Family Financial Strategies: Credit Card Use

Posted by Ben

August 13, 2009

This is a guest post by Al Jacobs, the author of OnThe MoneyTrail.com.

A running debate continues over the use of credit cards. Much of the controversy involves matters like annual fees, interest rates on the unpaid balance, and the use of an account to establish credit. Articles abound on charge strategies to secure tax deductions for otherwise nondeductible interest payments. There are even dissertations explaining how balances due on one card can be financed for prolonged periods through borrowings on another. Much of the information is of marginal value, and some is preposterous.

Here’s the straight word: The lower the annual fees and charges, the less you pay each year. Some banks and other organizations offer a card without a fee. If so, grab it. In case you cannot find a free one, shop around for the lowest price. In this regard, let me offer the philosophy of “Cheap Charlie,” a one-time Huntington Beach, California, shopkeeper who operated on the stated principal: “You can’t beat cheap” certainly words to live by. As an aside, Charlie closed up shop during an economic downturn; perhaps his prices rose too high. Nonetheless, make certain it’s not merely the first year’s fee which is waived. Also give thought as to whether the card is sufficiently usable. MasterCard and Visa are universally accepted; American Express, Diners Club, and others are of less value because fewer businesses accept them.

Does it surprise you interest rates charged on credit card balances generate dissention, resulting in litigation and legislation? This is understandable when comparing interest paid on bank savings accounts, currently at or below 2 percent, to the interest that credit cards incur, often running to 21 percent and higher. It’s true some issuers around the country offer credit card rates more in the 10 percent range, but these are the exceptions. Worst of all is what happens to those unfortunates who get tagged at the default rate, which can be triggered by any sort of contrived infraction such as exceeding an arbitrary credit limit or a single late payment. Default rates as high as 31.99% are not uncommon.

To add a second whammy, the federal Tax Reform Act of 1986 phased out tax deductibility on personal interest payments. Consider the ramifications of credit card debt at a 30% default rate on a taxpayer in the 28% federal income tax bracket, forking out an additional 7.65% in FICA withholdings as well as state income taxes (at 9.3%, if a Californian like me). This poor devil must earn $1,817 to retain $1000 after taxes to pay on the credit card. This calculates out to an effective annual interest rate of 54.5%. Such thievery would have caused Al Capone to blush.

In passing, be aware of other wrinkles. Many credit card issuers impose charges on users who avoid paying interest. They also collect fees, often retroactively, on a variety of pretexts. They rationalize these practices as necessary costs of maintaining the account, as if a reason to charge a fee is needed. Perhaps some relief is in sight. In an April 23rd radio address, President Obama called for legislation from Congress to reign in the credit card industry. He declared: “Rate hikes and late-fee traps have to end. No more fine print, no more confusing terms and conditions. We can’t tolerate profits that depend upon misleading working families. Those days are over.” What will come from all of this is uncertain. The bank and credit card lobbyists constitute a powerful interest group.

This finally gets us to the bare bones of the matter. My belief is a credit card serves a single purposea convenience when neither check nor cash is handy. Most importantly, when the monthly statement arrives, pay the full cash balance before the date interest is charged. Follow this rule and the interest rate means nothing. If for any reason you cannot regulate your credit card use in this manner, destroy your cards, swear off cold turkey, and fashion your life accordingly.

Here’s the straight word: The lower the annual fees and charges, the less you pay each year. Some banks and other organizations offer a card without a fee. If so, grab it. In case you cannot find a free one, shop around for the lowest price. In this regard, let me offer the philosophy of “Cheap Charlie,” a one-time Huntington Beach, California, shopkeeper who operated on the stated principal: “You can’t beat cheap” certainly words to live by. As an aside, Charlie closed up shop during an economic downturn; perhaps his prices rose too high. Nonetheless, make certain it’s not merely the first year’s fee which is waived. Also give thought as to whether the card is sufficiently usable. MasterCard and Visa are universally accepted; American Express, Diners Club, and others are of less value because fewer businesses accept them.

Does it surprise you interest rates charged on credit card balances generate dissention, resulting in litigation and legislation? This is understandable when comparing interest paid on bank savings accounts, currently at or below 2 percent, to the interest that credit cards incur, often running to 21 percent and higher. It’s true some issuers around the country offer credit card rates more in the 10 percent range, but these are the exceptions. Worst of all is what happens to those unfortunates who get tagged at the default rate, which can be triggered by any sort of contrived infraction such as exceeding an arbitrary credit limit or a single late payment. Default rates as high as 31.99% are not uncommon.

To add a second whammy, the federal Tax Reform Act of 1986 phased out tax deductibility on personal interest payments. Consider the ramifications of credit card debt at a 30% default rate on a taxpayer in the 28% federal income tax bracket, forking out an additional 7.65% in FICA withholdings as well as state income taxes (at 9.3%, if a Californian like me). This poor devil must earn $1,817 to retain $1000 after taxes to pay on the credit card. This calculates out to an effective annual interest rate of 54.5%. Such thievery would have caused Al Capone to blush.

In passing, be aware of other wrinkles. Many credit card issuers impose charges on users who avoid paying interest. They also collect fees, often retroactively, on a variety of pretexts. They rationalize these practices as necessary costs of maintaining the account, as if a reason to charge a fee is needed. Perhaps some relief is in sight. In an April 23rd radio address, President Obama called for legislation from Congress to reign in the credit card industry. He declared: “Rate hikes and late-fee traps have to end. No more fine print, no more confusing terms and conditions. We can’t tolerate profits that depend upon misleading working families. Those days are over.” What will come from all of this is uncertain. The bank and credit card lobbyists constitute a powerful interest group.

This finally gets us to the bare bones of the matter. My belief is a credit card serves a single purpose a convenience when neither check nor cash is handy. Most importantly, when the monthly statement arrives, pay the full cash balance before the date interest is charged. Follow this rule and the interest rate means nothing. If for any reason you cannot regulate your credit card use in this manner, destroy your cards, swear off cold turkey, and fashion your life accordingly.

Al Jacobs has been a professional investor for nearly four decades and a nationally syndicated columnist. He is the author of Nobody’s Fool: A Skeptic’s Guide to Prosperity. Subscribe to his financial column, “On the Money Trail,” at http://www.onthemoneytrail.com. Receive your free Life Stages report at http://www.onthemoneytrail.com/lifestages.html.

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Comments

Comment by Alan on August 24, 2009 @ 6:18 pm

Your article on this blog is fantastic. Well done! I’m a big fan of your blog and be sure to keep up the great work.
I plan on returning and linking to your site.

Sincerely,
Author
The Alan Haft Blog,

Comment by iberwang on September 12, 2009 @ 8:55 am

Credit cards indeed can be helpfull, but it also can be a burden if we mismanage it. So manage it well, use it wisely.

Comment by Credit Card Dude on October 4, 2009 @ 10:03 am

I run an Australian credit card site, and I agree with the majority of this article. You really need to choose a credit card that suits your needs, otherwise you’ll end up paying much more than you need too.