Credit or Debit?

River1Money magazine had an article in which they made the case that millennials should be using credit cards instead of debit cards.  I can certainly understand why millennials would shy away from credit cards.  Having seen many in their generation, if not themselves personally, saddled with huge amounts of student debt that seems impossible to overcome, why would they want to start accumulating debt with even higher interest rates?

Frankly, I think Generation Y is more fiscally savvy than their parents and grandparent’s generation.  Many of their elders have had millions of dollars flow through their hands over their working careers, yet are looking at entering retirement with a home mortgage that may not be repaid before they die and very little savings.  The choice to not use a credit card, opting for a debit card instead, is just another one of those smart financial things that they do.  I mean, if someone walked up to you and offered you a loan at 20% interest with huge penalties if you are late by even a day and they had the ability to change the terms at any time, would you take them up on it?  Yet that is what people do every time they sign up for a credit card.

The Money article does raise some interesting points, however, but misses some others.  Let’s look at these, starting with their points:

1.  Fraud protection is better on credit cards than debit cards. 

Their claim is that you’re limited to a $50 loss on credit cards due to fraud, where the loss on debit cards can be $500 or more.  In addition, while credit cards simply remove the fraudulent charges immediately after you report them, debit cards may take a couple of weeks to put the money back into your account.

I think in some cases they are right, but in many others, they aren’t.  Talk to your bank and ask them about fraud protection on their debit cards.  Ask what the loss you will take if there is fraud will be.  In many cases, it will be exactly the same as with credit cards – $50 per instance, and this is often waived.  Also ask them what would happen if someone came in and wiped out your account, taking your rent money.  See how long it would take to replenish.  It may actually be very fast.   Your bank wants you to use your debit card so that they can collect fees from the merchants you visit, so they are likely to have good terms.  If you don’t like the terms, maybe shop for another bank.

Also, consider having an account just for your debit card, where you put a limited amount of money in based on what you plan to spend and keep your rent money elsewhere.  This will require a bit of doing on your part since you’ll need to make sure you transfer money into the account as needed to cover charges, but there are many apps to help you.  You’ll also need to be careful of things like rental cars and hotels that may place a hold on some of the money for a period of time since that can freeze some of the money you have in the account for a few days to maybe a week or more.  If you keep a portion of your emergency fund in this account, that will cover any of these freezes.  You can expect to see fraud on your card maybe once every five years or so, based on my experience, although lately the companies have gotten a lot better of detecting fraud before any money is extracted.  Obviously a charge for gas in India probably didn’t come from me.  Because of this early detection, many fraud attempts may just require you get a new card.

2.  You need a credit card to build credit.

Personally, I’ve been very disappointed in the ability of Fair Isaac Corporation, the people who came out with the FICO credit score, to dominate the credit rating market.  While their product may be good at predicting who is a good credit risk for normal people – those who go into lots of debt and stay in it for most of their lives – it doesn’t do a good job for weird people who don’t take on debt.  Actually, the fault doesn’t really lie with Fair Isaac, but with lazy lenders who rely on a FICO score instead of doing some real research.  They want to make a decision based on one number, rather than doing the hard work of really looking at how you’ve done with money in the past.  Certainly someone who has been able to save up and pay cash for things their whole life would be a good credit risk since they’ve shown that they have discipline and are responsible when it comes to handling money.  If they have not taken out any loans, however, their FICO score would be undefined – not enough data.

Really, most of the things you’ll need a FICO score for, such as credit cards and many car loans, it is better to do without.  Home loans are a different story.  You can do without a home loan, but there is really no reason to since the interest rates are fairly low and it takes so long to save up for a home.  Good home lenders will check your credit history by hand, going through things like your work history, rent payments, and the steadiness of your income and will give you a loan without a FICO score.  Unfortunately, they can be somewhat hard to find.  Auto insurance companies have also started to use FICO scores since they find people with  bad credit tend to be bad drivers, so you pay a bit more if you have no FICO score.  Again, I wish that insurance companies would wise up and realize people who have paid cash for many years are going to be good credit risks, but apparently no one has figured that out yet.

It may be worth getting a credit card to just make things easier, but that doesn’t mean you need to go whole hog with the credit card.  Just open an account or two and put one or two things per year on it.  Keep your credit balance at zero and your credit limit fairly low – you get points off of your FICO score if you have a high credit limit since they think you may go out and run up your cards to the maximum.

3) Credit cards have rewards.

OK, this one is just wrong.  Debit cards have rewards too – you just need to find the right debit cards.  In addition, I’ll submit that the rewards are never worth it for two reasons:

  1. The amount of money you’ll spend with a credit card or a debit card will be greater than the amount you’ll spend with cash, so you’ll end up spending far more than the value of the rewards you’ll earn.  There are many studies to back this up.  Most people, with the exception of those who will spend all of the cash they have without a second thought, feel more pain when they use cash than when they use credit, so you spend less with cash than credit.  Plus, cash gives you a chance to budget – you bring $50, so you at least start to think about stopping your spending when that $50 is gone – where with a credit card, you keep spending way beyond your budget and then are surprised at the size of the bill.
  2. Eventually, you’ll mess up and be late on a payment, and at that time the penalties and interest payments you’ll pay will wipe out any rewards you’ve received.  Eventually you’ll write the check wrong, forget to put a stamp on the bill, mis-click when paying online, just be really busy and forget, or the post office will lose your payment.  Credit card companies do all that they can to make it difficult to pay so that you’ll miss a payment.

Now, here are some points that they missed about credit versus debit:

1. You can’t get into debt with a debit card.

This is the most important issue with credit cards.  With a debit card, the money is coming right out of your checking account, so you don’t end up going into debt.  With a credit card, you just swipe the card and presto, you’re in debt.  Even if you pay the card off every month, you’ll end up spending a consistent amount more than you have at the start of the month, making it difficult to stop using the credit card.  For example, if you normally have a credit card bill of $3,000 each month, you can easily get into the position where you don’t have that $3000 until just before the credit card payment is due.    If you wanted to stop using the card, you’d need to delay those purchases or save up $3,000 to pay cash during the transition.  If you had never used the credit card, you would never have gotten into this position.

2.  Credit card interest rates are really, really high compared to most other loans. 

The interest rates on credit cards are insanely high.  If the lender was almost assured of being paid back, the rate would be low.  If default was more likely, the rate would be higher.  Yet with credit cards, while there may be some low teaser rates, interest rates are still in the 12%+ range for virtually everyone.  At that rate, you’ll pay back twice the amount you borrowed in about five years.  At the 20% interest rate many people pay, you’ll pay back twice in about three years.  Rates for car loans and home loans have fallen a lot in the last five years, but credit card rates have remained high, even for people who are very good credit risks.

In biblical times, credit card interest rates would be considered usury, and might have resulted in the stoning of the issuer, because usury was considered an immoral and illegal practice since it put the lender into a situation where he could not pull himself out.  Indeed, credit cards are designed to get someone into debt and then trap them into paying interest on the cards forever.  They offer low minimum payouts where it would take 10-15 years to repay the loan.  Even more insidious is the psychological effect of seeing a minimum payment of $40 or so on a $2,000 loan.  People see that low amount and think, “Hey, that’s no problem.  I can spend more,”  and before they know it, they run up their cards to the point where they cannot pay any more than the minimum payment.  Because the interest rates are so high, you are paying almost all interest if you pay the minimum amounts.

3.  Credit cards can change their terms at any time.

Read the agreement you have with a credit card company and you’ll usually find that they can change the terms at any time, even for balances that you already have, and if you continue to use the card, you are bound by the new terms.  This means they can raise your rate up to 30% on a whim, or change how many days you have to pay back the loan before interest is charged.  They could require you bring a payment down to them in person if they wanted to.  What other agreement can be altered by one of the parties at any time?

So, credit or debit?  Credit is probably a necessary evil to build up your credit and maybe for some protection on purchases from somewhat sketchy places.  Looking for ways to limit use of credit, and to limit the use of debit cards at all to only essential purchases (ones you would make in any case) makes good fiscal sense, regardless of what the writers at Money think.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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