When it comes to personal finance, there is probably no bigger divide than the question of using cash versus credit cards. It is a polarizing topic and everyone seems to have a strong opinion.
Unlike the popular mantra, I believe that cash is not always king. In my opinion, credit cards, when used responsibly, are one of the greatest financial tools people can use.
In fact, many consumers avoid spending with cash. According to a 2017 ING International survey, about a third of people in the U.S. never or rarely carry cash. Additionally, 34% said they would go completely cashless if they could. Since the world is in transition to a cashless society, it is important to have an honest discussion about cash alternatives such as credit cards.
In the following guide, I discuss four smart reasons to use credit cards. In addition, I consider some reasons to avoid them.
Build Credit History
One important reason to use credit cards is to help build your credit history. Your ability to rent an apartment, purchase a home, purchase a car, or any other serious financial decision may be contingent on having a good credit score. The higher your credit score, the better interest rate terms you will receive from a lender. As a result, having a higher credit score can save you money down the line.
Some people assume that credit cards, even when used properly, can only hurt their credit score. However, if one considers what makes up a credit score, it is clear that avoiding credit cards and other types of debt does not help.
Credit reporting agencies calculate your credit score by using data such as your payment history, amounts owed, length of credit history, new credit, and types of credit in use.
In summary, the longer you use credit responsibly, the more predictable you are to lenders. Therefore, opening a credit card account may increase your credit score in the long-run.
Credit Card Rewards
Another reason to use credit cards is to earn rewards. Depending on the type of credit card, you can earn cash back, airline miles, hotel rewards, and many other perks.
Consumer Reports published an article that gives examples of how much cash back you can earn by using a combination of credit cards. Pretend you are a single professional that spends around $1,800 in typical monthly expenses. If you average 2.5% cash back on your purchases, you can earn $540 a year by using credit cards instead of cash. All spending habits being equal, this is free money.
Depending on a variety of factors, your cash back percentage may differ. In a future article I will discuss different strategies on how to maximize credit card rewards.
Compared to cash or debit cards, credit cards offer the most protection against fraud.
This is because a credit card is not linked to your bank account. Instead, your lender provides you with a credit limit which is the maximum you can spend in a month. After your bill comes, you pay it off and the process starts over again. This is ideal because crooks do not have access to the funds in your bank account. Instead, they are spending against your credit limit. According to the Fair Credit Billing Act of 1974, a person is only liable for up to $50 of fraudulent credit card charges.
When using a debit card, all transactions come directly and immediately from your bank account. This is not ideal for fraud protection because crooks may have access to all your bank account funds. If a fraudulent purchase takes place, you might not have access to your funds until the bank resolves the issue. This could be catastrophic for the average household. Additionally, fraud liability for debit cards is not as generous compared to credit cards. If you report your debit card stolen within two business days of learning about the theft, you may be liable for up to $50. If you report your debit card stolen more than two business days after learning about the theft but within 60 days of your account statement date, you may be liable for up to $500. If you wait more than 60 days, you have unlimited liability.
Finally, cash is great if you want your daily transactions to be anonymous. However, if a thief steals your cash, it may be gone forever.
Cash Flow Management
Credit cards can be a great tool for cash flow management as they grant users a grace period between when a statement arrives and when it must be paid. This basically amounts to an interest-free loan as you are purchasing something on credit without the requirement to pay for it immediately.
Pretend you are a freelancer with irregular income that lives paycheck to paycheck. Even if you spend within your means, some weeks might be harder to get by due to the lack of cash available at the bank. Since credit cards have a 30 day grace period, this would be a helpful tool in this circumstance. If you have no emergency savings, using a credit card may be your only option.
Additionally, credit cards for cash flow management can be useful for wealthier people as well. For example, it allows more time for money to compound and grow in a bank account.
Maintaining cash flow requires practice and discipline. If done properly, it is worth the effort.
Who Should Not Use Credit Cards
Although I am a huge proponent of credit cards, there are certain situations where cash is still king. In my opinion, if the following describes your financial habits, the benefits of credit cards do not outweigh the costs.
If you do not pay your credit card bills on time…
Not paying your bills on time can have a disastrous affect on your credit score. This is because your payment history is the largest factor that makes up your credit score.
If you carry a balance…
The average credit card interest rate is about 17%. If you do not pay it back immediately, your debt can quickly spiral out of control. No amount of credit card rewards can ever make up the difference. In addition, there can be negative effects to your credit score. Carrying too high a balance could result in a high credit utilization rate, or the percentage of your total credit limit that you are currently using, which in turn may lower your score.
If credit cards make you spend more…
Sometimes using credit cards can cause someone to think they have more money than they actually have. From a psychological standpoint, it may be easier to spend within your means if you only use cash.