I was watching the ABC special UN-BROKE: What You Need to Know about Money last week (which I thought was really good, incidentally) and one of the pieces of financial advice that the host, Mellody Hobson, stresed was "you only need one credit card." While I think that is a really great message to try to get out to people, I wish she had stressed one point that I think is even more important: Pay off your balance in full each month. As a matter of fact, I think you need more than one card (and maybe more than two cards for some very specialized situations) but no matter how many you have, if you commit to paying your balance off in full every month, you will go a long way towards taking control of your financial situation.
What's so Terrible About Carrying A Balance?
Often, when people find that are in a financial hole they have difficulty getting out of, it isn't because they bought a single big purchase that went wrong. Much more often, the culprit is a series of medium or even small purchases that just added up when they weren't looking. The best way to avoid that giant hole, is to stay out of the little holes in the first place.
But what if you are already in that hole and you are carrying a balance you'd like to reduce, but you can't afford to pay off in full in one month? Well, if you are truly committed to reducing your debt, you need to first start changing your spending habits so that you are not increasing your balance each month. Get a new credit card and put your monthly charges on that card (see below on what to look for in this new card). Pay that one off in full each month. Take your old card, the one with the balance, and put it away or even cut it up. You aren't going to make any new charges on that card. You may even want to try to transfer that balance to a new account with lower interest. Balance transfer offers are not as easy to find now as they were a couple years ago, but here are a few cards that offer 0% interest on balance transfers for about a year or so (those credit cards are only available in the UK). Just make sure that you never use this card with the transferred balance for any new purchases. Not only will that defeat the purpose of your debt reduction strategy, but it may also trigger an interest rate increase on your account.
Update [2009-6-5 19:28:44 by sarahnity]: Thanks to laurel in the comments for pointing out that those balance transfer cards are British. I left the link in, in case anyone reading this in the UK needs to find a balance transfer card, but if you are in the US, you may want to look at the list on Bankrate or this really long list at CardTrak.
The only other situation where I would advise carrying a balance on a card is if you are one of the lucky few who transferred a balance and locked in a low lifetime rate back in the days when such offers were available. If you do have a card like this, be sure to carefully check your statement each month. Credit card companies are using lots of tricks to try to break these agreements. They may unexpectedly change your billing date or other terms that you may not notice until it is too late.
If I Always Pay in Full, Won't the Credit Card Companies Cancel my account?
I keep reading rumors that people believe that if they don't carry a balance, the credit card companies may look upon you as a "deadbeat" customer and cancel your account. All I can say is that I have never seen that happen to anyone I know who has been using this approach for years. Do they occasionally raise your interest rate for no reason? Yes, that does happen. But what do I care, I'm not carrying a balance. They can tell me my interest rate is 30% and I really don't care. Do they occasionally lower your credit limit? Again, yes, that does happen and it has happened to me. But again, what do I care? I have almost never charged up to my limit in one month and when I did, I just made a payment in the middle of the month to free up some credit. Have I ever had an account canceled out of the blue? The only time that has happened is on accounts that I hadn't used in years, that I was only keeping open in case of emergency. If you are keeping an account open for just such a reason, make sure to make a charge to it at least once every few months.
The argument that credit card companies don't make any money off customers who pay in full ignores one key portion of the credit card industry's business model. They collect a fee from the merchant every time the card is used. The more people out there who use their cards for every little thing, the more money they make.
What To Look For In a Credit Card?
When you are picking the one card that you will carry, you need to look for one that offers a few key features:
- Acceptability: You want to pick a card that is accepted everywhere you shop. In America, that probably means picking either a Visa or a MasterCard. American Express and Discover are also widely accepted, but there are places that these two won't be accepted when the big two are.
- No Annual Fee: There is no reason you should be paying some company for the privilege of issuing you a card. There are plenty of no-fee cards out there if you just look around.
- Good Customer Service: Unfortunately, not all banks are equal when it comes to customer service. You may want to try your local credit union first. They tend to offer pretty good service.
- Rewards Program: There are lots of different rewards programs out there. I find that cash rewards are best for me, but you may find airline miles, hotel points, or store credits are more valuable to you than cash.
- Long Grace Period: This is the period of time between when the billing period ends and the interest starts to accrue. In essence, it is the time between when you get your bill and when you have to pay it. As long as you are paying your balance off in full each period, you are getting interest free use of the bank's money from the time you make your purchase to the time you pay your bill, so the longer this period is, the better for you.
"But what about interest rates and credit limits?" I hear you ask. "Shouldn't I be looking for low rates and high limits?" No, those things really don't matter. You are going to be paying that card off in full each month and never carrying a balance, so what do you care what the interest rate is? It is never going to apply to you. Similarly, you don't need a high credit limit, because you are only going to charge as much as you can pay off at the end of each month. A high credit limit is purely academic in those situations. If you ever have a month where you need to make a bunch of big purchases that would exceed your limit, you can always make a payment in the middle of your billing cycle to reduce your balance.
FYI, I recently found a card that meets all these requirements for me: Schwab Bank Invest First Visa which earns 2% cash back on all purchases and it has the added advantage that it charges zero fees on foreign transactions. Keep in mind that even if you don't travel, you could be subject to these foreign transaction fees. Credit card companies recently started charging these fees on any transaction made in foreign currency or from a foreign vendor. If you buy something over the web, you may not even always know when you are dealing with a foreign store until you see the surcharge on your statement. If you travel overseas a lot and are looking for the best credit and ATM cards, check out this list.
When to Carry a Second Card?
Personally, I like to have a backup plan for most situations. I always carry a second credit card, in addition to my primary card, just in case there is a problem with the primary. This is particularly crucial when you are traveling away from home. It doesn't hurt to carry a second card and it may actually come in handy in rare situations. I would strongly urge that your second card be from a different issuer than your primary card. I carry a Visa and a Mastercard, for just this purpose. Just remember that you need to pay the balance off in full on both cards every single month. Also keep in mind that credit card companies are trying to reduce their outstanding accounts, and so you may want to make a charge every so often to your secondary card.
Update [2009-6-5 19:33:3 by sarahnity]: One more travel tip: carry your primary card in a separate location from your secondary. For example, put one in a money belt and one in your wallet. Or let your spouse carry one and you carry the other. If one is lost or stolen, you will hopefully still have access to the reserve. (h/t to Land of Enchantment in the comments).
There is one more situation where it makes sense to have a second card, one that you actually make charges to. If you are running your own business, you want to use a second card for your business expenses. It makes your bookkeeping so much easier and your tax preparer will thank you.