How do credit cards work? 7 things you should know
If you are unfamiliar with how credit cards work, they can be intimidating to use.
I delayed getting a credit card for years because I didn’t understand them. In addition, I was afraid of going into massive debt. In fact, a woman I interviewed once did not understand how credit cards work – and thus accumulated a balance of $ 12,000.
But once you understand them, you see them for what they are: financial tools that you control. Credit cards can be invaluable for building credit quickly. However, if you’re not careful, it can be too easy to charge more than you can repay.
By understanding credit card basics, you’ll know how to spend responsibly with a credit card and always pay it off.
7 essential credit card questions and answers
So how do credit cards work? Let’s start with the basics.
1. What is a credit card?
Credit cards – plastic cards that banks and financial institutions issue to cardholders – contain coded information that links them to your credit card account. This information is used by merchants to process purchases and debit them from your credit card account.
2. What is a credit card account?
Your credit card is linked 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’re doing it with the money from the issuer, not your own.
A credit card account will have a limit. This is the maximum amount that the credit card company will allow you to borrow from the account.
3. What is a credit card balance?
All transactions charged to a credit card are added to your credit card balance. This is the amount of money that you have borrowed by debiting purchases from your credit card but have not yet paid off.
You increase your credit card balance every time you swipe your credit card, and you decrease it every time you make a credit card payment.
However, try to limit your credit card balance to what you can pay off in full each month. This is a good guideline to follow to keep your credit balance low and make sure you don’t borrow more than you can repay.
4. What is a minimum payment on a credit card?
The minimum payment is the amount you have to pay each month to keep your credit card accounts in good standing. Your minimum payment will be due on the due date of your credit card each month.
A minimum payment is calculated based on your credit card balance. This is usually two to three percent of your credit card balance, or any unpaid interest you owe plus one percent of the balance. Most credit card issuers also have a fixed amount which is the smallest they charge on a credit card each month, typically $ 15 to $ 35.
The minimum payment on a credit card is low compared to your overall balance. It is also recalculated every month. This means that the average credit card balance can take over a decade to pay off with minimum payments only – and you’ll be paying hundreds of credit card interest during that time.
5. What is credit card interest?
Credit card interest, also known as credit card finance charges, is the cost you pay to have a balance. This is set by the Annual Percentage Rate (APR) of your credit card, which is the rate at which your balance accumulates interest.
Understanding how credit cards work with interest can be tricky. But in simple terms, you will be paying credit card interest on your average daily balance for the month.
You usually have a 25-day grace period to pay off a balance with your credit card issuer before they charge interest on the borrowed money. Pay off your credit card in full each month and you won’t pay interest on the credit card.
But if you charge, say, $ 100 this month and only pay back $ 50, you’ll earn interest on the remaining $ 50 until you pay it back.
Hence, you always have to pay more than the credit card minimum to keep balances low. It will also help you avoid credit card interest and serious credit card debt.
6. What are credit card fees?
To understand how credit cards work, it’s important to know how much your credit card is costing you.
All credit card costs, APRs, and fees will be described in your credit card agreement that you sign when opening a credit card. Read this carefully to make sure you understand your credit card.
Different credit cards will have their own fee schedules, and some will charge more while others charge less – or skip certain credit card fees altogether.
The main fees you need to worry about are the annual credit card fees, which are billed to you every year just for the privilege of having the credit card. Depending on your credit card, you may have to pay an annual fee of $ 0 to $ 500. Typical credit card fees are around $ 50 to $ 60 per year and depend on the type of credit card you have.
Credit card companies will also charge other fees on certain transactions such as:
- Balance transfer fee. 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 cash line of credit, rather than through a purchase.
- Foreign transaction fees. You pay them for purchases made outside of your home country.
- Late payment fees. You pay them if you make your credit card payment after your monthly due date.
7. What are the different types of credit cards?
There are different types of credit cards and some work differently from others. Here are some common types of credit cards, along with what sets them apart:
- Rewards credit cards reward cardholders for purchases made with their credit card. Rewards can be cash back or points that can be redeemed for purchases of travel or other goods.
- Secured credit cards require a cash deposit which is used as collateral against the credit card balance. Because they are secured by the deposit, these cards are easier to qualify. They can be a good option for consumers who want to rebuild their credit.
- Payment cards require borrowers to repay their balances in full each month. Thus, the minimum payment is always equal to the monthly charge on the payment card.
- Retail Cards are credit cards issued by a retailer or store, rather than a credit card company or bank. These credit card accounts are with the store itself.
How do credit cards work? Simply, if you are well informed
Ultimately, credit cards can be a tricky financial tool to use. Too many credit card users make credit card choices that hurt their finances and their credit simply because they don’t understand them.
If you’re new to credit cards, take the time to explore them and understand how a credit card works. When you understand credit cards, you will know how to get the most out of them. And you’ll also avoid making disastrous credit mistakes just because you didn’t know better.
Interested in a personal loan?
Here are the best personal loan lenders of 2021!