There are numerous financial advisors running around telling people to not use credit cards. Pay off your cards and use cash only.
What most people do not realize is consumers are paying for the use of a credit card whether they even own a card. The merchant has gotten the expense of the card build into his price that everyone pays. There is no discount for paying cash at the majority of stores that accept credit cards. In fact, the discount comes from using the card and getting a rebate from the card company.
If the customer uses discipline when purchasing and pays off the card balance every month, then there is no reason not to use a credit card.
I not only believe what those "financial advisors" advocate are crap, I actually believe people SHOULD AND SHOULD ALWAYS carry a credit card and NEVER use cash except in this ONE scenario. But if they use cash all the time, they are actually not being responsible with their money. They are not using their financial assets effectively and almost wasting money away. And I will tell you why and I will illustrate what I am saying with concrete math examples.
The only difference between using cash and using credit card, is the timing of the payment. With cash, you pay right away the money gets taken out of your bank account right away and it's gone. But with credit card, you get to enjoy goods right away and pay a month later or even later if you are paying on time (more on that later). But we all know time is money in that there is $$ value on time, for each passing second or minute, a dollar not earned is a dollar lost. Where is the $$ value on time coming from?? Interest rate and compounding!! $1 today is not $1 tomorrow or one month later or one year later; it's $1 * 1+interest rate compounded timeframe later. So if you are paying cash, you are actually throwing away money when in fact it could be sitting in the bank earning interest. This concept is not as prominent today because the interest you can earn in the bank is so low but during the times when the interest rate is double digit, even just for one month, that's still money that you just threw away, GONE!!! Let me show you in math:
1: Let's say the annual rate of return on an investment is 5% just for ease of calculation. Let's say for each month, your salary is $2000. And you don't have a credit card. You pay for everything in cash. And let's say your total monthly expense is $1000 and you pay for it all in cash, so at the end of the month, your balance is:
(2000 - 1000) * (1 + 0.05/12 * 1) = $1,004.16.
2. Now everything is the same as in the previous scenario except you don't use cash, you use a credit card instead on everything, ALL expenses. And we pay off the credit card balance at the end the month when due; this is VERY IMPORTANT and this is the crux of the issue and I will illustrate why. So since we don't have to pay everything in cash right away, we get the ENTIRE $2000 salary to invest, our investment proceeds at the end of the month becomes:
2000 * (1+0.05/12 * 1) = $2,008.33
And then at the end of the month, we pay off the credit card balance of $1000 in full, so at the end of the month, our bank balance is:
2008.33 - 1000 = $1,008.47. not a lot richer but more than the $1,004.16 that we had last time when paying all in cash.
So another way to look at credit card is like you are getting an interest-free loan and you can use that loan proceeds to invest in whatever you want. You are basically borrowing to invest except the interest rate is zero!! And if you are worried about investment risk, well what kind of investment would not be able to beat ZERO borrowing interest rate? Any crappiest monthly GIC with absolutely guaranteed rate of the return would still be larger than zero?? Where can you find a loan that will charge you 0 interest rate for you to invest in whatever you want to get higher investment returns and you are refusing it?? That's WHY I say carrying cash and not using credit card is REALLY like throwing money away.
NOW having said that, I need to sate something clear. With everything to work, there is ALWAYS some conditions that need to be satisfied and credit card is no exception. In order to incur more consumer debt via credit cards and still be in sound financial situation, TWO conditions MUST be satisfied:
a) The card balance MUST be paid off IN FULL by the due date for EVERY SINGLE monthly payment cycle especially if you are NOT actively investing and just dumping your money in a savings account earning 0 interest. I will illustrate why below.
b) Your investment return rate MUST BE higher than the credit card interest rate you are paying if you REALLY want to carry a balance on your credit card.
Credit cards would only work in your favour if you satisfy the above two conditions. If you can't find yourself being able to satisfy those two conditions, then you should listen to the financial advisors to cut up your credit cards and just pay cash on everything.
Let me now illustrate why it's so important to pay off your credit card balance IN FULL each month if you are not investing, i.e. earning 0 returns on your savings:
Going back to our example, everything is still the same except your investment return is now 0% instead of 5% like in the previous examples because you are not investing anymore:
So with invest return at 0%, your balance at the end of the month is:
2000 * (1+0.00) = $2,000
You are still carrying a credit card to pay for your monthly expense of $1000 and at the end of the month, instead of paying off the entire $1000 balance, you decide to carry a balance for one more day and pay it off. An average credit card interest rate is like 19.5% annually and when you don't pay the balance in full, instead of just charging you for 1 month AFTER the payment cycle, they apply the interest on a daily basis retroactively from the first day that you have incurred the balance. And they use what's called an average daily balance. For ease of calculation, we will assume the entire $1000 expense was incurred on the first day of the billing cycle. So at the end of the month, your average daily balance is:
1000 * 30 days /30 = $1000
With your credit card interest applied daily, the daily interest assuming a 365-day period is:
0.195 / 365 = 0.000534 This is how much interest that is going to be applied everyday to your outstanding balance until you pay it off
So one day after the payment due date, your credit balance becomes:
1000 * 0.000534 * 30 = $16.02 + 1000 = $1,016.02
Assuming you are paying it off just ONE day late after the due date, this is how much you would have to pay off. Just one day after the end of month, your bank balance after two months becomes:
2000 - 1016.02 = 983.98 MUCH less than the previous two examples. And if you carry a balance every month like this, at the end of the year, you would've given 16.02 * 12 = $192.24 almost $200 to the credit card company all because you were just ONE day late in paying off the balance, making a financial loss every year. And the reason why is because your $2000 salary is NOT earning any returns anymore and is just sitting in a saving account earning 0% interest rate so there is NO time value on that $2000 now. That $2000 is no different from cash now so it's no difference whether you save that $2000 or not save that $2000 unlike the 2nd scenario above. So since everything is cash, then you need to use your credit card as cash as well; however much you spent, however you pay at the end of the month otherwise you suffer financial losses and not getting anything for it. That $16.15 interest to the credit card company did not earn you anything; you pay for it but you got nothing back!!
BUT if you REALLY want to carry balances, there is still a way. You would have to satisfy condition b) that I specified earlier is that IF and ONLY IF your investment return is high enough to cover the daily compound interest of your credit card balance, then you can carry a balance. I will illustrate below:
From your previous example, the interest incurred at the end of the month on the credit card balance was $16.02. And from the first example that we saw that even a 5% return on your salary wasn't enough to cover this interest as it only generated a return of $8.33. With that 5% return, you are still paying more than what you earn.
In order to generate a return enough to cover the interest charge incurred on the credit card balance so you are getting more at the end of month after covering your expenses, your investment has to earn a rate of return of:
2000 * (X/12 * 1) = 16.02 Solve for X: (16.02 / 2000) /1 * 12 = 0.09612 = 9.61%
So in order to carry a balance each month for just ONE day more, your investment rate of return has to be AT LEAST 9.61%, almost double of the 5% rate that we looked at earlier. So with our condition b) IF you are able to earn a rate of return of 9.61% annually at least, then you can carry balances but remember you would only be able to carry the balance for ONE MONTH and you have to pay it off and if you choose to carry the balance for longer time, then the rate of return from your investment would have to be even higher to cover the interest charges which is compounded daily from the very first day that the balance is incurred.
