Cash or Credit - Being savvy about the real cost of credit

Credit cards are tricky.  I love them for their points and rewards (as I described in my From Romania to Israel to Paris on points post), and there are cases in life where having a credit line is very important, but dependence on credit can become a dangerous financial trap.

I know I've been sending out all kinds of great shopping deals and sale codes, but as the voice of Classy Not Pricey it is essential that I give you an important reminder/lesson on the actual cost of items you may be purchasing on credit, even if they are sale items... on sale :).

Let's start with a scenario:
  • Classy Not Pricey sends out a great promo code for a sale at J.Crew (oh yes we did!).  
  • Terry found a sweater unlike any other.  On sale with the coupon code the total comes to $100
  • Terry plans to pay the sweater off over four months to ease the cost into the budget
  • Terry uses a credit card to buy the sweater, has no other charges on the card, and plans for the sweater to cost about $25 a month

Credit card basics:
Terry is making an incorrect assumption that there will be an even-steven cost exchange for the sweater using a credit card.  In reality, there are two key items that change what the actual cost of that sweater will be in the end.
  1. Credit card interest rates are higher than many people expect, with the average running in the range of 15% (according to yesterday's report on creditcard.com).
    • Do you know yours?  Make sure you find out, you might be surprised!
  2. Credit cards also often provide a "minimum payment" option, which rarely matches your intention of how quickly you were going to pay off a purchase.
    • Minimum payments are usually 2% of the total balance - or -1% plus interest - or a set amount (avg is around $25), whichever is higher.
We will assume Terry makes the purchase and does exactly as expected, paying $25 a month.  Over the four months with the 15% interest rate, the total interest due is $3 - not such a bad deal for having the ease of mind to pay over time (while potentially gaining some valuable points).  Total cost of the sweater = $103.

Let's make that scenario a bit more realistic:
Terry buys the sweater, already has a balance of $1,000 from other previous purchases, and pays the minimum payment each month.  If Terry stops ALL use of the credit card after purchasing the sweater and pays off the $1,100 balance with minimum payments as described above:
  • The total interest paid would be $507
  • It would take 65 months to pay off the debt
  • The TOTAL cost of those purchases worth only $1,100 would be $1,607!

   Now THAT is PRICEY!   

Seeing the interest equaling almost half of the actual cost of goods is...well...many words come to mind... not many of them very classy.  For one thing, it is a complete buzz kill on the sweater. :(  On another level, this is a very clear example of why so many people find themselves suddenly drowning in debt.  The system is not automatically set up for success for the credit card user, and the less one knows the more trouble one usually finds.

Here are a few valuable tips for staying financially savvy while using credit cards:
  1. Always ask yourself if you can afford to pay for an item with cash before making the purchase.
    • If you can't, be honest with yourself about whether the purchase is a good decision, and if so, make a plan for how to complete step number two...
  2. Pay off your credit card balance in FULL as soon as you possibly can.  Doing so on a regular basis, even daily or weekly, will help keep the balance manageable (I pay mine weekly, so it acts more like a debit card).
  3. If you can't pay the balance in full, pay as much above the minimum payment as you can pay. That will minimize the amount of interest you will pay in the end.
  4. Try to minimize how many cards you have - the more excess credit cards you have the more likely you are to lose track of payments and balances (keep in mind, I haven't even touched late payment costs!).
    • Don't be fooled!  Store-specific cards are credit cards too, and often carry outlandish rates, so resist the urge to "save 20% on your purchase today by opening a [insert store name here] card with us today".  That's one discount I will rarely promote.
Lastly, do not be discouraged, only savvy!  There are many great ways to spend wisely and keep your debt level in check (or eliminate it altogether!).  As Classy Not Pricey grows, more tips and tricks will be shared to make the MOST of whatever circumstance you are in today.

Please share your comments or additional tips/tricks that I may have missed below!
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Credits:  Payment and interest calculations are based on resources found at: http://www.creditcards.com.
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