How do credit cards work? – A complete guide to using these to your advantage
Do you want to know how credit cards work and how to get the most out of them? You have come to the right place. This article will help you understand the ins and outs of how credit cards work and how to best use credit cards. If used appropriately, credit cards can become a beneficial asset in your financial portfolio.
Credit cards are extremely useful in making secure purchases, earning rewards and paying over time. We will first focus on fundamentals. Let us begin this journey and understand how credit cards work.
What is a credit card?
A credit card is a payment product issued by banks or other Financial Institutions, which we’ll refer to as the Lender, to individuals or businesses. They can be used to purchase goods and services on the promise to pay back the Lender. Credit cards can be used at businesses that have a contract with a network (e.g. Visa, MC, Discover, American Express) and accept the specific card as a form of payment.
How does a credit card work?
You use a credit card to make purchases up to the credit limit specified by your lender. Every month you will receive a bill, referred to as a Credit Card Statement, which will detail every charge that you made and your total balance. This balance is equal to the sum of all the charges that you made this month, plus whatever balance remained unpaid from the previous month.
Your monthly statement will also advise you of what your minimum payment due is each month. While you do not have to pay the full balance, you do need to pay the minimum amount due! If you do not pay the minimum amount due each month, your account will age, you will be charged late fees, and your Issuer may report your missed or late payment to the Credit Bureau, which will negatively impact your Credit Score.
If you pay your balance in full, the issuer will not charge any interest charges.
- Pay-in-full customers are generally known as transactors. Transactors benefit from free float, rewards, and the protection the card offers without paying interest to the lender.
- When the card balance is not paid in full, the user revolves the balance to the next cycle, hence these users are called revolvers.
The Issuer will charge interest on any unpaid balance which you revolve to the next month.
- If on a given month your Balance is $500, the Minimum Due is $50, and you choose to make a Payment of $200, then
- You will Revolve $300 (=$500 Balance – $200 Payment) and be charged interest on that Balance of $300..
- Next Month your new Balance will be equal to $300 (Starting Balance) plus the sum of all charges that you make during the month.
This interest rate that is charged on unpaid balances is initially set in the Card’s Terms and Conditions, which is the agreement between you and the Credit Card Issuer. It is also listed clearly each month on your statement. Interest rates are subject to change, due to among other reasons, missed or late payments. Therefore, make sure you check your statement each month to see what interest rate you are being charged. We will discuss interest rates in further detail later.
How to use a credit card?
It is crucial to understand how to properly use a credit card. The convenience and safety of credit cards have made them widely popular. However, if recklessly used, the same can lead to unwanted troubles. Some examples of card behaviors that are nor recommended:
- Paying only the minimum: Credit cards are great convenient tools to make large purchases, go on vacations and use for everyday expenses. However they are not the best way to borrow money, because interest rates are typically very high. It’s ok to revolve some balance once in a while, but don’t get in the habit of paying only the minimum as it will take you a long time to pay-off the balance and you will end up paying a lot in interest.
- Not paying on time: Paying on time not only helps you keep a good credit score but it also prevents you from being charged penalty fees, paying interest on your revolving balance, and will prevent your interest rate from being raised. If on one occasion you are late making a payment by a couple of days, call your lender and ask politely for them to waive the late fee.
- Having a high utilization of your credit limit: Utilization is defined as the % of your Credit Limit that you are carrying as a balance. For example, if your Credit Limit is $2000, and your balance is $1000, your Utilization = $1000/$2000 = 0.50 or 50%. Credit bureaus receive a record of your card every month and use the reported history to score your credit score. If you cards are highly utilized this could negatively impact your score (as well as late payments). It is recommended to keep the utilization below 30% of the credit limit.
- Using your Credit Card to Withdraw Cash at an ATM: While it is a useful feature to be able to do so in a pinch, the interest rate charged is usually very high, and is incurred from the day that you withdraw the cash.
- Revealing your card information to unknown parties: One of the biggest mistakes that credit card holders commit is revealing their credit card details to fraudulent callers who claim to be a representative of their lenders. You have to understand that your lender will never ask for your credit card details, and anyone who does that is a fraud.
As important as it is to know how credit cards work, it is also essential to understand and learn the proper usage of a credit card. Taking basic precautions can save you a lot of money in the long term.
Why Are The Different Interest Rates on My Credit Card?
Now that you have covered the basics on how cards work, it is time to learn about credit cards’ interest costs APR (Annual Percentage Rates). Interest is what you will be charged for the borrowed amount; however, there are various types of interest rates associated with a Credit Card.
- Purchase rate: This interest rate will be charged on your account when you make purchases using the credit card and if you have not paid the full amount.
- Money transfer rate: In addition to the balance transfer fee (next section), some cards have a balance transfer rate that is charged going forward on the balance transferred, this interest rate might be different from the purchase rate.
- Cash withdrawal rate: This interest rate is levied when you withdraw cash using your credit card. It is very important to understand that this interest rate is high and levied from the day you withdraw cash. Hence, it is advised to use this feature only for emergencies.
- Penalty rate: As stated in your Card Agreement, many lenders will charge a Penalty Rate if terms and conditions are violated usually taking the form of returned payments or late payments.
What Fees Do Credit Cards Charge?
Understanding the fees charged by credit cards is an important part of understanding how credit cards work. If you are cautious about using credit cards, you may avoid any extra fees. However, it is always better to understand these fees, just in case.
- Annual Membership fee: some Cards charge one, others don’t. Often Cards with very rich rewards will Charge a Membership Fee.
- Late payment fee: If you miss a monthly payment, this charge will be levied on your account, usually a fixed fee or a percentage on the balance.
- Cash transaction fee: Associated with cash withdrawals using your credit card, you might be subject to a charge.
- Foreign transaction fee: If you make transactions internationally or in a different currency, you will incur this charge.
- Overlimit fee: If you exceed the credit limit prescribed by your lender, this charge could be levied on your account. This is less common as many lenders will decline you before allowing you to go over the limit but be aware it might be charged.
- Balance transfer fee: A few credit cards allow the balance of other cards to be transferred. The ones which permit this feature charge the stated fee on the balances transferred.
How does the reward system work?
You will also need to know how the reward system works in credit cards. Rewards offered by credit cards fall under three distinct categories: miles, points, and cash. Miles and points can be exchanged for a variety of goods and services including gift Cards, Airline tickets, Hotel stays, Charitable giving, or even investing. The miles or travel rewards earn you free holidays and trips to beautiful destinations. The cash rewards earned by using your credit card can be utilized to reduce the balance on your credit card. Rewards make using a credit card even more worthwhile, so let us understand a bit more about them.
- Cash back rewards: These rewards are easy to use and straightforward. However, these rewards do not necessarily come in the form of hard cash. Most of the time cash back rewards will be redeemed in the form of a credit to your account.
- Points rewards: These rewards are points programs created by the Lenders that are earned by spending using your credit card. For instance, you might earn a point for every dollar worth of purchase you make or a multiplier for a specific spend category (e.g. restaurants or gas). Depending on your credit card company, you may be able to redeem these point rewards for travel, cash, and gift cards.
- Travel or miles rewards: These rewards help you earn travel miles or points that can be redeemed for airline tickets or hotel stays. The points or miles you earn can vary from company to company, and the number of miles required to purchase a flight ticket or a hotel night can vary depending on the program. So, if you are an avid traveler, you can use your everyday spend to buy a free ticket to your favorite destination.
Which Card is Best for Me?
So, what is the ideal credit card for you? The answer to this can be a personal question, and you have to conduct thorough research before choosing a credit card. A credit card that is best suited for your needs might not be for everyone. There are many factors that you have to take into account – are you looking to make a large purchase and pay the debt slowly over time? Or, are you looking to transfer the balance of your current card, which is incurring high interest rates? Are you looking for airline or hotel miles? These questions will help you choose the best possible credit card for yourself.
To get the most out of a Credit Card, get a Cash Back Card or one with Rewards that you value, try to pay the Balance in Full each month, and make sure you make your payments on time. This will allow you to reap all the benefits of using a Credit Card, reduce or eliminate high interest charges on revolving balances, and help you establish a strong Credit Score necessary for getting other Loans in the future.