities and groceries) is not enough to allow them to keep up with those making more money.

Compounding this problem is the fact that a great many people have multiple cards, not just one, so the issue is multiplied across each card in their possession.

You Bought It On Sale?

Great! Those infamous pieces of plastic can, indeed, freeze a sale price until the paycheck comes in. ... ...IF you actually pay it off! (Cue sound effect for screeching brakes...)

If instead, it gets added to monthly carryover debt, then not only have you lost out on the supposed savings, but paid many times the original price for the item as well. Why is this so? Because whatever payments you do make on the outstanding balance are applied:

  • first to the interest,
  • then to any principle,
  • and that amount goes first against the oldest charges.

It's a terrible psychological trick to which people seem to be vulnerable time and time again.

Double, Triple, Quadruple, Whatever, Dipping

In theory, interest is charged on your purchases. This is true only if you make few purchases which you can pay off over a matter of not over two months' time, and do not add to the debt load by charging additional items in the meantime.

However, if you typically maintain a carryover balance year-round, you are charged interest on top of interest on top of interest, because the interest charges accrue against your total balance! So, if you owed, for example, $100, and paid only $50 the first month, in the second month, you'd be charged the remaining $50 plus interest. All good.

However, if you owed that same $100, then paid $50, then made an additional charge of $75, then paid another $50, then charged yet another $100, you are now "in the door" of the reason they call these "revolving" charge accounts. It's a perfect analogy, for it is exactly like being trapped in a revolving door with no exit point.

You can see by the example in the table below how this works on a very elementary level, assuming the same monthly payment amount each time, how you continue to fork over interest on older purchases you may not even recall--such as dinner and a movie--where you have no physical posession to remind you. Purchases of such things, known as "consumables" account for a great deal of debt.

(See this handy calculator for the full picture--you can enter your own figures.)

Revolving Credit

ChargesPaymentsBalanceInterest Added









































Additional Fees

Now, what if you get into difficulty of some sort, and can no longer afford the minimum monthly payment? You're really going to take a hard hit. Many card issuers are going to charge a penalty of some kind for failing to make the minimum amount due.

If the payment was late on top of being insufficient, a late fee is also added. These are very high fees--sometimes as much as $46 or more-- and can, all by themselves, wipe out your entire payment or most of it.

That's right--they take the late and penalty fees right off the top of your payment, before applying any of it even to the normal interest charges. Then, if any is left, it goes toward the interest. Most likely, there will then be a zero balance left from your payment to apply toward the principle.

Guess what happens next? You got it! Those fees are added right into your balance, on which you get charged interest for the following and all subsequent months until the card is paid off. Get too many of these fees, and pretty soon, your available credit is all used up. You can no longer use the card to buy anything, yet your balance continues to rise.

In the cruelest twist of all, the bank now adds on an "over-limit" fee to penalize you for using more credit than they had allotted to you. Wait a minute! You wouldn't have gone over the limit if it were not for their added-on fees!!! Yes--a cruel twist indeed, but apparently legal, for they all get away with it. It is, in my opinion, unethical in the extreme, but technically legal.

If your difficulties escalate to the point where you simply cannot afford to pay off the card at all, in however small payments, such as the loss of a job, and have no option but to default on the card, just watch the dunning notices start coming in demanding payment.

Try to reason with the billing department staff and arrange a new payment that is affordable for you. Try and get the interest rate lowered. No way! They don't care! The lowest interest rates go only to those who probably don't even need credit in the first place. Outrageously high rates are charged to those who can least afford to pay. Something is very wrong with this picture!

The Safest Credit Cards

If you have even a slight twinge of doubt about your will power, it is best to stay away from credit cards altogether. The very safest credit card is no credit card at all. In our grandparents' day, these insidious pieces of plastic did not exist. Now, these cards have spread like a cancer. Operating on a cash-only basis is always wisest.

There are only two absolutely safe ways to use credit cards. The first is to cut them all up into tiny pieces and use them to create a mosaic art project.

The second is to use a pre-loaded card that can be had at many major retailers, and use your own cash to fill/refill this card with whatever "extra" amount you may have on hand. There are no payment due dates, because the money is already there, and simply deducted from your original balance. There are no interest charges, because it's your own money and not a loan. Essentially, these are debit cards, except they have the security advantage of not being linked to your bank account.

However, there may be a good many other fees, such as "activation" fees;monthly transaction fees; where you are charged for each use; fees to speak with a service rep, etc. If you must have a credit card for making reservations, etc, these may be a good option, but research the different ones carefully first to get the best deal.

To Stay Out of Trouble With Credit Cards:

Memorize and chant this mantra:

If I don't have the cash, I can't afford to buy the item.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2011 Liz Elias


Zaton-Taran from California on February 10, 2017:

Credit cards work rather well if you use them right. I almost always pay my balance in full and avoid interest charges; however, if there's an emergency, I dont mind paying the companies a pittance in order to use the much-needed cash.

Liz Elias (author) from Oakley, CA on December 27, 2011:

Hi, randomcreative--You are correct, but therein also lies the rub, and the irony. You can't get credit until you have credit--the old catch-22 situation. And again, yes, IF you pay it in full every month, but the people who are that disciplined over a lifetime of credit use is pitifully small. If you are one of them, I salute you!

It is so easy to fall behind, especially in the current economy, with people losing their jobs right and left. "Planning" to pay it off every month sometimes falls by the wayside if the income is lost...You know what they say about the road to hell being paved with good intentions...

It wouldn't be so bad if the credit companies were more strictly regulated, and disallowed, for example, to add fees and penalites in an amount that causes the limit to be exceeded, or prohibited from counting those fees into the balance and charging yet more interest on the fees.

Thanks so much for stopping by and adding to the discussion.

Rose Clearfield from Milwaukee, Wisconsin on December 27, 2011:

I don't think that there's anything wrong with using a credit card that you plan to pay off every month. My husband and I had zero credit when we got out of undergrad and using and paying off a credit card regularly really helped us get credit established. It is important to stay on top of things, though, and only charge what you can pay right away.

Liz Elias (author) from Oakley, CA on December 27, 2011:

@ Kangaroo_Jase--We, too, have gotten rid of every last credit card. Chopped them up into tiny pieces, we did!

Good for you on using lay-away or saving up. Although, I don't put much faith in any worthwhile interest earnings at banks--when I was a kid, I got 5% on my savings. You are lucky to get 1.5% or 2% these days!

The only time I miss having credit cards is when looking for something in a store, only to be told, "Oh, we don't carry it in the store, but you can order it online from our website." Nice. I can't shop online due to the lack of a credit card; I refuse to use my debit card online for security reasons; and not enough stores' websites accept PayPal, my only means of online shopping. So, every now and then, I find I must simply do without...and in the long run, I survive just fine without "whatever it was."

@ surelucky--Thank you very much; I'm pleased you liked the article.

As your story shows, too many people fall victim to these sneaky little plastic traps. I'm glad he was able to break free. (LOL @ in the toilet--fitting, indeed!)

surelucky from Penang, Malaysia on December 27, 2011:

Well written ^_^. How I wished my brother-in-law had a chance to read it before he got himself into endless debt repayment which still enslaving him. I advised him to convert credit card debts into term loan, but due to his poor credit rating, the bank imposed quite a high loan rate on him but it's still cheaper than that of credit card rate. I told him to cut his credit card into 2 and framed it in his toilet to remind himself what happened to him. He told me that was the best advice he ever received on credit card. LOL

Kangaroo_Jase from Melbourne, Australia on December 27, 2011:

Got rid of credit cards five years ago. This is after spending about seven years just getting rid of $4000 worth of credit card debt. Without also, spending any additional on the card.

I use lay-away or put money aside and 'save' for items now. I stopped using credit cards when I realized it is more beneficial for me to have a financial institution having my money earning interest. Rather than them giving me a plastic card using money I don't have that they own, with interest charges and fee's on top.

Liz Elias (author) from Oakley, CA on December 26, 2011:

Hello, dumindu89--Thanks very much. I'm pleased you found the article useful.

dumindu89 from Sri Lanka on December 26, 2011:

Good guide. Thanks for sharing.

Liz Elias (author) from Oakley, CA on December 26, 2011:

@ Arlene--Thanks very much for the votes! It's good that you know how to deal with these deceptive tricksters.

@ Rochelle Frank--yes, knowing how to work with the things is key, and not carrying a balance is that main master key!

You bring up an interesting point with the "points" for "free stuff." That, of course, only works for those such as yourself who do not carry a balance. For people who do, those "points" are anything but "free!"

Rochelle Frank from California Gold Country on December 26, 2011:

I love my credit card! I enjoy being able to travel and pay for almost everything and then get a statement of how much I spent where and when. I love being able to go shopping without having to write out checks or carry a wad of cash.

I also love paying it off each and every month to avoid any interest charges.

I also love that I don't pay an annual "service charge"-- because I requested the card company to remove it, by reminding them that I am a prompt payer, and I could always move to another provider without such charges.

We use two different cards, one for me, one for him. I usually pay whenever we are together-- because I get 'points' for each dollar spent, which can be redeemed for free stuff.

Never carry a balance! Don't spend more than you can afford to pay for. That's the key.

Arlene V. Poma on December 26, 2011:

Oh, MsLizzy: If I only listened to Daddy-O. "Do not use that plastic money!" he used to say. Yes, credit cards are evil. An uneccessary evil. Only a few have control over their credit cards and spending. As long as we are given "plastic money" balances to spend, we will spend it. And, we will remain in debt. Now, if the money is real--yes!!! When it's gone, it's GONE! Voted up and everything else. What I should do is wrap copies of this Hub around all my credit cards. This includes the ones that sit in my safe deposit box!

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