HOW CREDIT CARDS WORK

HOW CREDIT CARDS WORK

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The concept of credit has been around for thousands of years. Merchants around the world would sell goods to farmers, with payments due after harvest seasons.

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Modern-day credit-card-like payment system was first introduced in 1950 by Diners Club. Back then, the cards were technically “charge cards” as payment had to be made in full each month.

The major banks introduced the revolving credit aspect, allowing cardholders to carry a monthly balance forward for a fee (interest) in the late 1950s.

Today, for better or worse, credit cards have become commonplace. With the rise of online shopping, they are increasingly the main form of payment accepted by most merchants. In the United States alone, the annual credit card debt now exceeds $1 trillion.

Since “paying with plastic” is an essential part of most people’s financial lives, this article will discuss credit cards and how to use them responsibly.

How credit cards work

What is a Credit Card?

Credit cards are short-term loans issued by banks or financial services companies.

When you purchase something on a credit card, the card issuer pays the merchant on your behalf and bills you later. You are then obliged to pay back the issuer for the cost of items or services purchased, plus any interest or fees assessed.  

What is a credit card?

 

Credit cards vs. Debit cards

Debit cards draw on money you have deposited in a bank account, and they do not build credit.

On the other hand, credit cards are a type of revolving credit that can build your credit if used wisely.

 Credit Card Terminology

Credit limit

A credit limit is the maximum amount that an issuer will allow you to borrow on a credit card. Your credit score typically determines your credit limit.

The higher your credit score, the more comfortable issuers will be to extend you more credit.

Your income could also influence your credit limit. Even with a perfect credit score, issuers will not allow you to borrow an amount that exceeds your income.

Balance

Your balance is the amount that remains unpaid on a credit card. Making a payment reduces your balance while making purchases increases your balance.

Available credit

Available credit is the amount that is still available to use before hitting your credit limit.

For example, if your credit limit is $1,000 and you have spent $300 on your credit card, your available credit will be $700 ($1,000 minus $300).

Billing cycle

The billing cycle (or billing period) is the set period for you to purchase your credit card. It is typically between 28 and 31 days.

Two main things happen when your billing cycle ends (also known as your statement closing date):

  • The issuer sends you a bill
  • A report is issued to credit bureaus with your balance

TIP: To maintain a low credit utilization, always make your payments before the billing cycle closes.

In this way, a minimum balance is reported to the credit bureaus and, thus, improves your credit score.

Statement due date

Statement due date is when you have to make (at least) a minimum payment on any outstanding credit card balances.

It is typically 21 days after your billing cycle ends to give you time to arrange payment.

The time between the billing cycle end date and your statement due date is called a grace period. Credit card companies will not charge you interest during this time.

Note: A grace period only applies to new purchases. There is no grace period for cash advances or balance transfers.

Terminology

Minimum payment

A minimum payment is the amount you are required to pay on your card balance each month. This amount is typically a small percentage of the total outstanding balance.

It may be tempting only to make the minimum payment. However, carrying a credit card balance means paying high-interest later.

TIP: As much as possible, only spend on credit what you can afford to pay off in full each month.

Annual Percentage Rate (APR)

APR is the annual rate of interest you pay on any outstanding credit card balances beyond the grace period.

Your credit score determines your APR. The higher your credit score, the lower your APR and vice versa.

You may have various APRs applicable to your account. The most common type is the purchase APR, which is the interest rate applied on regular purchases.

Other types of APRs may include:

  • Introductory APR: A promotional rate applied temporarily after opening a new card. After a few months, the issuer will use your regular APR for any outstanding balances.

  • Balance Transfer APR: A promotional rate temporarily applied when you transfer balances from one card to another. The issuer will use the regular rate after a few months.

  • Cash Advance APR: This is the rate used when you borrow cash on your credit card. It is the most expensive APR and does not have a grace period. Credit card issuers will assess a cash advance APR immediately.

According to the Federal Reserve, the average credit card interest rate in the U.S. is a whopping 14.58%.

TIP: If you pay your credit card balance in full each month, you will not have to worry about the exorbitant interest rates.

Types

Types of Credit Cards

Secured Credit Cards

A secured credit card issuer requires a refundable deposit before extending credit to you.

The deposit acts as collateral should you miss a payment. It is often equal to the credit limit on the card. For example, if the required deposit is $1,000, the card’s credit limit will typically be $1,000.

The purpose of a secured credit card is to build your credit and bridge you to a regular unsecured card. It is ideal for people with:

  • Limited credit history, such as students or new immigrants.
  • Damaged credit history due to any prior financial missteps.

After using and maintaining a secured credit card in good standing for about 12 months, you can close the secured card, get your deposit back, and apply for an unsecured credit card.

Unsecured Credit Cards

Unlike a secured credit card, issuers of unsecured cards do not require a deposit or collateral.

As this involves a more considerable risk for the issuer, there are stricter requirements to qualify for an unsecured credit card.

Such requirements will typically access an applicant’s credit score, income, and other liabilities. 

There are many types of unsecured credit cards, including:

  • Business credit cards: As implied in the name, these cards are designed for business use.

A business credit card offers a company convenient access to revolving credit. It is also generally easier to qualify for a business credit card than a business line of credit.

  • Student credit cards: These are cards designed for students who tend to have a low current income but a high-income potential in the future.

There are a few requirements to qualify for student credit cards. However, these requirements are slightly less stringent.

The credit card limit on student credit cards is typically low.

  • Reward credit cards: These are cards that offer a benefit for use, and they vary widely depending on the issuer. Credit card rewards generally fall into three buckets:
    • Cash Rewards: Offer a percentage refund for each dollar spent.
    • Travel Rewards: Provide miles to purchase airline tickets and book hotels.
    • Point Rewards: Provide points that are redeemable in cash, gift cards, or travel.

Types of credit card fees

Issuers charge various fees for the convenience of having a credit card. It is crucial to be aware of the different charges and avoid incurring them as much as possible.

  • Interest (finance) charge: This fee depends on your APR and varies with your outstanding balance. You can avoid this charge altogether by paying in full before the payment due date.

  • Late payment fee: Issuers may charge you a late payment fee if you miss making the minimum payment by the due date.

  • Over-the-credit limit fee: Much like an overdraft fee, this is a fee for going over your credit limit. You may opt-out of this fee, but the credit card payment system would decline your payment if you go over the limit.

  • Balance transfer fee: Should you transfer balances to one card, the receiving issuer may charge a fee for the transfer. The cost-saving from consolidating debts is often enough to justify this fee.

  • Cash advance fee: It is a fee for withdrawing cash using your credit card. This fee is generally higher than your standard APR. Issuers do not allow for a grace period on cash advances, and interest accrues from the moment you make a withdrawal.

  • Foreign transaction fee: A fee charged by some issues for making purchases outside the country of the card’s origin. It covers foreign exchange costs. Most cards that offer travel-related rewards do not charge a foreign transaction fee.

  • Annual fees: This is an account maintenance fee paid annually, typically for cards that offer various benefits. Annual card charges could range from $90 – $500 and offer perks such as priority boarding, free checked bags, low-interest rates, etc.

How to get approved for a credit card

Before applying for a credit card, it crucial to know your credit score.

With a high credit score, you can qualify for cards with various perks. However, with a low credit score or limited credit history, qualifying for credit can be challenging.

Below is a general guideline on credit scores.

  Canada United States
Excellent 780 – 900 800 – 850
Very Good 720 – 779 740 – 799
Good 680 – 719 670 – 739
Fair 600 – 679 580 – 669
Poor 300 – 599 300 – 579

You can find out your credit score for free from companies such as Credit Karma or Credit Sesame. These checks are soft inquiries and will not affect your credit score.

The next section will discuss the steps you can take to improve your credit score.

How to be responsible with credit cards

How to be responsible with credit cards

Here are the essential tips to keep in mind to avoid excessive credit card charges and maintain a high credit score:

  • Pay your bills on time each month. Payment history is the most crucial factor affecting your credit score. A single missed, or late payment can significantly negatively impact your credit score, credit card fees, and future interest rates.

  • Maintain a low credit utilization. While using credit cards can help you build credit, relying heavily on credit will negatively impact your credit score. The ideal credit utilization is below 30% of all your available credit.

  • Keep old paid-off credit cards open. Closing credit cards will wipe out all the credit history associated with those cards. If there are no annual fees, keep your old credit cards open.

  • Maintain a diverse mix of credit. Keeping different credit types such as a mortgage, a credit card, and a student loan in good standing demonstrates financial responsibility. Managing various credit well will have a positive impact on your credit score.

  • Keep hard inquiries at a minimum. A hard inquiry is a credit score check with the intent to borrow more money. Frequent hard credit inquiries will reflect poorly on your financial position and thus lower your credit score.

  • Check your credit report regularly and dispute any errors. Errors may occur in your credit report and negatively impact your credit score. It is essential to check your report at least once a year and dispute any mistakes as soon as possible.

  • Avoid ‘bad’ types of loans. Certain types of credit, such as payday loans and car title loans, indicate financial distress, and will lower your credit score. Avoid these types of loans at all costs.

Pros and Cons

Benefits of using credit cards

  • Using credit cards responsibly will enable you to build credit, which can help if you need a mortgage or any significant loans later.

  • Credit cards provide the opportunity to earn various rewards (signup bonuses, cashback, points) with your everyday purchases.

  • They are universally accepted, which makes them a far better option for travelling over debit cards.

  • Credit cards offer the incredible convenience of not carrying cash and the ability to purchase before receiving your paycheque. Just be sure only to buy what you can afford to pay back in full within a month.

Limitations of using credit cards

  • High-interest and fees. Credit cards are one of the most expensive loans, and the charges associated with them can be significant. Credit card fees are so high that you should not start investing while incurring interest charges. The returns on investments often cannot exceed credit card interest rates.

  • Short-term introductory rates. You may end up paying higher interest rates than expected once the initial period is over.

  • Can lead to a debt spiral. It is tempting to make the required minimum payment and carry a balance forward when you are on a tight budget. However, not paying the balance in full will keep you in debt longer, not to mention the high-interest fees you will have to pay.

Common Credit Card Myths

  • Carrying a credit card balance and paying interest will help to boost your credit score.

This assumption is false. Carrying a credit balance leads to unnecessary high-interest charges and high credit utilization. Both of these results will lower your credit score.

  • Checking your credit score will hurt it. This statement is a false assumption. A soft inquiry will not have an impact on your credit score.

Hard inquiries, however, will temporarily hurt your credit score.

  • You should close old unused credit card accounts. Closing old credit cards will decrease your average credit history and thus lower your credit score.

  • Student loans do not affect your credit score. This statement is incorrect as your credit score is not limited to credit cards only. All credit types (student loans, mortgages, car loans, all bills, etc.) affect your credit score.

If you enjoyed this article or have any questions, please leave them in the comment section below! I’d love to hear from you! Also, please feel free to share this with anyone that may benefit from it.

“The most difficult thing is the decision to act, the rest is merely tenacity.” —Amelia Earhart

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Ever feel like money just seems to slip through your fingers month after month? Our Monthly Budget Tracker will guide you to start making the most of every dollar. It’s a game changer—get it free for a limited time!

Nikki Kirimi

Nikki Kirimi is a finance professional (MBA, CPA, CMA) and the creator of Money World Basics. She enjoys acquiring and sharing personal finance knowledge to help people better their lives.