Rule #1: Don’t spend more than you earn.

It goes without saying that spending more than you earn is unsustainable, and a detrimental trap to any future financial goals you may have. This has a lot to do with the way most Americans borrow money. We already touched on the mortgage as the biggest and most important debt that someone will take on during their life. That is still true. This debt is being used to secure housing, and is therefore collateralized by the asset (in this case, the house). But what if you’re in a situation where you don’t have cash on hand and need to pump gas, buy groceries or pay the electricity bill? This is where a credit card comes in handy. But sometimes this can also be detrimental to a person’s finances.

Besides mortgages, most people access debt through a credit card. A credit card is simply a card linked to money belonging to a financial institution, usually a bank, or one of the independent credit providers, American Express or Discover Financial. They then set a limit on your card, the maximum amount you can spend. If used carefully, a credit card is an extremely useful tool. Oftentimes, though, this isn’t properly executed. This money is not free, and the credit card issuer will inevitably come knocking. They let you spend their money and in turn, must be rewarded in the form of interest. Credit card debt carries one of the highest interest percentages of borrowing. It is not uncommon for desperate business owners to take out credit cards in their own names to build and invest in their companies when no other options are available. This process is known as bootstrapping. Bootstrapping is risky for the same reason excessive use of credit cards to finance your personal expenses is risky – the interest you will have to pay back generally falls between 10-25% annually. If you think about it, that number is actually quite crazy. Credit card debt is the exact opposite of owning an asset. Over time, you will owe more and more. To the credit card issuer, however, you are an asset. If they can loan you $10,000 and earn a 10% APY, your account is growing and making them money – in the same way as a stock, bond, or real estate investment.

The average American credit card balance stands at $6,006 – more than the maximum allowed contribution to a Roth IRA investment account annually.^[1] Most people thus have more in debt than the allowable contribution to their retirement for any given year. This debt works against your other assets, as it negatively returns the amount of your APR, which is always in the double digits. Picture a game of tug of war between your investments and your credit card debt, oscillating back and forth based on the money you put to work on either side. You could also picture your investment as a race car, speeding up on a long straightaway, with credit card debt being the parachute tugging behind, preventing it from reaching top speed. Any way you approach it, it is detrimental to your financial success. Got it? Got it.

Recently, in my practice, I met with a new client who had saved a fair amount of money. Although wary of the stock market, he decided that he was ready to start making investments. We sat down, and as I got to know him, I worked through my standard financial profile questions. I asked about his income and expenses, and if he had planned any large upcoming purchases that might impede his investment ambition. I was excited – this client looked like a great fit given his spending, income, and savings. Lastly, however, I got to the question of debt. I knew they weren’t a homeowner, so credit card or student loan debt would be the only result. He indicated to me that he had some credit card debt, so I asked if I could see a statement. He obliged, and I took a close look. Quickly, I realized that I might not be able to help him with investing just yet. I found that the credit debt roughly equaled the amount of savings put aside for investment. I scrolled to the bottom of the statement and looked at the APR rate for the debt. It was 17%. I turned to the prospective client as calmly as I could and proceeded to explain that it was my best financial advice (and part of my fiduciary duty) that he should use all of his savings to eliminate his credit card debt and wait to begin investing. I explained that even if we were to kill it in the markets, a 17% a year return would be incredibly hard to come by. He could immediately achieve that return for himself by simply paying off the credit card debt and starting anew. This was not what the client may have wanted to hear, but it was the correct advice. I strongly encourage you all to eliminate all credit card debt as soon as possible. Earn yourself that immediate return and release the stress of your debt.

It’s not all bad news, however. Now, we will move into the possible benefits of appropriate credit card usage. First, credit cards should only be used to make purchases that you can afford to pay off right away. The credit card companies give you a month in total to pay your debts before interest begins to occur. If you are able to successfully pay for your gas to be filled up on your credit card and pay the entire amount from your checking account in that first month, that would be a very appropriate use of the card. It will also earn you rewards or cash back, some nice perks that are provided to credit card holders to entice them into getting the card. Secondly, this will show the company that you pay your debts back consistently and in full, which will help you establish good credit with the credit bureaus who give you your credit scores. Banks and financial companies contract credit bureaus to analyze your transaction histories, providing you and the company with your credit score. This credit score amalgamates your risk into a clear actionable number to be used in decision-making regarding any money you look to borrow now and in the future. We will touch on credit score in the next section.

The problem is that many people do not use their credit cards appropriately. While the benefits I may have outlined seem pretty clear and easy to accomplish, it becomes much more difficult when you see some shoes you want or want to eat out because you dread doing the dishes. It is an easy trap. We, as humans, have an awful tendency to be impatient when it comes to money and an innate tendency towards convenience. Thus by nature, we aren’t good savers, thoughtful spenders, or patient investors. You have to practice this, and I bet it will take an unfortunate use of your credit balance for you to realize that you need to be more careful in the future. This is how I learned. Only use the credit card for what you already have the money for. If this is tough for you, consider using the debit card as your primary means of transaction. Don’t spend more than you earn.