Credit Card News: Your Money

What common item do many people carry with them but not know how to use? More specifically, they know how to use them, but they don’t understand how they really work. Here’s a hint: they’re made of plastic and you probably have one in your wallet right now.

It might comes as a surprise that the majority of Americans don’t really know how credit cards work. But a study from Dartmouth College and Harvard Business School showed that only one-third of consumers understand how interest is compounded and other basics relating to the use of credit cards.

Called “debt illiteracy,” this issue was found to be more common among women, older folks, minorities, and people who were divorced or separated. However, those were not the only demographics that suffered from misunderstanding they way credit cards work. Debt illiteracy was directly connected to the financial experiences people have had. The survey identified four distinct credit card personalities: those who pay in full each month, those who borrow and save, those who pay fees, and “alternative” users.

Lack of financial know-how leads to greater debt

The survey, called “Debt Literacy, Financial Experiences, and Overindebtedness,” was conducted jointly by researchers from Dartmouth and Harvard. They asked respondents questions to asses their knowledge about financial concepts, as well as questions about their particular experiences with borrowing, investing, and other financial activities. People’s levels of debt were self-reported.

In general, folks who owed a lot of money also tended to pay higher fees and interest rates, and had lower levels of financial literacy. The study likewise found that people with higher debt literacy had lower debt loads and paid fewer fees.

The study’s authors questioned whether people who have higher credit card debt also lack financial knowledge, and designed a set a questions to judge folks’ ability to understand simple principles around contracts, interest rates, and financial decision-making.

Consumers who have a better understanding of how their credit cards work are generally better able to avoid fees, such as late fees, overlimit fees, penalty fees, and cash advance fees.

They may also look for credit cards with lower interest rates, balance transfer deals that allow them to pay off debt more quickly and pay less interest, and promotional offers that let them make purchases with no interest for a period of time.

Understanding how those cards in your wallet work is the first step to financial freedom. Credit cards are an important tool for any consumer, as long as they are used wisely.