How Do Credit Cards Work?

How Do Credit Cards Work?

Reading Time: 5 minutes

You’ve probably had a friend tell you about the awesome rewards they get on their credit card which helped pay for their trip to Mexico. There are other stories that you’ve heard too. About how credit card debt is taking over people’s finances.

 

These negative repercussions have made you hesitate about getting a credit card. Understanding how credit cards work and how to use them responsibly will help avoid pitfalls like accumulating credit card debt. Then you can reap the benefits and rewards that come with having a credit card.

 

How do Credit Cards Work?

A credit card is basically a type of loan. The bank, called the “issuer” will set a credit limit, which is the maximum amount that you can spend.

 

Your billing cycle is about a month long and you must pay back the balance within the grace period to avoid paying interest. Your grace period is typically about three weeks long. The statement closing date is the last day of your billing cycle and you’ll receive a statement either by email or in the mail, based on your preference, that lists all the charges for that billing cycle.

 

For example, you charge $250 of purchases on your credit card on the tenth day of your billing cycle. Your total credit limit is $1000 so you have $750 of available credit that you can still borrow. You’ll have more available credit when you make a payment.

 

Since your billing cycle is 30 days long, you have 20 days remaining plus another 21 days from your grace period to repay the $250. That’s a total of 41 days to pay back those purchases without interest charges.

 

That flexibility is why credit cards are a popular choice among consumers. However, if you spend more than you can afford, then you will quickly get yourself in a very bad financial situation.

 

What Interest and Fees do Credit Cards Charge?

The interest charges on a credit card is called the annual percentage rate, APR. This is the annual cost of borrowing money on your credit card. You’ll pay this interest rate on the balance of what you didn’t pay during the grace period.

 

Let’s take the following scenario: You have a credit card with a 15% APR, which is about the average interest charged on a credit card. If you carry a balance of $1,000, you’re charged daily interest on that balance. This is computed by dividing the APR by 365 and multiplying the amount you owe. You’ll owe an additional $150 if you keep that balance for a year, hypothetically.

 

Credit cards will require that you make a minimum payment each month to avoid fees and to keep your account in good standing. This minimum amount is generally around 2 to 3 percent of the balance.

 

Other than interest, there are other fees that you might be charged, depending on the credit card you have. Your credit card agreement will list all the fees associated with your account.  Here’s a list of some of the fees that are common:

 

  • Annual Fees – This charge is common on travel credit cards that generally offer more perks and benefits. The fee is charged annually for owning the credit card. The most typical amount that is charged is $100.
  • Balance transfer fees – If you move credit card debt from one card to another, this is the amount the issuer will charge. Some credit cards will waive this fee as an introductory offer to incentive you for opening an account. Balance transfer fees are usually between 3 and 5 percent of the amount of the balance.
  • Cash advance fees – If you use your credit card to withdraw cash like you would a debit card, you’ll be charged this fee. The charge will usually be the greater amount between a percentage of the transaction or a flat amount.
  • Foreign transaction fees – Travel credit cards will usually waive this fee as a perk of having the card. This charge is what you’re assessed if you use your credit card to make purchases in foreign currency. The fee is typically a percentage of each purchase you make so it can add up quickly.
  • Late payment fee – If you don’t pay at least your minimum payment by the due date, you’ll be charged a late payment fee. The fee is normally around $39, which is a pricey mistake!

 

What types of Credit Cards are there?

There are many types of credit cards out there. They can serve different purposes; therefore, certain types of cards are a better fit for certain people. Here is a rundown of the most common types of credit cards that are available:

 

  • Rewards Credit Cards.This type of credit card offers some type of rewards to its cardholders. Cash back, statement credits, and points that can be used for airfare, hotel, etc. are examples. 79 percent of consumers named rewards as the most attractive feature on their credit card according to a TSYS study.

     

    Rewards credit cards are the most popular type of credit card. If you are getting your first credit card, you might not qualify for the cards with the best rewards program. Using your credit card responsibly will help you qualify for credit cards with better rewards in the future.

  • Secured Credit Cards.Secured credit cards require that you put down a deposit upfront to open an account. This deposit also typically serves as your credit limit. Other types of credit cards are “unsecured” and there’s no deposit requirement.

     

    Secured credit cards are ideal for people who are new to credit or trying to rebuild credit. Just like unsecured credit cards, payments on a secured credit card are reported to the credit bureaus. This helps you build credit and qualify for other types of credit cards with more benefits.

 

Why should I get a Credit Card?

Credit cards offer many great benefits as long as you use them the right way. These benefits include:

 

  • Help with building your credit
  • Earn rewards
  • May have additional shopping and travel perks
  • Are more secure than a debit card; Better protection with online shopping
  • Have access to interest-free short term loans

 

To get a credit card, you should look for one that fits your current situation. If you’re new to credit, a starter credit card, student card, or secured card would probably be the right fit. Many issuers will allow you to check if you’re pre-qualified for a credit card offer on their website. Use this feature to see what you might be able to get before completing an application.

 

How do I build Credit using a Credit Card?

 

Credit cards are arguably the best tool to build your credit score. A good score can get you approved for things like mortgage loan with lower interest rates. Landlords, employers, cell phone providers, utility companies, and insurance providers also use your credit score to help determine if they will enter into a relationship with you. Here are some things you can do to help you build credit with a credit card:

 

  • Pay your bill on time – 35 percent of your FICO credit score is based on whether you pay your credit card bill on time. It’s the most important and easiest thing you can do to build good credit. Use features like auto-pay on your account so that you never miss a payment.
  • Don’t’ use too much of your balance – Ideally, you want to keep your balance below 30 percent to build credit. Charging more than that is a red flag to creditors and may indicate that you’re borrowing more than you can afford.
  • Don’t close your accounts – Even if you stopped using your first credit card months ago, don’t close it. Otherwise you lose out on that credit history. It also reduces the average account age, so it’s actually better for your credit score to keep it open.