The Credit Card Basics You Need to Know
Credit cards can be a useful financial tool if you understand how they work. However, it’s easy to spend more than you can repay. Let’s dive into how credit cards work so you can learn how to responsibly use them.
What is a Credit Card?
A credit card is a way you can borrow money to make purchases. Essentially, the credit card issuer is lending you money that must be paid back by a specific date. If you don’t pay it back, you will be charged interest plus any applicable penalties.
The Basics of How Credit Cards Work
Credit card companies will offer you shiny sign-up bonuses (e.g. 0% interest for 12 months), however, these incentives are often fleeting. Before you apply for a credit card, you should fully understand the basics of how a credit card works. Here are six things to keep in mind.
1. Your Credit Card Will Have a Credit Limit
Your credit card is not just a piece of plastic you can swipe to make purchases. It is attached to a credit card account. Your account will have a credit limit, which is the maximum amount you can borrow. Unlike a loan, you do not get all of this money at once. You borrow as you spend on the card.
2. Your Credit Card May Have Fees
Credit cards are notorious for two things: high-interest rates and pesky fees. Some credit cards charge an annual fee just for having the card. Virtually all credit cards charge the following fees:
- Late payment fees: penalty for not paying the specified monthly minimums.
- Cash advance fees: penalty for using your credit card to withdraw cash.
Make sure you read your credit card’s terms and conditions to gain a solid understanding of all the fees you may incur.
3. Your Credit Card Will Likely Offer Rewards
A major perk of using a credit card is the rewards. There are many types of rewards but cashback and travel rewards are two of the most common.
Cashback rewards are just as the name implies – you are rewarded a certain percentage of cash back for each qualifying purchase made on the card. Travel rewards often work on a point system. Points are earned from certain purchases and you can redeem them for travel. Keep in mind that the rewards you earn will never outweigh the penalties you incur in the event you spend more than you can pay back.
4. As You Spend, You Add to Your Credit Card Balance
Each time you make a purchase on your card, this is added to your credit card balance. It’s important to spend within your means and not rack up a credit card balance you can’t payback. This is called “carrying a balance.”
5. To Keep Your Credit Card in Good Standing, Pay at least the Minimum
Each month, your credit card company requires you to repay a minimum amount. The minimum payment is typically 3% of your total credit card balance. That’s the least amount you must pay each month to keep your credit card account in good standing. Keeping in mind, this is only a fraction of your total credit card balance. If you only make minimum credit card payments, you will quickly accumulate interest and your debt will build quickly.
For example, if you have racked up $5,000 in debt on a credit card with an 18.9% interest rate and pay the minimum payment of 3%, it would take you more than 19 years to pay it off. During that time, you would have paid the $5,000 plus another $5,300 in interest!
6. To Avoid Credit Card Debt, Pay Your Balance Off
Credit card debt is hard to get out of and the culprit is high interest. If you don’t pay off your balance in full each month, then the unpaid portion will collect interest. The interest rate you get on a credit card depends largely on your creditworthiness, but the average rates range from 15-25%.
Thankfully, the typical credit card gives you a grace period before each payment is due. The credit card will begin to charge you interest only after the payment date. To avoid paying interest altogether, always pay your credit card balance on time and in full.
Why Do Credit Cards Carry Such High-Interest Rates?
Credit cards are known for charging much higher interest rates than those charged on loans, such as mortgages. There is a simple explanation for this—risk.
For example, a mortgage is a loan given out specifically to buy a home. If you can’t or don’t make your monthly payment on your home, eventually, the bank can repossess it. This is not true for credit cards. As a result, credit card interest rates tend to be much higher because there is greater risk that the lender will never get their money back.
The Pros and Cons of Credit Cards
- You are able to make large purchases now and pay them off in installments over time
- Credit cards are more widely accepted than personal checks and are also a safer option compared to carrying cash
- They can help you build your credit score
- Credit cards commonly offer you rewards such as cash back and travel rewards
- You can quickly accumulate debt if you are not disciplined about fully paying off what you spend each month
- The convenience associated with credit cards can lead you to spending beyond your means
- If you are not careful and miss your repayments, your credit score will take a hit
- High interest rates even on small balances can compound quickly into large unmanageable debt
Debit Card vs. Credit Card: Which One is Better?
Unlike a credit card, a debit card deducts purchases directly from your bank account. You can typically only spend the money you have. This means you don’t need to worry about being charged an interest rate or a late payment penalty. However, debit cards do not help you build credit, which is important for most people’s financial futures.
Debit cards and credit cards each have a specific purpose as financial tools and which one is better for you depends on your personal circumstances. If you have the ability and discipline to only spend what you can afford to fully pay off each month, credit cards could be the better option. Otherwise, a debit card card is likely the way to go.