How Do Credit Cards Work? The Complete Guide
As your parents always told you, establishing good credit is one of the fundamental lessons of Adulting 101. In fact, they probably advised you to apply for a credit card the moment you turned 18.
Why? Mom and Dad knew that navigating your financial future would be much easier with a good credit history. It might mean that you can readily buy a car, purchase a home, or even launch your first business when the time is right. Without a doubt, some people who use credit cards abuse them. In fact, it has been proven that going cashless at retailers that accept credit card payments tends to make us spend more. Used responsibly, however, credit cards are convenient and valuable financial tools.
Having a good understanding of how credit cards work before you get one will help you use them to your benefit. In this article, you will learn:
What credit cards are and how they work
All about payments and fees
How using credit cards builds your credit
What Is a Credit Card?
The word “credit” came to English from the Latin verb meaning “believe” or “trust.” As such, your credit card represents a contract of trust between you and its issuer. Money is loaned to you on a revolving basis to buy things because the issuer trusts you to pay it back.
The agreement that comes with your card is important because it spells out the rules by which you will need to pay your bill. If you always pay your bills on time, the issuer will see you as trustworthy, or “creditworthy.” You can be counted on to pay that money back. Conversely, if you don’t pay your bills on time, issuers will begin to see you as a credit risk. Credit card issuers use your credit report to determine whether or not extending you a line of credit is a good risk. On that report is a credit score, which changes based on your circumstances and habits.
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How to Get a Credit Card
There are several ways you can show financial institutions that issuing you a card is a reasonable risk.
Have a Job. Part-time or full-time employment will give major credit card companies reassurance that you can repay the money you spend on their card.
Try Your Bank. If you have held a checking account or savings account in good standing with a bank in the past (i.e., not overdrawn), then you will have a good chance of getting a credit card through that bank.
Try a Retail Store. Stores that issue their own credit cards are often relaxed about extending credit to people with a limited credit history.
Types of Credit Cards
You won’t have trouble finding a credit card that is a good fit for you. Here are a few of them:
A Secured Card. If you are just beginning to build your credit, you can ask your bank for a card that is secured by a deposit. If you make your payments on time, you have taken the first steps toward building a good credit history.
A Student Credit Card. Many card issuers offer starter cards for college students. Be aware that these often have high interest rates.
A Traditional Card. You should aim to include at least one of the big three in your eventual credit card arsenal: VISA, Mastercard, and American Express. These are accepted worldwide, and many of them also offer rewards schemes.
A Retail Card. If you shop at one place often, it may behoove you to get a credit card for that store. Some stores offer discounts just for their loyal card users, usually around 5%. Be careful to always pay the bill on time because these types of cards often have higher interest rates associated with them.
How Do Credit Card Payments Work?
Once per month, your credit card issuer will send you a bill, either electronically or by mail, detailing what you have spent on your card. If you pay your entire bill each month in full, there will be no charges to pay. The credit card company will still make money through credit card processing fees charged to the stores you shopped at.
You will not be required to pay your bill in full each month, but if you do, you can expect a high credit score. If you need to carry a balance, the bill will state what minimum amount you need to pay and not paying it will negatively affect your score.
What Is a Minimum Payment?
A minimum payment is set by your card issuer and can vary from month to month. This is the lowest monthly fee you must pay to stay in their good graces. It will only represent a small percentage of the total you owe, usually around 2% if you have a large balance. If you owe less than $1,000 or so, your minimum payment will probably be a flat $25.00. If you owe less than $25 on your credit card, your whole balance will be due.
The problem with paying only the minimum is that it won’t be enough to make a real dent in what you owe. If you want to avoid racking up long-term debt, you should pay more than the minimum.
Should You Keep a Credit Card Balance?
If you have heard that carrying an occasional balance is a way of building good credit, cast that myth aside right now. The best and most inexpensive way to use your credit is to pay your bills off every month in full.
What Are Credit Card Fees?
Anything you do with your card other than transacting and then paying in full will incur credit card fees. Some of the most common fees are:
Interest. If you carry debt, you will be charged an interest rate that was agreed on when you signed up for the card. Interest rates vary from card to card and from person to person and are expressed as an Annual Percentage Rate (APR) on your bill. APR is simply the percentage of interest you will be charged every year on what you owe. When divided by 365, your card’s APR yields a daily rate the issuer will charge to your monthly bill based on your average daily balance.
Balance Transfer Fees. These are special offers that allow you to transfer a balance from one card to another. They can be useful if you have debt at a high rate on one card and subsequently get another card with a lower interest rate. Balance transfer fees are usually 3–5% of your balance plus a small transaction fee.
Credit Card Cash Advance Fees. Many credit cards can be used to get cash from ATMs. Unlike debit cards, however, there are fees associated with this convenience, and they can be quite high.
Late Payment Fees. If you miss a payment, you will pay a penalty that is set forth in the fine print. These fees range from $25–35.
Foreign Transaction Fees. When you use your credit card in a foreign country, you will pay a premium to convert the local currency into U.S. dollars. Your bank imposes this charge to cover the interchange fees with foreign banks.
Annual Fees. Some credit cards have an annual use fee, ranging from $25 to hundreds of dollars depending on the perks associated with the card. There are many cards, however, that have no annual fees at all.
The Credit CARD Act of 2009 was passed to increase consumers’ awareness about the fees issuers charge and the law requires that issuers be clear when communicating them to you. Naturally, it is your responsibility to read the terms and conditions they send, and if you don’t, that’s on you.
Understanding Your Credit Card Limit
Your credit limit is the maximum amount you can charge on your card. Once you have hit that limit, you have “maxed out” the card. Generally, it is best to keep your balance below 30% of your limit.
Credit card limits are calculated individually. Yours will be set based on your income, your credit score, your debt-to-income ratio, and your credit history. Higher limits are given to people with good credit histories who can clearly afford to pay larger bills.
How to Choose the Right Credit Card for You
The key to choosing wisely when it comes to credit cards is understanding all the costs associated with them. If you were to carry a balance, what would your APR be? Does the card have an annual fee?
Also, consider the cornucopia of rewards credit cards out there and think about what perks would benefit you most. Is it travel miles? Discounts at gas stations? Or simply cash back?
The Bottom Line? You Need a Credit Card
The benefits of having credit cards far outweigh the dangers of overspending for most people. Credit cards are your first foray into the world of lending, and down the road, you will be glad you established good credit.
Want to read more about how credit cards work? Keep learning with these articles:
Credit Card Processing Fees: A Guide for Small Business Owners
Leveling Up: Why Customers Spend More at Small Businesses That Accept Credit Cards
