May 14, 2020
As Covid-19’s financial impact spreads, a fairly predictable trend has surfaced for those struggling to pay expenses, as salary reductions or job losses mount. The rate of credit card use has increased. According to a recent report from Compare Cards, 30% of card holders are using credit cards more, due to Covid struggles.
Generally speaking, spending has fallen for households through this crisis, but not enough to offset the lost incomes. As a financial rule, most professional’s one piece of advice for most clients: Eliminate credit card debt. With an average annual interest rate of 19% (and sometimes much more), credit card debt is the villain of the financial world. It's a fair accusation in normal situations and times. I don’t subscribe to this notion that all credit card debt is bad. Just like any other debt, there’s good credit card debt and bad credit card debt. Reframing the discussion will help you gauge whether it’s truly a tool you should use.
The reality is that the longer these lockdowns continue, salaries drop, jobs are lost, the worse this financial crisis deepens. As your expenses and spending outpace your income you will have to manage this, presumably temporary, shortfall. For some, the best way to keep the lights on in your home or to ensure your business remains operational will be with a credit card. But you need to take the right approach when doing so.
Here’s a guide on how, when and why credit card debt can be a great option, in certain situations. When doing so, it requires an understanding on how to manage — and utilize — good debt.
When you lose a job, you may find yourself strapped for cash. A credit card —especially the right one — can provide you with cheap funds, as you make up for the lost cash flow.
If you find yourself in this situation, most credit cards offer interest-free grace periods of up to 50 days. This is the spread between your purchase date and your statement due date. How many days you have will depend on when in the cycle you make the purchase. This feature provides you with a free way to pay for your necessities, as long as you pay the balance in full prior to the statement due date. For fixing a short-term income issue, this can add up to a significant boost, since it gives you time to find other sources of cash flow.
Change groceries, fuel and daily expenses into credit card purchases and make sure to avoid adding extra, unnecessary items to your expense line. Short term, this can provide you access to hundreds-to-thousands of accessible funds, as you work to move forward.
It is hard for many people to imagine, partly because it’s not a suggestion you read very often, but there are cases where credit card debt is cheaper than other ways to borrow funds. This, of course, requires a calculation to determine if credit cards make sense, based on the interest rate it charges.
In order to evaluate this, first look at your credit card interest rate. Finding one that has a 9.99% rate will make it easier to carry a debt than one that demands a 31.99% interest rate, for obvious reasons. The good news? You have control over this. You select the credit card, and don’t have to sign up for the large interest one. If you plan to carry a balance, explore your options. Often you can very easily change from a rewards card with a high interest rate to a low interest credit card with no benefits, without much of a headache.
Next, look at the costs associated with setting up a new credit facility versus the ability to pull cash from the credit card periodically without having to reapply for a loan. For small business users, this is particularly important. Think of it like this. When you refinance a mortgage to carry debt at a low interest, it can make sense in theory to reduce your interest rate, but the process incurs costs. Home appraisals, legal fees or the cost of breaking your current mortgage can easily add thousands in one time expenses, which would reduce the value of a lower mortgage rate. The same goes for the credit facilities like lines of credit or term loans. You only want access to it, if it will reduce your costs.
Third, look at how long you expect to need the money. If you’re only going to carry debt for a short period of time, like a month or two, the difference in interest will not matter as much, and instead look for cards that provide easy access and lower set up costs. A card with an 18% interest rate and a 1% withdrawal fee would be superior to a 12% interest rate with 3% withdrawal fee, for example, when you only need the money for a couple months.
This concept is remarkably simple, particularly for small business owners that suddenly need a cash infusion. Credit card interest rates are expensive but if you can make more than interest costs, then they can help.
New business owners that have restricted capacity to credit often learn to utilize credit cards to increase their inventory and equipment needs to build a business faster. If you carry a balance at 18%, but use the extra capital to return 60% or 80% on the investment, then using a credit card makes sense.
You also have to keep in mind that credit card interest rates are annualized, but many small business owners feature inventory that’s sold within weeks or months (even in this economy). Looking at the math, if you make 15% on a product eight times per year by carrying credit card debt that costs 20% per year, you would make approximately 100% profit on that year’s credit card debt. There’s a lot of value in that, even if the number looks scary. Keep in mind, though, that leveraging credit card debt is a high risk. Therefore, you should require a large margin for error to pursue this tactic.
Also not every business should utilize such a strategy. You shouldn’t try untested products or risky assets when utilizing this capital-raising maneuver. But if you have a reliable income source, which you can boost through the borrowing from a credit card, then it’s potentially a smart — and very profitable — risk to take.
Sometimes life gets hard and things don’t go as planned. Credit card debt only compounds such a slide and the high interest rates can get scary quickly. No one takes on credit card debt expecting it to get out of hand but sometimes it does. We’re currently in a pandemic and making sure you can pay for housing and food is top priority. That may mean running up credit card debts in the short term as a means of survival.
When it comes to having a roof over your head and feeding your family versus protecting your credit score, the choice should be obvious. Place all necessities possible on credit cards and keep your money for rent and mortgage payments. Hopefully, the current shutdown ends soon enough that you can actively recover from your debt.
If you do run into financial problems, renegotiate with credit card companies after you begin to recover. You might have to make minimum-to-no payments until your income recovers. At that point, credit card companies will lower your interest costs, waive extra fees and, in some cases, even reduce the principal amount to less than what you actually spent in hopes of recovering some money. They will do this because with your last ditch option, bankruptcy, they have no further recourse. If worse comes to worse, you can file for bankruptcy, which would leave them unable to collect anything.
You don’t want to do this. But credit card companies really don’t want you to do it. This gives you leverage while negotiating your payback strategies.
Remember, when dealing with credit card debt, make sure to have a plan. Understand why you’re taking it on and when you expect to pay it back. You should have a vision of how to escape this debt with clear timelines.
The reason most people are so afraid of credit card debt is because they or someone they know have had unbelievably bad experiences with it. But training yourself to feel comfortable with taking on credit card debt when appropriate will open up options for you, especially if you’re a small business owner. Too many people make their lives worse off by avoiding credit card debt on principle when in fact it may benefit them or even serve as a lifeline.
There are many conversations in the financial community about what is good and bad debt. Credit cards, almost universally, land in the bad debt bin. I ask you to reframe this.
Good debt is debt that helps improve your life or financial situation. Bad debt is debt that has negative consequences long term with little or no upside to it.
Under this definition, credit card debt can fall into either category, depending on how you use it. I implore you to become comfortable in embracing the times when credit cards offer good debt.
By Timm McLean, MBA |
CEO at WLTH