If you find credit cards intimidating and are unsure about how they work, you’re not alone. Many people are hesitant to use credit cards because of a lack of understanding.
However, once you grasp the basics, you’ll realize that they’re powerful financial tools that you can control. In fact, credit cards can be invaluable for building credit quickly.
In this comprehensive guide, we will answer seven essential questions about credit cards to help you become a responsible user and avoid common pitfalls.
What is a Credit Card?
A credit card is a plastic card issued by banks and financial institutions that allows you to make purchases and charges them to your credit card account. The card contains encoded information that corresponds to your account and enables merchants to process transactions.
What is a Credit Card Account?
Your credit card is tied to a credit account — which is a borrowing tool and a form of debt. But unlike an installment loan, a credit card is a form of revolving credit.
This means that instead of borrowing all the money at once like you do with a loan, you borrow as you spend with a credit card. Every time you make a purchase with your credit card, you are doing it with the issuer’s money, not your own.
A credit card account will have a limit. This is the maximum amount the credit card company will let you borrow on the account.
What is a Credit Card Balance?
Any transactions charged to a credit card are added to your credit card balance. This is the amount of money you’ve borrowed by charging purchases to your credit card but have yet to repay.
You add to your credit card balance every time you swipe your credit card, and you lower it every time you make a credit card payment.
However, try to limit your credit card balance to what you can repay each month in full. This is a good guideline to follow to keep your credit balance low and ensure you don’t borrow more than you can repay.
What is a Minimum Payment on a Credit Card?
The minimum payment is the amount you must pay each month to keep your credit card accounts in good standing. Your minimum payment will be due on your credit card due date each month.
A minimum payment is calculated based on your credit card balance. It is usually two to three percent of your credit card balance, or the outstanding interest you owe plus one percent of the balance. Most credit card issuers also have a flat amount that is the smallest they’ll charge on a credit card each month, typically $15 to $35.
The minimum payment on a credit card is small compared to your overall balance. It’s also recalculated each month. This means that the average credit card balance can take over a decade to repay with minimum payments alone — and you’ll pay hundreds in credit card interest during that time.
What is Credit Card Interest
Credit card interest, known as a credit card finance charge, is the cost you pay to carry a balance on your card. Your credit card’s annual percentage rate (APR) determines the interest rate at which your balance accrues. Credit card interest is calculated based on your average daily balance for the billing cycle.
If you pay off your credit card balance in full within the grace period (usually around 25 days), you won’t incur any interest. However, failing to pay the full amount will result in interest charges on the remaining balance. To avoid high-interest costs and potential debt, strive to pay off your balance in full each month.
What are Credit Card Fees?
An important part of understanding how do credit cards work is to know what your credit card is costing you.
All credit card costs, APRs, and fees will be outlined in your credit card agreement that you sign when opening a credit card. Carefully read this to ensure you understand your credit card.
Different credit cards will have their own fee schedules, and some will charge more while others will charge less ― or skip some credit card fees altogether.
The main fee you should worry about is the annual credit card fee, which you are charged each year simply for the privilege of having the credit card. Depending on your credit card, you could face an annual fee of $0 up to $500. A typical credit card fee is around $50 to $60 a year and will depend on the type of credit card you have.
Credit card companies will also charge other fees on certain transactions such as:
- Balance transfer fees. These are charged when you use one credit card to pay off the balance on another credit card.
- Cash advance fees. These are charged when you borrow from your line of credit in cash, rather than through a purchase.
- Foreign transaction fees. You pay these for purchases made outside of your domestic country.
- Late payment fees. You pay these if you make your credit card payment after your monthly due date.
What are Different Types of Credit Cards
There are various types of credit cards and some work differently than others. Here are some common types of credit cards, as well as what makes them stand out:
- Rewards credit cards give cardholders rewards for making purchases on their credit card. Rewards can be cash back, or points that can be redeemed for travel purchases or other goods.
- Secured credit cards require a deposit of cash that is used as collateral against the credit card balance. Because they are secured by the deposit, these cards are easier to qualify for. They can be a good option for consumers who want to rebuild credit.
- Charge cards require borrowers to repay their balances in full every month. So the minimum payment is always equal to the monthly charges on the charge card.
- Retail cards are credit cards that are issued by a retailer or store, rather than a credit card company or bank. These credit card accounts are with the store itself.
Conclusion
Credit cards can be powerful financial tools if used responsibly. Educate yourself on their workings and understand the intricacies of credit cards to make informed decisions. By comprehending essential concepts such as credit card accounts, balances, minimum payments, interest, fees, and different card types, you will gain the confidence to navigate the world of credit cards effectively. Use this knowledge to your advantage, benefit from credit card perks, and avoid common credit mistakes. Happy swiping!
Remember, credit cards are a means to an end, not an end in themselves. Use them wisely, and let them assist you in achieving your financial goals.
