“Credit cards are like fire, it can transform civilization or it can kill you.”
These were the exact words muttered by my mother when I got my first credit card at the tender age of 20. I thought she was just being the typical worrying mother and brushed it off like most of her other advice.
In reality, I didn’t even want a credit card at that point in life. The only reason why I got one was that it offered two free flights vouchers to Europe so I could take a beach holiday with a plus one. Some pushy university campus sales rep from the bank somehow convinced me into applying for it and it was magically approved with a £3,000 credit limit the next day. There I was, a university student with zero income, but a piece of plastic with a £3,000 spending power.
Over the next few years, I went through several stages of a relationship with my credit card(s) that can be summarised as the metamorphosis of courtship.
1. Mutual attraction: it’s freaking free money bro!
2. Oh sh*t: what have I got myself into?
3. Age of Enlightenment: Oh, I see where this is going…
4. Symbiotic coexistence: we love each other but respect our boundaries.
Stage 1: mutual attraction
Armed with the 2 free flight tickets and a piece of £3,000 plastic in my pocket, I set sail for Spain and one of the best holidays ever, for a student. We drank, partied and had fun like there was no tomorrow. I felt exhilarated by the fact that every time I wanted to buy another drink or take a cab ride, I didn’t need to worry about whether there’s sufficient balance in my account. I would simply whip out my credit card and voila, I could have whatever I wanted.
It was an intoxicating feeling that was devoid of all financial worries and internal resistance.
In the hindsight, it was probably the closest feeling to financial independence I had felt to-date, albeit an illusionary one.
10 days and almost £1,500 later, I returned home to a statement from the bank, detailing every transaction from my holiday with a host of FX fees (didn’t even know what they were at the time). The headline figure however read:
MINIMUM PAYMENT: £87.67
I was skeptical initially so I called the bank just to confirm that £87.67 was all I needed to pay that month. After receiving an affirmation, here came the second voila moment. I could spend £1,500 and get away with paying 5% of the sum.
I love you credit card. You are my money printing press!
Stage 2: Oh sh*t!
The discovery that I could almost spend as much as I liked and still got away with paying a tiny fraction of the spent blew my mind. It was akin to the discovery of the New World where it was a land of gold and fortune. I went on a rather reckless binge and had the most amazing time during the next academic year.
I approached my credit limit several times however the sales rep from the bank, who initially approved my application was more than willing to up my limit to eventually £7,000. All the while I was making the minimum payment every month.
After about 6 months, I went back to China for a few weeks, during which I spent very little on that card. So it was a surprise when I returned back to the U.K. to discover that the credit card balance still inched up despite an almost zero-spend month. It was at that point when the calculation led me to the discovery that even if I spent nothing, it would take me 29 years to clear the debt if I only made the minimum payment every month. The total amount I paid out would be more than 150% of the total outstanding balance
I felt as if a bomb had landed next to me.
Stage 3: Age of Credit Enlightenment
The first thing I did was to lock away that credit card to ensure that I spent on it no more.
I then devoted the next 2 days doing nothing but to read up on the terms and conditions of the credit card and it’s intricate mechanism. I wished there was a clear and simple guide to help me but unfortunately, there wasn’t so it was a rather painstaking research process.
Fortunately, I emerged 2 days later with my brain slightly frazzled but my financial kind enlightened.
I realized what a fool I had been in making so little payment on my credit card debt. It soon became apparent that the business model of credit card companies isn’t to lend a helping hand but to ensure consumers are stuck in perpetual “just about managing” debt levels using the following technique:
- An enticing initial offer: like the free flight tickets in my case, companies might offer strong incentives (such as interest-free periods, initial cash back, gifts and rewards) in order to get customers through the door. This forms part of their customer acquisition cost.
- Encourage spending: this is done through a variety of tactics like automatically increasing your credit limit, regularly pushing through sales offers and sometimes extending your interest-free period. The purpose of this is to encourage you to load up on your card as much and as frequently as possible (so it can earn transaction fees for every purchase you make).
- Discourage payment: the interest of borrowers (consumers) and lenders (credit card companies) are inherently conflicting. Borrowers want to pay as little interest as possible. Lenders want to charge as much interest as possible without placing their lending capital at risk (of default). So they introduced the Minimum Payment model.
Minimum payment = Interest accrued during the month + A fixed % of the outstanding capital
A credit card is essentially a lending contract and the interest accrued is what determines the profitability of the lender. For obvious reasons that’s why the APR is always in double digits and that’s also why lenders want that portion to be paid first (it falls straight into the revenue line on the P&L statement).
The outstanding capital is the initial amount borrowed. It sits under the asset section of the balance sheet (i.e. amount owed to the lender to be received in the future). It is not a direct indicator of the profitability of the business but instead a determinant of its future profitability. This is due to the fact that the greater the balance, the longer the repayment period and the higher the interest it can charge.
Over the years, lenders have worked out a number that can:
– Maximises the repayment time horizon
– Minimises the probability of default (borrower unable to repay, leading to debt write off and loss)
This number is around 1-5% of the outstanding capital. It essentially means that you are only chipping away a tiny proportion of your original loan amount, whilst incurring interest on the outstanding balance, every month.
What’s even scarier is that interest accrued in one month that’s not paid off will be added onto the capital amount during the next month, starting to accumulate interest on itself. So we get into this vicious cycle of interest-earning-interest-earning-interest. This phenomenon is called compounding and Einstein described it as the Eighth Wonder of the World.
Thanks to My Journey To Millions for illustrating the horror of making Minimum Payment only every month.
Stage 4: Symbiotic coexistence
Staring myself in the mirror in absolute terror at the financial mistake I had just made, I vowed to make a change.
My mother’s words of wisdom rang louder than ever before. Using a credit card is like playing with fire. Use it wisely and it will transform your life to smooth out your finance. Playing with it recklessly will ensure a rapid burn, literally and figuratively.
Nowadays I only have 2 credit cards instead of 6 at my peak.
- I use one of them exclusively for buying my train tickets and enjoy the 31-month interest-free offer.
- I use the other for my daily expenses and travel bookings because purchases made on credit cards enjoy the highest level of consumer protection than any other means of payment. This is due to a combination of consumer legislation and credit company offering perks such as free travel insurances etc. I once received a £3,000 refund for a canceled holiday.
- I always pay off the balance in full every month to avoid interest charges
My credit card journey has been one of costly financial mistakes, dawning discoveries and transformation. Credit cards are double-edged swords and it is how you use them that will make the difference between a financially trouble-free life and one of debt slavery.
Do you have a credit card? Have you had an interesting relationship with it? I’d love to hear more about it. Please comment away.