Credit cards are a staple of American commerce, with consumers using them to make more than $2.2 trillion worth of purchases last year1. Cards fuel online shopping, provide an easier way to make purchases when travelling abroad, and allow you to spread payments for big-ticket purchases over time.
But that convenience has a downside: Credit cards can be the source of debt troubles that plague many households. That’s why it’s important to understand the role of credit cards in your overall financial strategy. “Credit is an important tool in your financial toolbox,” explains Stefan Ross, director of credit and debit cards at Fidelity Investments. “Using credit cards in the right way can help you build wealth, get better loan terms, and plan your future spending by providing you with greater flexibility.”
Here are seven steps to help you use credit cards safely and more effectively, so you can make the most of the benefits offered by this important financial tool:
1. Build credit wisely.
“Credit is a critical component of your personal economy,” says William “Sam” McLimans, senior vice president of cash management at Fidelity Investments. “Debt, and how you manage it, plays an important role in helping you reach the financial goals you’ve set for yourself.”
But a good rule of thumb is that your total debt payments—including mortgage, car loans, student loans, and credit card payments—shouldn’t account for more than 20% of your income. If you are near that threshold, you might need to pay down other loans or hold off on additional credit card purchases. Adding more debt than you can handle could jeopardize your long-term financial goals, such as retirement or college savings.
2. Check credit reports regularly.
Your credit information is compiled by three credit reporting agencies, TransUnion, Experian, and Equifax. Those reports form the basis of your credit score, which potential lenders use to make decisions about whether to lend to you and what interest rate to charge. “Your credit information is a record of your ability to borrow responsibly,” says McLimans. “Lenders have a risk-reward ratio they follow, and your history is the basis of their decision.”
Credit reports include the total amount you owe, whether you pay your bills on time, what types of credit you use, and how many new credit inquiries you’ve initiated. Errors in any of this information could lead to a lower credit score, which could disqualify you from more attractive interest rates—or from borrowing at all. So it’s important to review your report on an annual basis to check for errors. You can request a free copy of each of your three reports once a year at AnnualCreditReport.com. Or, for more regular monitoring, review one report from each agency every four months.
3. Manage credit well.
The most important factors on a credit report are your debt-to-income ratio and your payment history, say Ross and McLimans. So keeping your debt levels low and making on-time payments help make you more attractive to lenders.
But it’s not just negative actions—such as missing a payment or carrying a large balance—that can damage your credit. Canceling an older card or closing down an account that you don’t use much can also lower your credit score. The reason: Lenders care about your credit history, and the longer that history the better.
The ratio of available credit to the amount of credit you are currently using is another factor that affects your credit score. Closing down a little-used card will lower the amount of credit available to you without reducing the amount of credit you are using. That could skew your credit ratio and make you seem like a riskier debtor.
4. Read policy agreements.
Not all credit cards are created equal. Some charge annual fees, while others charge fees for balance transfers, cash advances, exceeding your credit limit, or other actions. To keep your fees manageable, choose a card with rates and fee structures that match your expected behavior. For instance, if you plan on carrying a balance, choose a card with the lowest interest rate you can find. If you intend to pay off the balance each month, you might look for a rewards card that carries a higher interest rate. Also, the days when only banks issued credit cards are long gone. These days, retailers, brokerage firms, travel agencies, and online retailers are just some of the institutions that issue credit cards.
To make these decisions, you’ll need to read and understand the issuer’s credit card policy agreement. Look for how and when your interest rate might increase, what actions carry fees, and how the issuer will charge for overseas transactions. If you still have questions, reach out to the issuer by phone or online. Most issuers make resources available to help explain the agreement.
5. Use cards safely.
Credit card fraud and identify theft are major risks for the modern-day consumer. Most cardholders aren’t liable for fraudulent charges on their cards, but consumers still have a responsibility to keep their information safe. “Fraud prevention works best when consumers and credit card companies work together,” says Ross.
Be proactive to reduce the risk of fraud by reviewing your credit card statements at least once a month, if not more frequently. Keep your receipts in a safe place so you can compare them with your monthly statement. Then, notify your card issuer if you spot any transactions that you don’t recognize. And, of course, report a lost or stolen card immediately.
6. Maximize rewards.
Credit card rewards—such as points toward merchandise, airline miles, or access to exclusive clubs—have become popular with consumers. But in most cases, a card that offers cash rewards provides the most flexibility. “If you are going to be spending money anyway, you might as well get cash back and build wealth from it,” says Ross.
You can use cash rewards to pay down your debt or, in some cases, have that cash automatically deposited in an IRA or savings account. That way, your credit card purchases can actually help you accomplish other financial goals. For example, cardholders who have the Fidelity® American Express® Rewards card have received a total of $635 million in rewards deposited into their eligible Fidelity accounts.2
7. Pay off balances strategically.
Thanks to the Credit CARD Act of 2009, credit card statements now show cardholders how long it will take to pay down their balance if they only make the minimum payment—not to mention how much more it will cost. Naturally, the faster you can pay off those balances, the less debt will cost you. If you can’t pay a card balance in full each month, review your budget to determine how much you can earmark for that payment without sacrificing other important long-term goals, such as saving for retirement.
Making minimum payments on one card can make sense if it’s part of a strategy to pay off higher interest rate cards first, which likely will save you money over time. And because credit cards typically charge higher rates than other forms of debt, it often makes sense to focus on reducing card debt before paying off other loans. That said, it’s important to always continue making payments on all your debt, or else your credit rating will suffer.
Remember that although we might use them like cash, credit cards are not just a tool for transactions. They’re another debt product that can have a big impact on your financial goals. Take the time to consider credit cards in the context of your overall budget, debt picture, and other financial priorities and you can better use cards to your advantage. “Be an educated consumer,” says Ross. “Figure out what makes the most sense for your situation, so credit can help you build the wealth you want.”