The paradox of credit cards

        I don't recall all the prohibitions of being a little kid placed on me by the adult world, but I'm quite sure that I heard from time to time that I shouldn't play with matches, run with scissors, or play with knives. Those are all now common sense principles, but to an inexperienced kid it wasn't quite clear the reasoning behind the prohibitions. As I became a young adult and moved far away from my family, the every day decisions I faced were less likely to inflict physical harm to me. Nonetheless, there were still some poor life management skills that could have a major negative impact on my future. One of those undeveloped skills was learning how to handle credit cards.
       There was something about being perpetually broke that made the first mailing I received from a credit card company stating that I was "pre-approved" very enticing. I'll be the first to admit I knew nothing about credit history, credit scores, or how compound interest was calculated when I received my first credit card. The only thing I knew was they were going to give me access to $500 that I could spend now even with no realistic plan on how to pay it back later. You give a broke college student access to immediate cash at a 25% APR, it's the equivalent of giving a little kid matches, sharp objects, or anything that the consequences are easily foreseeable.

       Since I was completely ignorant on how credit worked, I made the minimum payments when it was convenient. I'd take a couple months off when I was too broke to make the payment in a particular month with the plan to make 3 minimum payments all at once later. I didn't really notice that I was getting a $25 late penalty tacked on each month mainly because I moved away and forgot to tell the credit card company my new address. Eventually, the company called my number and explained to me that I needed to make a payment every month. That was news to me, but I promised them I would. Since then, I don't think I've ever missed a payment when I had a balance.
        Living within my means and avoiding debt should have been intuitive, considering my parents avoided credit card debt growing up. As legend has it, one year we took a road trip from Minnesota to Florida with the intention of going to Disney World.  If you can imagine 6 kids piled into a full-size van and arriving at the parking lot of the park only to find out that the entrance fees were way higher than expected. My parents did a quick back of the napkin calculation and realized that if we went into the park that we'd likely run out of money prior to making it back home to Minnesota. Therefore, we left the parking lot and found an alternate and much cheaper water park to visit. The Disney World entrance was not the happiest celebration on Earth at least for our family that day a long time ago.

The Paradox

         It's nearly impossible to not have at least one credit card as an adult in today's world. There are some companies that don't accept anything but credit cards as a form of payment. Try paying for a rental car with cash sometime to test my theory. Almost everybody I know has at least one credit card to their name.

         The paradox is that credit card companies' business models are ethically objectionable. They prey on the weak and the struggling. Their best case scenario is that you carry high balances at staggeringly high interest rates where you make the minimum payment month after month. If you had favorable terms in the beginning to entice you to sign up, they are waiting for signs of struggle to kick you while you are down. They do this by consistently monitoring your credit score to decrease your favorable terms at a moment's notice. I have first hand experience with this while clawing my way through several years of graduate school.

 

         Here's a scenario that could easily play out for someone with 2 credit cards with a $2K limit each. I made up this scenario, but it is based on a real life situation I had to deal with: 

          You start doing well by using each card and paying them off each month without paying interest. Then one month, you have unexpected car repairs and run up a $1,500 bill on one of the cards that will take you 5-6 months to pay off. The other credit card company (hereinafter credit card company #2) notices that your debt utilization ratio is up and your credit score has declined.
          Credit card company #2 sends you a notice that you'll be charged an annual fee of $99 and will increase your interest rate from 12.99% to 24.99% and lower your credit limit to $1K. Keep in mind that you haven't touched this credit card, but they are just sitting back and monitoring your credit to see that you are possibly in over your head. Of course, you get upset at the changes and close the account prior to the changes taking effect. (that is if you happen to notice the term changes that come to you in the mail and read through them). All of a sudden, your credit utilization goes from 37% to 75% and your credit score drops even further. You scramble to apply for another credit card, but find that you get declined based on a too high of utilization score. Your current card company smelling blood sends similar change of terms notices to make you pay an annual fee and an increased interest rate. The end result is that you pay back your $1,500 at very unfavorable terms unless you want to be without a credit card.

         The moral of the story is that dealing with credit card companies is like a chess game. They are bound by the terms of the agreement, which is unfortunately heavily skewed in their favor. Even when you think you might be taking advantage of a great offer, there are always loopholes for them to kick you while you are down. Even though they will never be able to take your first born child, they will find a way to make you pay in their best case scenario (minimum payments, high balance, high interest) if you are struggling.

        What could you have done differently in the above scenario? My advice is to have at least 3-4 cards on hand and to keep the debt utilization score below 20% on each of them. As a rule of thumb, balances should stay below a 20% level before creditors treat it as a warning sign. You should be well versed in what these companies are looking for and be detail oriented regarding the terms. If you meet the expectations of credit card companies and don't set off any warning bells of struggle, you might just get along with your creditors.

The Flip Side

         When you are on cruise control financially, credit card companies are going to great lengths to win your business especially in 2013. A person with a great credit score should be collecting the rewards of merely signing up for cards. The rewards can be miles, points, or even no interest for multiple years to carry a balance. Signing up for one card can net you a free round trip ticket to Europe without any effort by way of example.
         If you are signing up for one card, you may want to consider doing multiple applications on the same day. The credit card companies will catch on to the strategy and will decline an application on that basis, but it usually takes them a while to see what's happening. Therefore, you can get approved for multiple cards at the same time and collect all the rewards. Just don't cancel right after collecting the signup bonus as it will have a negative impact on your score. I'd wait a year to close each account that you don't have further use for.
         Your credit score is hardly affected by multiple inquiries unless your score is right on the borderline of acceptance criteria or you have a very short credit history. Inquiries over the previous 12 month period are tracked, so you get a fresh start annually. Of course, credit card companies might get antsy if they see too many inquiries wondering what you're up to. I personally wouldn't be tepid about doing 6-7 inquiries on the same day. Let them tell me that my inquiries are too many. Just because I have too many inquiries according to one company doesn't mean that all companies will respond the same way. Every company has their own acceptance criteria and warning signs to decline. If you are declined by one company, that doesn't mean another 3-4 companies might still be happy to get your business. The bottom line is that you can be fearless if you have a great credit score. You have nothing to lose unless you happen to be buying a house/car in the near future where you absolutely need a loan.  The Points Guy writes about this all the time on his blog. Even if you see the following letter, it doesn't really matter if you don't absolutely need the new credit card and were merely motivated by the signup bonus:

Conclusion

       Credit card companies only care about the terms of their agreement with you and are cold-hearted about extenuating circumstances about you not meeting your obligations. They'd like nothing more than for you than to become their average profile of making minimum payments on high interest debt. Compound interest particularly at high levels can run amok over your future plans. Be very careful about running up balances without a game plan to pay it back quickly. 

        On the other hand, there are great advantages to those who have no need for credit cards, but have them anyway. You can collect their rewards and maximize their special offers with no fear that you'll be stuck getting run over by compound interest. Turn about is fair play, so getting all the upside and none of the downside of having credit cards can be a refreshing position to be in.