All too often, credit cards are given a bad reputation. You might have heard a friend or family member say that opening a credit card was one of the worst financial decisions they made.
Don’t get me wrong, irresponsibly using a credit card or racking up a balance without properly understanding your interest terms is an awful idea that can land you in a lot of financial trouble. When used properly, though, credit cards can be a powerful wealth-building tool.
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By leveraging interest-free periods, choosing cards that reward your spending habits, and always paying balances in full, you can improve your financial health, grow your credit profile, and create new opportunities for yourself.
How credit cards can help build wealth
Last month, I wrote a column debunking some of the most common credit score myths. One of these myths was that credit cards are inherently bad.
But when used properly, credit cards can help your financial standing. Here are some of the ways:
1. Regular payments can improve your credit score
Making on-time bill payments is one of the top factors that affect your overall credit score, according to Equifax.
When you make your payments on time (ideally early), your credit card company will report the timely payment to both of Canada’s major credit bureaus -- TransUnion and Equifax. The greater your history of timely payments, the more your credit score will increase as well as your overall credit profile.
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You see, having a good credit score often isn’t enough. This is why first-time car buyers often have trouble getting approved for an auto loan, even with a good score. They simply don’t have a long enough payment history on their credit profile.
Opening a credit card, and regularly paying off your monthly balance is an excellent way to build a positive payment history, making it easier to get approved for loans in the future. This shows potential lenders that you’re the type of person who pays their bills on time, every time.
2. Credit cards can diversify your credit
Another major factor that contributes to your credit score is your credit diversity. There are multiple types of credit that you can apply for, including:
- Credit cards (or “revolving credit”)
- Personal loans
- Auto loans
- Mortgage loans
- Student loans
While it may seem somewhat counterintuitive, diversifying your lines of credit actually improves your credit score. This shows that you’re financially responsible and can manage different types of loans/credit while still making all of your payments on time.
3. Maximizing your credit card rewards
No matter how you spend your money, there’s a rewards credit card out there that will help you earn extra cash back and rewards for it.
Some cards offer a simple cash back rewards system, such as 2 to 4 per cent cash back on certain spending categories, while others run off of a points system, where you can redeem points for experiences such as an all-inclusive vacation.
If you fly frequently, an air miles card can get you cash back whenever you use it to pay for travel expenses. If you dine out frequently or spend a lot at the gas pump, a dining rewards or fuel rewards card can help you save there as well.
4. Exclusive cardholder benefits
Once you get access to some of the more prestigious credit cards out there, you’ll be able to take advantage of special perks offered to cardholders. For example, some airlines' rewards cards offer complimentary access to fancy members-only airport lounges, priority boarding and free baggage checks.
Disclaimer: don’t let your credit cards use you
I don’t want this post to be misunderstood as a blanket statement that everybody should get a credit card and start spending with it.
Before signing up for any credit card, I recommend taking the time to understand how your credit score and report are created, as well as how credit cards and credit card interest works.
One of the most common pitfalls that many first-time credit card users fall into is racking up a high balance and then only making their minimum monthly payments. Often, these minimum payments only cover your interest payments, leaving an outstanding principal balance that never seems to decrease.
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If you’re a first-time credit card user, I have a simple and easy rule that will help you stay out of trouble - treat your credit card like your debit card.
Your credit card shouldn’t be used to pay for things you can’t immediately afford with your debit card or current bank account balance.
Use your credit card to pay for regular budgeted purchases, such as fuel, groceries, or utility bills. Keep track of everything you spend and make sure that you pay your credit card balance off before the next billing cycle begins.
This will prevent credit card interest charges, while still allowing you to take advantage of any cashback rewards offered by your credit card. Each payment will also be reported to the credit bureaus, helping to improve your credit score and build your payment history.
It starts with a budget
The key to using a credit card responsibly and taking full advantage of all of the rewards offered by each card is to create (and stick to) a budget.
The biggest issue I see new credit card users face is spending outside of their budget, and then being unable to pay their balances off in full by the end of the month, resulting in interest charges and/or missed payments.
The best way to avoid this is to know your budget and keep track of where your money’s going.
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Christopher Liew is a CFA Charterholder and former financial advisor. He writes personal finance tips for thousands of daily Canadian readers on hisWealth Awesome website.
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