Did you know that 67% of Americans have a credit card in their name right now?
In fact, the average person actually has three credit cards. This makes sense when you hear that there are 1.5 billion credit cards in the U.S. alone!
People have these cards in their wallets for a reason. When used the right way, they can help us navigate our lives day-to-day more quickly and easily. From buying your clothes to going to a moving, they’re a necessary item for most of us.
But for first timers, it might be hard to understand the basics.
What is a credit card? How does one go about using it—and then paying it off? And how can you avoid that average of $6,354 in credit card debt?
What Is a Credit Card? How Does It Work?
A credit card is a convenient form of payment that lets you efficiently build up your credit score. That’s important for people with no credit history. You’ll find that out if you don’t have a credit history or likely a credit card as soon as you apply for a home loan, car loan or insurance.
It helps to consider a credit card like a loan. A credit card is a loan, but instead of a loan for a fixed amount, it is a revolving line of credit.
When you apply for a credit card, the credit card issuer gives you a credit limit. That limit is based on factors like credit score, payment history, and so on. With your card, you can borrow up to this determined limit amount per month.
Understanding Your Credit Card’s Interest—AKA APR
Like all loans, though, you have to pay back what you borrow.
Unlink a typical installment loan that has a preset payment each month, there are two options to pay your credit card bill.
- Pay the entire balance in full
- Pay the minimum monthly payment each month—usually, 1 to 3% of your total balance—until your card is paid off.
If you pay your bill in full, you save yourself from paying interest on the balance you’ve borrowed. That interest can cost you a lot of money if you don’t pay your balance off each month.
If you choose to make the minimum payment, you choose to carry a balance. And the balance left on the card carries over into next month. And as the balance carries over, you’re charged interest on that loan—and that interest compounds each time it’s not paid, which means you pay interest not just on the original balance, but on the new balance that has had interest added.
Interest rates vary by credit card types, credit cards and credit card companies For the purposes of this guide, we stick to a standard—14.24%. Interest rates charged on credit cards are an APR, or annual percentage rate, which is the card’s yearly interest.
And although paying the minimum credit card payments each month seems tempting, it’s not the best option. The longer you take to pay off your bill, the more interest you pay, and the more you owe. It’s a snowball effect.
Let’s say you charge $1,000 in a month. You pay only the minimum payment of $10 (1% of 1,000). The next month, your new balance is $1,130.98—that’s $1,000 minus your $10 payment, times 14.24% interest. But it doesn’t stop there.
Your minimum monthly payment the next month is $11.31 (1% of $1,130.98). Your new balance is $1,279.11. And, you’ve now paid almost $280 in interest on your original purchases.
As the example shows, interest is charged on any balance you don’t pay in full each month. Interest is also charged on any late fees you end up with, balance transfers and even cash advances.
Just one month of not paying your bill on time can have a slew of negative effects. Besides that late fee, you risk your credit score, too. If you continue to not pay, your debt may get sold to a collection agency.
Types of Fees and How to Avoid Them
Fees vary by credit card and are usually avoidable. To ensure that you’re not paying unnecessary fees, read your credit card or cardholder agreement. It should outline every fee and when you might encounter it.
Here are some common credit card account fees. Note that many issuers offer no fee for some or all of these items to get you to apply for their cards—it helps to shop around:
Foreign transaction fee—This fee results from making a purchase that is in foreign currency.
Late payment fee—A late fee can occur month-to-month if the minimum payment isn’t made by the due date. While not a hefty charge, repeat late fees put you at risk of losing your card and accruing more debt!
Annual fee—Some credit card suppliers charge an annual fee for their credit cards or select cards. Many offer benefits that outweigh the annual fee, sometimes make this fee a good option.
Balance transfer fee—If you transfer a balance from one credit card to another, you may be charged a balance transfer fee, which varies by dollar amount.
Cash advance or cash withdrawal fee—This is a fee charged if you need to use your credit card to get cash.
As we mentioned, fees vary by card supplier. You may see some that aren’t listed here. The best defense against fees is knowing as much as possible about your specific credit card.
Types of Credit Cards
There are almost as many types of credit cards are there are types of credit card fees. And there’s no one-size-fits-all when it comes to credit cards. There’s a card to suit every need, every lifestyle. Here are some types of credit cards you’ll find:
Cards by credit score—These cards are issued depending on credit score. They range from credit cards for bad credit—599 or below—to credit cards for excellent credit of 750 and higher and everything in between. For beginners, there are even cards for people with no credit history.
Cards by type—These cards get categorized based on what they’re used for. The 3 main groups are Business, Personal, and Student credit card types.
Rewards credit cards—There are many cards on the market that offer rewards for your purchases! Rewards include cash back rewards, hotel points, gas points, airline miles and general points. It’s standard to see a higher interest rate on rewards cards, due to the rewards offered.
Cards by perk—there are also credit cards available for specific benefits, include cards with no annual fee, cards with no foreign transaction fees (usually also rewards cards) and cards with low interest rates or low APR.
Many cards also offer sign-up bonuses. These cards are usually offered to those with an established credit history. Sign-up bonuses can take the form of extra rewards or introductory APRs that are lower than the ongoing APR for the card.
Secured credit cards—these cards are different than the other cards we’ve discussed here, which are unsecured cards. The difference is that a secured card requires a security deposit and a higher APR, which acts as some or all of your credit limit. Secured cards are aimed at people with poor or no credit who need a card to help build their credit. Secured cards typically report responsible usage to the credit bureaus to help the cardholder build credit. Once a good payment record is in place, the cardholder can typically get a higher credit limit without an extra deposit or move on to a standard unsecured card.
Credit Card and Your Credit Score
Credit cards are like a loan. And like loans, you have to pay them back, preferably on time.
- Your payment history
- Your credit utilization rate—how much of your available credit you’re using
- Your credit age or how long you’ve had and used credit
- Your mix of credit accounts
- Any newer credit inquiries you have
Some of these factors account for more than others. For example, payment history accounts for about 35% of most scores. Whereas new credit inquiries only account for about 10%.
Using a credit card smartly is a good way to improve and build your credit score. The opposite is true as well.
Ready for Your First Card?
After this lesson, you’ll hopefully never have to ask “what is a credit card?” again!
In fact, you could probably teach your friends a thing or two about what this piece of plastic means!
When you’re ready to apply, check out this handy guide on how to get the best first credit card! And before you do apply, know your credit score, so you have an idea of what types of card you may get approved for, including what cards you might get pre-approved for. You can get your free Experian credit score on Credit.com. Your score is updated every 14 days, so you can see what’s up with your credit. And you get access to a free credit report card that tracks the main factors that go into your score and offers tips on how to improve or maintain each one.
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