There are only a few proper uses for credit. These are:
1) To buy an asset that will appreciate more than you pay in interest. Usually this is real estate but it could also be some other investment. Borrowing to buy stocks ("buying on margin") is also popular but is significantly more risky.
2) To buy something you absolutely must have but which you can't pay for with cash on hand. For a lot of people this is a car (or at least they think so). You do have to be careful. I'll talk about this later; most people are completely wrong-headed about buying cars.
3) As an emergency source of quick funds for unanticipated expenses. Needless to say, if you can anticipate an expense, you should budget for it rather than using credit. When your car hits 60,000 miles and needs a new timing belt, you shouldn't be going "OMGWTF, this is an emergency!" and whip out your credit card. You knew the car was going to eventually need a new timing belt when you bought it and should have been prepared for the expense. Still, for genuinely unpredictable expenses, having a sizable, untapped line of credit can often save the day, and if you have to pay a little interest (or even a lot) that's often the lesser of the evils available to you.
4) To get discounts on the stuff you buy. This is the most interesting one to look at from a variety of angles so I'll spend some time talking about it.
The first and most obvious way to get discounts is to use a rewards credit card. I currently have a State Farm Platinum Visa that earns a 1% rebate on everything I buy with it. You have to deposit the rebate in a State Farm banking or investment account or else pay for your State Farm insurance with it. I have State Farm auto insurance, so every nine months or a year or so I get a free month of car insurance. I went through all my monthly recurring bills and put all of 'em that took Visa onto this card, plus I use it for gas, groceries, entertainment, and whatever else I can. Plus, it's a platinum card, so I have double the warranty on anything I buy with it.
The State Farm card is pretty typical of rewards cards. Discover pioneered the practice and is still popular -- you get 1% cash back on most purchases, but each month they have a different category of purchase that earns you 5% (it's dining and entertainment this month). Or you can pick a specialty card (e.g. gas) that gives you 5% on that category and 1% on everything else. Citibank offers a card that gives you a 5% rebate on gas and groceries and 1% on everything else, and another card that offers a rebate for each mile you drive. Other popular cards offer non-cash rewards such as airline frequent-flyer miles; if you fly a lot, these can be more valuable than cash. Some cards have limits as to how much free loot you can earn each year.
There are lots of sites where you can find the best card for you, so I won't go into that here. I ended up with the State Farm card because it was easy to get (they pre-approved me) and I don't want to ding my recovering FICO score too much applying for cards from more picky lenders. As my FICO score goes up, I expect to get better rewards card offers in the future.
Another way to get a discount is to accept a no-interest loan. This isn't the way most people look at these sorts of loans, but it's true. If a lender offers you a "no interest no payments for a year" deal on a $1000 couch, then you get a couch worth $1000 in 2005 dollars. But the bank, amazingly, is willing to accept only $1000 in 2006 dollars in payment. If inflation holds steady, 2006 dollars will be worth about 3% less than your 2005 dollars. Or in other words, your $1000 couch, had you waited a year to purchase it, would cost $1030. Plus, of course, by buying it now, you get the couch a year earlier than if you'd saved up and then bought it in 2006.
If you actually have the $1000 in 2005 and could have paid for the couch with cash, you come out even further ahead, because you can invest the $1000 in the meanwhile. You shouldn't invest money you'll need in a year in stocks, but you can earn 4% on it by putting it in an EmigrantDirect savings account. So when 2006 rolls around and you have to pay off the couch, you'll have $1040 in the bank. You've saved $30 on a $1030 (in 2006 dollars) couch by buying it for $1000, and you made $40 in interest, for a total savings of $70. If you were smart, you bought the couch on a rewards credit card and saved an additional $10 on top of that.
The power of using other people's money holds true as long as the interest rate you're paying is below the inflation rate. Taking a 1.9% loan on a car is actually less expensive than paying cash.
What's required to make this work is, put simply, discipline. If you put off a $1000 loan for a year and then don't have the money to pay it all off on the due date, the bank's going to charge you the interest for the past year, and it's probably going to be 18% or more. Do this consistently and not only will you pay 18% more than you need to for your furniture, you will quickly find yourself in debt over your head. I know. It happened to me, and it took me years to dig myself out. I'm still paying for it in lowered FICO scores caused by negative remarks on my credit report.
But if you do have the necessary discipline... then you're really ahead of the game. Last month I got a Providian Platinum Visa that offered me 0% until next March and have already put more than $4000 on it. I was going to buy that stuff (including a mini Tablet PC) anyway, but now I can take the money I was going to spend on it and earn 2% in my savings account over the next six months. Alternatively, I could put my $4000 annual contribution into my Roth IRA on January 1 instead of having to wait until February or March, which, depending on how well I invest it, might well turn out to be more profitable long-term than the savings account. Another bonus? One of the things I put on the card was my flight home at Christmas -- by buying the ticket in August I was able to get a better price and a better seat than if I'd waited until October, which is what I usually do. (I only wish I'd realized I could have got an additional 2% off that ticket by buying it at Travelocity and using eBates.)
Posted by kindall at September 22, 2005 02:08 PM