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More than 86% of Americans use credit cards to make purchases. The magic of credit cards is that they extend your buying power and require almost no effort to use. Simply swipe your card or enter your card number and your purchase is complete. There’s more, however, to credit cards than a 16-digit number.
Take a look at this overview to learn how credit cards work and to understand how to take control of your financial future.
The most common way to use credit cards is as a method of deferred payment. This transaction method works like a loan.
A bank or credit card issuer offers you access to a lump sum of money—known as your credit limit. You can use some or all of that money. But, like any loan, you then have to pay the money back. The card gives you a line of credit and is known as revolving credit. Revolving credit is a loan that essentially goes back to the full amount as you pay it the credit you’ve used.
Whether you get a credit card from a bank or non-bank credit card issuer, the bank or the issuer acts as the lender. That lender is loaning you money in exchange for your promise that you’ll pay them back either in full before interest is due or with interest if you carry a balance. The exception is an unsecured credit card—see below.
With a traditional card, you have to pay a minimum monthly payment, usually $25 or the full balance if your balance is less than $25. If you don’t pay your balance off in full, you pay interest on your remaining unpaid balance.
You do though have a grace period. If your billing cycle ends on March 31, you have another 25 or so days to make your monthly payment before you have to start paying interest on the balance.
In addition to paying interest on unpaid balances, you have to adhere to the terms of the credit card’s cardholder agreement. Terms cover items such as:
Banks and credit card issuers—like Visa, MasterCard, American Express and Discover—don’t require collateral before giving consumers traditional credit cards. They grant credit cards to consumers based on the consumer’s creditworthiness or credit score. This makes those credit cards a form of unsecured debt. They’re called unsecured credit cards—or just credit cards—to most of us.
The exception is secured credit cards, which do require collateral in the form of a deposit before a bank or issuer gives consumers one of those cards. With a secured card, you’re usually limited to charging no more than the amount of your deposit. Although there are exceptions.
Your credit limit for a traditional credit card is based on your credit score and is determined by the bank or issuer. Your limit may or may not be an amount you can afford to repay if you charge the full limit at once. Credit card issuers count on you to manage your spending habits, so can repay that debt.
The technology behind credit cards relies on a number or swiping a magnetic strip or using a chip embedded on the card at the point of purchase to process payment for the purchase. Chip-enabled cards are now the standard for making purchases.
The number, swipe or chip relays your information and the information about the merchant and purchases through a payment processor. The processor is a company that processes the transactions for the merchants and the banks involved—yours and the merchant’s.
The processor sends a message back to the merchant to confirm whether your credit card account can cover the expense. Declined purchases mean you don’t have enough credit available to cover the cost, something in the processing has failed or there’s a problem with your card and the bank or issuer has blocked the transaction. Problems can include the possibility of identity theft and other items.
Chip-enabled credit cards provide more security than the older magnetic swipe technology. A magnetic swipe includes your personal information and can be cloned by thieves. The chip, created by Europay, MasterCard and Visa, creates a unique code for each point-of-sale transaction making it very difficult to copy.
Credit cards are not free. Banks profit from your use of a credit card by charging an interest rate. That interest rate is called the annual percentage rate or APR. For a credit card, interest rate and APR are the same thing—that’s not true for all loan products, but we won’t cover that here.
The bank or issuer determines the APR you pay based on your creditworthiness or score. When you see APRs for credit cards, you’ll often see a range, such as 15.24%–26.24%. The APR in that kind of a range will vary depending on whether you have excellent credit or fair credit. If you have excellent credit, you’ll likely pay the 15.24% APR. If you have only fair credit, you’ll likely pay the 26.24% rate.
In some cases, credits cards aren’t made available to people with lower credit. Some cards though cater specifically to people with lower credit.
If you have little to no credit, you can apply for credit cards for high-risk borrowers. These credit cards generally have higher than average interest rates.
Knowing your interest rate is easy—your bank or card issuer will tell you. Understanding how your interest rate affects your balance, however, can be tricky. An interest rate applies when you carry a balance. For example, you spend $500 in January and decide to only pay $75 on the balance each month. Each month the remaining balance you leave unpaid accrues interest.
Leaving a balance on your credit card can have a snowball effect over time. Let’s assume an interest rate of 14.24%. If you charge $1,000 on your credit card but only make a payment of $50 each month, it will take almost two years to pay off the balance. The total amount of interest paid would equal $148.36.
Table 1 shows the effect of paying interest on a single beginning balance by making payments over the original debt over time. As with any loan, you end up paying more for the goods you purchased than you would if you could pay in full upfront. And the table assumes you aren’t adding additional charges to the card each month.
If you want to avoid paying interest rates, pay back the amount you spend on the card each month. If you can’t do that, make as large a monthly payment as you can.
Banks and credit card issuers make a profit by charging interest, but also by charging credit card fees.
The most common fee people are aware of is the annual fee. This is a fee charged on some cards in exchange for the privilege of getting added perks for using the cards—such as rewards—or in exchange for the bank or issuer taking a risk by extending you credit. Many cards are available that charge no annual fee.
A common credit card fee is a late payment fee. When you make a payment after your payment due date or fail to make a payment at all, a fee is added to your card. That fee can be $25 or $35.
There are a few cards that don’t charge late payment fees.
Making purchases while traveling can result in foreign transaction fees. Foreign transaction fees apply to any transaction that requires the bank to convert money into a foreign currency or process through a foreign bank. Traveling is just one way to incur a foreign transfer fee. Shopping online with international retailers can also lead to a foreign transaction fee.
As with late payment fees, some credit cards—usually travel credit cards—don’t charge foreign transaction fees.
A cash advance fee is when you take money from your available credit card balance using an ATM or convenience checks. The fee can be a flat fee or a percentage of the amount of cash you withdraw. Cash advance fees might also be charged when you use your credit card like cash. These transactions include things like buying a money order or send money to another person.
Before you apply for a credit card, always check the card terms to ensure you’re comfortable with the fees the card is charging. You can also use fees as you compare cards to find the best one for your needs and budget.
There are benefits to credit cards that go beyond having access to money you wouldn’t otherwise have. Issuers offer special card types based on your interests and as an incentive to get your business.
Here are a few common types of credit cards:
The biggest risk to owning a credit card is spending more than you can afford to repay and therefore racking up credit card debt. With interest added to the balance each month, debt only grows and becomes harder to manage.
According to Experian’s annual state of credit in 2017, the average credit card debt in 2017 in America was $6,375. That’s per person.
Keeping your balance small each month helps your credit utilization ratio remain low. Credit utilization ratios are a way of measuring how much credit you’re using of your available credit limit. Your credit utilization makes up 30% of your credit score.
The ideal credit utilization is 10%. So if you have a credit limit of $1,000, with a credit utilization of 10%, you would never have a balance of more than $100. That would apply to all your credit cards if you have more than one. The maximum utilization before your spending habits start to hurt your credit is 30%. At that percentage, you would never have a balance of more than $300.
Once you fall behind on credit card payments or have a utilization that’s too high, your credit score suffers. Because your bank or card issuer reports high utilization and late payments to the credit bureaus.
If you use credit poorly, you can end up with a less-than-ideal credit score. And fair, poor or bad credit can mean you pay high-interest rates on loans and credit cards if you qualify at all.
That’s your “how do credit cards work 101 primer.” Know enough? Find a credit card that’s right for you and your credit score.
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