By Richard Thomas
Overview
Debt is a standard, accepted feature of American life, and credit cards are the dominant form of unsecured credit. Credit cards, unfortunately, almost always have higher interest rates than any other form of debt a consumer is likely to encounter. On the other hand, they offer easy and open access to a line of unsecured credit that can prove quite valuable to the responsible borrower.
Disadvantage: APR is Sometimes Misleading
The main misunderstanding about credit cards also stems from their core feature: the APR. Most people think that the annual percentage rate (APR) is the actual interest charged on the outstanding balance of the account. This is not true. A credit card's APR is an estimate of what the interest rate is or will be in the near future. Given stable conditions, the APR is at best a partial reflection of the effective annual rate (EAR), but this is not always the case. Unstable conditions can cause the APR to bear little resemblance to what the EAR will be by the end of a fiscal year. For example, assuming a stable balance and all other conditions remaining the same, an APR of 12.99 percent over the course of a year's worth of compound interest is the same as an EAR of 13.79 percent. The math involved in determining these figures is complicated. The result is that planning to pay down credit card debts by regular installments is often faulty, because, in the case of a large balance, the difference of 1.5 percent can still add up to hundreds of dollars per year. This difference can make calculating a sound repayment plan difficult.
Advantage: Convenience
An advantage of credit cards is that they offer consumers a ready, open line of credit. This can provide a useful tool for individuals or families seeking to make ends meet when faced with short-term financial difficulties. That is especially the case in the United States, where there's a very low rate of personal savings.
Disadvantage: Misleading Minimum Payments
Another thing running against credit cards is the misleading minimum payment. Unlike a personal loan from a bank, where the payments are structured to gradually pay off the debt in steady installments, the minimum payment on a credit card is mostly for satisfying interest payments and does little to chip away at the principal of the debt. This is partly because of the open terms of a credit card; because a borrower can continue to add to the account balance, predicting a stable monthly payment that will eliminate the debt is impossible. If that were attempted, monthly payments could vary wildly, depending on the actual account balance. However, the larger consideration for credit card companies is maximizing the amount of interest collected from customers. For example, assume you have a credit card balance of $3,000, an interest rate of 19.9 percent and a $58 monthly payment. It will take 116 months--almost 10 years--to pay off that balance, assuming no additional use of the credit card. In the meantime, the credit card company has collected a large sum of money in interest payments.
Advantage: Favorable Balance Transfers
Balance transfers can be a good way to consolidate credit card debt, as credit card companies sometimes offer special balance transfer APRs that are more advantageous than even the most generous personal loan. Balance transfer offers of 3.9 percent for three years are uncommon, but not unheard of, and anyone who can actually get terms like that from a bank doesn't need to borrow the money. If a borrower can consolidate all or most of his debt under one lower interest rate, it will allow him to pay that debt down more quickly, because more of his payments go toward the principal and less toward interest.
Disadvantage: Usurous Interest Rates
Credit cards invariably have higher interest rates than personal loans from a bank, which are the other form of legitimate, unsecured credit. The average rate for personal loans in 2008 was 11.9 percent, and the average for credit cards was 13.9 percent. This makes a personal loan superior to credit card use for most purposes, if a personal loan can be obtained.
Expert Insight
Credit cards have their pluses and minuses. They are very useful and worth the high costs if they are treated as what they are: a convenient source for borrowing money that must be repaid in a responsible fashion. People who look at credit card use as borrowing typically avoid trouble. It is when a credit card is looked at as a source of "free money," and borrowers don't look at themselves as borrowers, that they get into trouble.
Advantages & Disadvantages of Credit Cards by about-credit-cards.org