Reprinted by permission of the authors, Kyle Prevost & Justin Bouchard, from More Money For Beer and Textbooks. Copyright©2013 by Young and Thrifty Publications.
If you have ever been to a post-secondary campus during the first two weeks of the fall semester, you've probably noticed the attractive displays and booths set up by credit-card distributors. Credit-card companies make oodles of money, and they can afford to hire some pretty smart people in their marketing departments. This usually results in clever little giveaways and freebies that entice impressionable young students into signing up for their product. A 2009 study found that nine out of 10 graduating university students now had at least one credit card each. Yet some financial "gurus" tell young people to avoid credit cards at all costs: "They're evil!" they shout from their mountaintops of frugality.
We don't belong in that group of "experts". Much like any other tool, a credit card has perfectly valid uses and can fill a variety of needs for a student. At the same time, abusing a credit card can absolutely wreck your finances for many, many years to come. Credit cards are not the root of all financial evil, but financial illiteracy is–and the two put together can be disastrous.
To understand fully just how credit cards can throw you off your game so quickly, it is kind of important to understand how interest, especially compound interest, works. Yes, there is some math involved here, but don't worry–we're not math guys either, so we'll keep it simple. Before we look at any numbers, it's worth taking a peek at what a wise man once said about compound interest:
"The most powerful force in the universe is compound interest."
The great thing about compound interest is that, when you start to invest, it's going to work in your favour and it will help make many of you millionaires. (Because you're going to graduate debt-free after reading this book, you'll be on the right track.) The other side of the same coin is that compound interest is just as powerful when it works against you–which is what it does when you borrow money–and it creates a negative feedback cycle that can quickly drown you in debt.
Be Afraid . . . Be Very Afraid
Just so the powers that be are satisfied, we'll illustrate the worst-case scenario that can result from irresponsible credit-card use, before we let you in on why you should get one anyway. When you borrow money on a credit card, the credit-card company charges you interest on the amount of money that you borrowed. (The amount you initially borrow is called the principal. For a refresher on the basic concept of interest, turn to page 69 and to the Glossary.) Let's look at an example, and for this you'll need to know that when you "carry a balance" you're paying back less than the full amount you owe–each month, some money you borrowed more than a month ago still hasn't been paid back. If your credit card has an annual interest rate of 19.99 per cent, and you carry a balance of $100 all year while paying back only the interest each month, you will have paid the credit card company roughly $20 in interest by the end of the year–on top of the original $100 you borrowed. When you use small amounts, like that $100, this doesn't seem so bad–but this can snowball in a hurry. Carrying $1,000 for the year will cost you $200–and we've seen a few students graduate with $5,000 or more in credit-card debt, and it was costing them $1,000 and up, every year, just to pay the interest!
Even worse problems arise when you can't even pay all your interest every month, let alone any of the principal. Most credit cards will let you pay a small monthly minimum payment, usually $10 or about three per cent of your balance, whichever one is larger. What happens at this point is that, if you can't afford to pay back at least your interest, it gets tacked on to the principal you already owed and essentially becomes part of a newer, and larger, principal. This doesn't just happen at the end of the year: it happens every month–when next month comes, the new interest you owed this month will be considered just the same as the original amount you borrowed, and they'll charge you interest on the interest too. That is what they call compound interest, and it can sink you quickly. You're paying for the privilege of borrowing money to pay for the privilege of borrowing money, to pay for the privilege of . . . you see the pattern–and it goes back as many months (or years) as it's been since you first swiped your card to buy something, and lasts until you've finally paid every penny you owe, including all the interest, and get things back down to zero.
This negative example of compound interest is one reason why Rule Number One of most personal-finance gurus is to pay off your credit-card balance every month. Indeed, although we each use our credit cards to the tune of several hundred dollars a month, we always pay the full balance. Credit-card companies hate people like us, the ones who pay their balances monthly: we get all the advantages of credit-card use without paying any interest (and interest is the main way the credit-card banks make their money).
So, who would be crazy enough to carry a balance on a credit card, you might ask? Well, according to a report released in 2011 by TD Bank, 21 per cent of Canadians made only the minimum required payments on their credit cards. And, according to a Prairie Research Associates study from 2009, 24 per cent of graduating Canadian university students reported carrying an average monthly balance of $3,440. It's probably safe to say that most of those students would not have felt comfortable walking around every month thinking "I owe my friend more than three thousand bucks–and I owed her three thousand last month, and the month before, and the month before that." But the credit-card banks don't have a personal relationship with you: they just send you a bit of paper every month, and they "kindly" tell you that this month you need to pay them not even one twentieth of the full amount you owe them–and, even though you owe them so much, they won't mind at all if you borrow some more to pay for that night on the town you so desperately "need." To put it mildly, this setup is not good news.
Here is a little frame of reference for you, as far as how interest rates work in the financial world and how quickly credit cards can mess up your life. Wall Street sharks are generally hailed as geniuses if they can turn $100 into $112 or $115 over the course of a year and maintain that rate of growth for a good while (and that's before fees and taxes chip away at the growth). That's just 12 to 15 per cent we're talking about. You can beat the sharpest minds on Wall Street by simply paying off your credit card with its 19.99 per cent annual interest rate, because that is nearly a 20 per cent return and it's after taxes are taken into consideration! This is worth repeating: do not carry a monthly balance on your credit card if you can at all help it! And, if you carry it one month, do everything you can do to get rid of it the next month.
Credit Cards Don't Kill Bank Accounts –People Do
There. Now that we've covered the personal finance basics, let's take a look at why you should ignore those gurus who think you can't handle a little piece of plastic in your wallet.
The best reason to get a credit card while you're in school is that responsibly using one will help build your credit rating. Once you graduate and set out to buy a car or a house, this little thing called a credit score will start to creep in to your life. A credit rating, as it's also called, is a three-digit number that summarizes your credit report. Your credit report is basically your report card on how well you've handled credit; it traces your history over several years, including all the ups and downs. If you've never paid a monthly bill, never opened a line of credit, and never borrowed money from any institution, your credit score will actually be worse than those of people who are in a little bit of debt but have proved themselves able to make consistent payments to get rid of the debt. This might sound strange–that a person who owes money has an easier time borrowing more money than someone who owes no money at all–but it is true nonetheless. Having a student credit card, using it rarely, and always paying off the monthly balance are a great way to show that you are responsible with credit.
If worse comes to worst, always remember that you absolutely have to make the minimum required payment on any debt that you have. If you fail to make a minimum payment, you will probably default on the debt, and your credit score could be badly hurt. Rebuilding it will take years; and, while we're sure your credit score means less than the score in the hockey game last night when you're eighteen, trust us–it will matter a whole lot more in a few years. If you ever want to be able to borrow money in your life (and you're extremely unlikely ever to be able to own a home without borrowing), it's worth taking into consideration.
When you're searching for a student credit card that's right for you, it's probably simplest to take a look at the offering of whatever bank you have a student bank account with. (If you don't even have a bank account–get one. Compared to conducting your financial life with cash and gift cards, banking saves you a ton of time, a ton of effort, and even a ton of money. It's also much safer, drastically reducing the risk that your money will disappear without your intending it.) A decent student credit card will have no annual fee (you shouldn't pay just for having a card, but some banks do charge exactly that kind of fee) and an interest rate under twenty per cent (get it as low as you can find, just in case there is a month when you don't pay your entire balance). Some student cards today even have small rewards programs, which give you a little money back, collect air miles for you, or even reward you with free tickets to movies. As long as the card doesn't have an annual fee and has a low interest rate, feel free to choose whatever rewards program fits you best.
What factors should not affect your choice of card? The fact that it is (or isn't) decorated with a cool picture or the logo of your favourite hockey team. Also, don't pick a particular card just because its marketers had the best giveaway the first week of school: the free team blanket or school T-shirt is the oldest trick in the book.
Take a quick look at the information pamphlet to see whether the student card meets our qualifications before signing on any dotted line! In the ideal world, a student credit card will make your life easier (online shopping, anyone?), allow you to build a credit rating, get you some cool rewards, and never cost you a nickel.
Finally, one last time, repeat after us: "I . . . will . . . NOT . . . carry a balance on my credit card!"
Student Lines of Credit
Since you're now all experts on that whole pesky credit-card thing and can avoid every doomsday scenario, let's take a look at the other main credit option available to students.
If you're set up with a bank or credit union under a student plan, chances are you have received promotional materials for their student lines of credit (SLOCs). Like credit cards, SLOCs can be beneficial if used properly–and can really get a student behind the debt 8-ball if they're used just to pursue "the moment" with no thought for the future. A SLOC really isn't that different in most ways from a regular line of credit, and is not in any way a student loan. Unlike a student loan, a SLOC can be used for anything a student wants: it's basically a running balance with a limit. The limits for most undergraduate student lines of credit are between $5,000 and $10,000. Both of us had SLOCs when in school, but with limits under $5,000. The interest rate on a SLOC usually ranges from prime plus 1 per cent to prime plus 3 per cent, and then floats up and down with the bank's prime rate. Take a look at our sections on repaying student loans, starting on page 79, for an explanation of interest rates, what "prime" is, and why that stuff is important. Most institutions allow students to make interest-only payments on their SLOCs until they graduate.
A student line of credit is sort of a midpoint between a student loan and carrying a credit-card balance. Student loans are really a much better option, because they do not accumulate interest until after you've finished school; even when you've finished your studies, the student loan is better because the interest on it is tax-deductible, whereas the interest on your SLOC is not. While interest-only payments on SLOCs might sound attractive at first (they usually keep the monthly costs pretty manageable), paying just the interest is not a good cycle to get into. Undergraduates carrying thousands of dollars on a SLOC, month after month, are probably locked into bad spending habits. But SLOCs are a much better option than carrying a balance on a student credit card. As we just talked about, carrying a balance on a credit card sucks in so many ways. The difference between interest-rates on a SLOC and on a credit card is huge. Right now, the interest rate is prime plus 1 per cent on some of the student lines of credit available at the major banks. Our current prime lending rate is 3 per cent, so, at the moment, the effective rate of interest is 4 per cent on a SLOC from RBC, for example. We don't think the Bank of Canada will raise interest rates much–but, next year, prime could conceivably be 4.5 per cent or 5 per cent. That's still a much better deal than your student credit card can offer. We're big fans of using a credit card for their convenience, to track spending, to get rewards, and to build a credit rating; but carrying a balance on it should be a last resort. Using any space left on your SLOC to pay off your credit-card balance is probably a good idea–as long as you are not addicted to debt and you don't just go refill your credit card to the max again!
SLOCs for Graduate Students and Dentists
It is worth noting that there are much different rules and expectations for SLOCs when you are a graduate student, specifically if you're going into certain professions, such as medicine and dentistry, that have high tuition costs but also have high expected future earnings. Most graduate-student limits range from $40,000 to $50,000, with yearly limits as well. Dental students, who have to pay for many of their tools up front in addition to high tuition rates, can usually sign on the dotted line to access up to $200,000 from a SLOC. Those studying to be lawyers, doctors, pharmacists, and optometrists also have access to much bigger loans, including all the opportunities for success (and financial nightmares) that come with such big loans. In addition to having access to higher-paying jobs (and a corresponding higher probability of paying off large loans), these future professionals are very valuable long-term consumers to banks. Think about the profits that are waiting to be made from someone who earns a $200,000 yearly salary. Such a person's investment portfolio alone probably generates massive profits for a bank, and such persons are likelier than others to take out large mortgages and conduct other big transactions with the bank. The brand loyalty that can be established early in a professional's life is worth hundreds of thousands of dollars, which is another reason why banks are willing to lend so much to students going into those fields. The value of brand loyalty also is important to remember if you're negotiating an interest rate and you're in this enviable career position.
A Good Tool in Your Tool Belt
There is little doubt that many students abuse lines of credit and student credit cards, and that access to credit of any kind can and does hurt a large portion of Canadian students. That being said, we believe that almost all students should have both credit options set up, for two main reasons. The first is to help with emergencies, when there may be a quick need for a few thousand bucks (such as when you're a commuter and your engine blows). The second reason is that student lines of credit and student credit cards are great methods for establishing a solid credit rating. Just remember to remind your less responsible friends that a student line of credit is not actually code for "Shots, shots, shots . . . EVERYBODY."
Reprinted by permission of the authors, Kyle Prevost & Justin Bouchard, from More Money For Beer and Textbooks. Copyright©2013 by Young and Thrifty Publications.