The truth about credit cards: myth vs reality
Aug 23 '01
The Bottom Line Credit cards may be good or bad for individual users, but many people think they are purely good for the economy as a whole. Think again.
You probably recognize yourself in one of these two scenarios:
1. Your credit card use is out of control. You spend more than you can afford, so you always carry a balance and maybe your balance is steadily increasing. You pay high interest charges. Although you get frequent flyer miles, the annual fee plus interest charges far outweigh the value of the flights you are able to take.
2. You use your credit card as a convenient way to pay for products and services instead of carrying cash or writing checks. You have a no-fee card, and you pay off the balance every month in order to avoid interest. You even collect frequent flyer miles or get 1% cash back on your purchases.
If you're in the first category, you already know that credit cards can be a major source of financial pain. On the other hand, if you're in the second category, you probably feel virtuous and a bit smug about "taking advantage of the system."
The reality is that, regardless of the benefits of credit cards, they are far from a perfect method of payment, and they actually are a net drain on both merchants and consumers. Here are some of the myths and realities about credit cards.
Myth: The use of credit cards reduces transaction costs for merchants.
Reality: When you spend $100 on your credit card, the merchant only gets about $97 or $98 credited to his/her account: that's a 2-3 per cent cost of doing business with credit cards. The merchant also has to invest in or lease credit card processing equipment. Of course, you the customer are really paying these costs through increased prices for goods and services.
The use of debit or ATM cards is much less expensive for merchants, typically less than one-half of one per cent on a $50 purchase. Of course, the merchant must still acquire the associated equipment. In addition, the merchant's account is credited much faster when you use an ATM or debit card.
Myth: Using Credit Cards Saves Money for Consumers
Reality: Everyone realizes that credit users who don't pay off their bills every month lose tons of money through the exorbitant interest charges. If you just make the minimum payment every month, it will take about 20 years to pay off the balance even if you never spend another cent on the card.
On the other hand, people who pay their balance every month somehow feel they are getting free use of a significant amount of money. The reality is a little different. If the average "pay every month" card user actually invested the cash he/she didn't have to fork over because he/she used a credit card instead--putting it into a money market account--annual money market interest would amount to roughly $100, a surprisingly small amount, especially considering that many cards charge annual fees of $75 or more.
Myth: Rewards Like Frequent Flyer Miles and Cash Back are Free
Reality: TANSTAAFL. There ain't no such thing as a free lunch. Of course, you the consumer pay for these rewards through annual fees, interest, and higher prices at merchants who accept credit cards.
In additional, most people unrealistically overvalue their credit card "rewards." For example, they see that a flight from point A to point B normally costs $500, so they set a $500 value on the frequent flyer points used to make that flight. The reality is that airlines charge many different prices for essentially identical seats, and if they had to sell a seat in the open market rather than through a frequent flyer mile redemption, they would probably have to charge much less than the $500 price tag. Remember, frequent flyer miles are used to fill seats that would otherwise be empty.
Myth: Credit cards are vital for many industries that provide online or telephone booking and/or purchases.
Reality: The airline, rental car, hotel, online merchants would all be better off if they accepted only debit cards. Bookings and purchases can still be made over the phone or online, their accounts are credited more rapidly without the 2-3% discount, and transaction costs are very low.
Myth: Credit cards have inherently higher security and fraud protection than debit cards.
Reality: At the moment, credit cards have a greater degree of fraud protection than debit cards, but there's nothing inherent in these two methods of payment that prevents an equivalent level of protection for debit card transactions. It's just a matter of passing laws that require appropriate protections.
Myth: Credit cards are essential for building your credit history.
Reality: You can build credit history with small personal loans from your local bank or credit union or by getting a loan to buy an automobile.
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