Copyright © 2008, The McGraw-Hill Companies, Inc.
10.1 Credit Cards 41910.1 Credit Cards
It’s no secret that credit cards can be useful to both businesses and individual consumers.
It’s also no secret that letting things get out of control with credit cards can be disastrous to
your financial well-being. Given these facts, it is worthwhile and important to have a solid
understanding of the mathematics involved in their use.The Basics: What Is a Credit Card Really?
Credit cards are a convenient and flexible way of paying for things with borrowed money.
Swiping your credit card through the payment machine at the gas pump may not feel like
taking out a loan, but that is what you are doing every time you pay with a credit card.
The bank (or other financial institution) that issued your card pays the gas station on your
behalf, and then you pay them back later. You are borrowing money.
People do use credit cards to buy things that they do not have the money to pay for
up front. There are, though, many other reasons to use a credit card to pay for something
beyond needing to borrow the money to pay. You might perfectly well be able to pay at the
gas station with cash, but simply choose to use a credit card because it is more convenient
to pay at the pump. Using a credit card to pay for Internet purchases is usually much easier
than paying by other means. And for some payments (such as hotel rooms and car rentals)
a credit card may avoid the need to leave a large deposit. There are other reasons to use
a credit card as well, such as “cash back” or frequent flier mile awards offered by some
card issuers. Whatever your motives may be, though, using a credit card means borrowing
money, whether that is your reason for using the card or not.
Since using a credit card means borrowing money, it also means interest. One common
complaint about credit cards is that their interest rates are often very high compared to the
rates on other loans, such as car loans or home loans. With those sorts of loans, the lender has
collateral. This means that if you do not repay the loan as promised, the lender has the right to
take the property for which you borrowed the money. With a car loan the collateral is the car;
with a mortgage or home equity loan the collateral is the house. Loans that have collateral are
called secured loans. Lenders would much rather have you pay back the loan, but if you don’t,
they at least have the ability to recover what you owe them by claiming the collateral.
Credit cards, on the other hand, are normally unsecured loans.^1 Usually, a credit card is
issued without any collateral. The only guarantee that the lender has that you will pay back
what you borrow is the fact that you promised you would when you applied for the card. If
you fail to pay back what you borrow, the lender can—and will—take steps to collect what it
is owed, but it does not have the right to seize any particular property from you as compensa-
tion. This makes the matter of collecting from someone who is unable or unwilling to pay far
more complicated. Credit card debts often wind up being settled in bankruptcy court, where
the lender typically will be able to collect only a fraction of what is actually owed.
The higher interest rates charged by credit cards are there to give the lender the oppor-
tunity to make up for these sorts of losses. This also means that applicants for credit cards
who have strong credit histories may be able to get a card with a much lower rate, since the
risk of someone with strong credit failing to pay is lower.Debit Cards: The Same Except Different
As we already mentioned, there are reasons to want to pay for something with a credit card
that have nothing to do with borrowing money. Debit cards present an alternative for those
who really don’t want to borrow. Debit cards have grown dramatically in their popularity in(^1) There are some exceptions to this. Credit cards are sometimes issued in connection with a home loan or with
some other sort of collateral. There are also secured credit cards that require you to put money on deposit to
serve as collateral for the card. These cards are not the norm, but they are sometimes used to get a lower interest
rate, because of certain tax advantages, or in cases where someone wants a card but has a credit history that is
not strong enough to qualify for an unsecured credit card.