Credit cards are financial tools that can save you money or completely ruin your finances, depending on how you use them. One of the biggest money mistakes you can make is to use credit cards without really understanding how they work.
This guide will explain the main benefits and pitfalls of credit cards. When you understand basic terms and concepts, you can avoid common mistakes and use credit cards to your advantage.
What you need to know about credit cards
- What is a credit card?
- How is interest charged on credit cards?
- What kinds of credit cards are there?
- What fees can credit card companies charge?
- What are some smart ways to use credit cards?
- How do you get a credit card?
Here are the details on six things you should know about credit cards.
What is a credit card?
A credit card is a financial product that lets you make purchases, take cash advances and transfer balances from other accounts. When you’re approved, you receive a plastic card showing your account number. The card also includes encoded data so that merchants can process transactions.
Cardholders are given a credit limit, which is the maximum balance you can accumulate on a card. Your limit is determined by the card issuer and might change based on information such as your income, credit score, and relationship with the card issuer. In general, higher credit scores and higher income enable you to qualify for a higher credit limit.
Many people use the terms “credit card” and “charge card” interchangeably, but they’re not the same.
A charge card requires you to pay off your balance in full each month. A credit card lets you carry a balance indefinitely if you make monthly minimum payments by the due date. Cards are a type of revolving debt because they typically remain open as long as you wish, without a set payoff date.
The main benefit of using credit cards is the ability to borrow money with every purchase you make and then repay it over time.
Your credit limit is the most you can borrow, and your minimum payment is the least you are supposed to pay each month.
How is interest charged on credit cards?
When you make charges on a credit card, you must pay an annual percentage rate (APR) on your unpaid balance. This interest expense, known as a finance charge, is set by your card issuer. Each card company has different terms depending on the type of card, your credit history, and the type of transactions you make.
For instance, you might be charged 12% for new purchases, 18% for balance transfers, and 28% for cash advances. If you don’t realize that it’s expensive to take a cash advance on a credit card, you could end up with a massive bill that you struggle to pay off.
When you make more than the minimum payment, the card company generally must apply the excess to your highest-interest balances first. In this scenario, that means the money would go toward reducing your cash advance balance before it would apply to your regular purchase balance.
You typically get about 25 days, known as a grace period, to pay your balance each month before interest is tacked on. If you pay it off in full, you avoid a finance charge. But, if you carry balances over from month to month, the card issuer adds interest charges.
Let’s say you charge $4,000 to a card with an 18% APR and have a minimum payment of 4%, or $160. If you pay only the minimum each month, it would take you almost 11 years to eliminate the balance. That’s why it’s so important to pay as much as possible on your credit card debt every month — ideally, paying it off in full.
What kinds of credit cards are there?
A variety of credit cards are available with a variety of benefits.
Rewards credit cards come with rewards for making purchases, such as cash back or points to redeem for goods and services. Travel cards are popular, which offer points for flights, hotel stays, and car rentals.
The downside is that rewards cards charge relatively high interest rates. If you don’t pay off your balance in full each month, the interest could more than offset the benefits. So, these cards are ideal for the most responsible credit card users.
Student credit cards help young people build credit. However, for anyone under age 21, card companies require an approved adult co-signer or proof of income.
Many student cards offer benefits such as cash back rewards. But the downside is that they charge high interest rates. A naïve or irresponsible student could easily rack up debt that he or she can’t pay off.
Balance transfer credit cards offer a low-interest or no-interest promotional period if you move an existing balance to the card. A typical promotion might last 3-18 months.
You can transfer higher-interest debt, such as credit card or auto loan debt, and save a substantial amount of interest. The amount you can transfer depends on the credit limit you’re offered. Note that there’s usually a transfer fee (around 2% to 5%) for each balance that you switch to another card.
Once the promotional rate ends, the card issuer usually charges a much higher interest rate. That means doing a transfer is a good strategy if you can pay off the balance in full before the promotion ends.
Secured credit cards require an upfront deposit, which normally becomes your credit limit and also can be tapped if you miss a payment. The deposit amount depends on the card issuer, but it could range from $100 to $5,000.
Secured cards are a good option for riskier borrowers who might not qualify for a regular “unsecured” card. Choosing one that reports your payment history to at least one of the major credit bureaus can help you build credit.
What fees can credit cards charge?
Besides charging interest, credit card issuers make money in a number of ways. All financing charges and fees must be disclosed in the card’s application and online. Read the fine print carefully, as charges and fees vary based on the issuer and the type of card.
Annual card fees are charged by some issuers for simply letting you have a card. They might range from $50 to $500. These annual fees might be worthwhile if you use rewards that are worth more than the fee.
Balance transfer fees apply when you use a card to pay off another debt. They typically range from 2% to 5%.
Cash advance fees come into play when you borrow from your credit line by making a cash withdrawal (instead of making regular purchases).
Foreign transaction fees apply to many cards when you make purchases outside your home country.
Late payment fees can be as high as $27 for your first missed payment. However, these fees can be even higher if you miss several payments within a six-month period.
When you authorize your card company to approve transactions that exceed your credit limit, over-limit fees apply. The issuer will process the charges but also penalize you as much as 29.99%. Otherwise, a transaction that would exceed your credit limit is rejected.
What are some smart ways to use credit cards?
Even with all the potential credit card fees, you can avoid them by paying off a balance before the due date. Also, making on-time payments (either a minimum or full amount) is an easy way to build credit.
A card issuer typically reports each monthly payment you make to at least one of the three major credit bureaus (Equifax, Experian, and TransUnion). Developing a good payment history is the most important factor in determining your credit score; a solid payment history demonstrates that you manage credit responsibly.
When used wisely, credit cards can provide many benefits, such as:
- Building credit.
- Earning rewards.
- Shopping online or over the phone.
- Getting built-in insurance for products or travel-related services.
- Being protected by maximum liability of $50 for a stolen card or unauthorized charges.
How do you get a credit card?
Getting a credit card is as easy as completing an online application. A card issuer typically asks questions to verify your identity, such as your name, address and Social Security number. Plus, you’ll need to provide proof of your annual income.
Focus on applying for a secured card to improve your credit, if you can’t get approved for a regular card.
If you successfully manage a secured card for several months, the issuer might automatically qualify you for a regular card.
Another option: Become an authorized user on someone else’s card. This lets you use the card without being legally responsible for the debt. In some cases, if the account history is reported to at least one of the credit bureaus, being an authorized user helps build credit. Just be sure the card owner makes payments on time; otherwise, negative information on your credit reports, such as late payments, could hurt you.
Remember that credit cards come with different interest rates, fees and benefits. It’s important to shop around and choose one that matches the types of purchases you make and the rewards you will actually use.