How do credit cards work? It is one of the top questions for anyone who can legally apply for one should be asking. We are here to enlighten you on all things credit cards so you can make an informed decision.
You probably have a rough idea of credit cards. You go shopping with a loved one, and they hand in an ATM-like card. They will run the card and walk out happy and bags full of goodies.
Yeah, it looks pretty easy, convenient even, which it is. But do you know that the money they have used is like a loan that they must pay back?
What a credit card is
It is a plastic card, like an ATM card, that allows you to purchase goods and services on loan or credit without paying cash. Unlike a bank loan that the bank gives you in cash, a credit card will have a credit limit that you use and reuse as long as you pay back the borrowed money.
How a credit card works
As mentioned, a credit card is a short term owed to the credit card issuer. When you pay via a credit card, the card issuer pays the money on your behalf and bills you afterward.
As long as there is available money in your credit card, depending on your credit limit, then you can always pay stuff. Every purchase reduces the available money in your account by an equivalent amount.
For example, you have just received your credit card, with a limit of $200. What this means is that you can not use your card to pay for anything over $200.
In case you buy an item worth $80, you can use your credit card to pay for the goods. Your credit card issuer will pay the $80, which will put you in their debt of $80. Consequently, your available credit balance will drop to $120.
Another purchase of $100 will reduce your balance to $20, and you will owe the credit card issuer $180. If you repay the first $80, then you will only owe the issuer $100, and your new balance will be $100.
As long as you repay the credit card issuer what you owe and abide by their terms and conditions, you can keep using your credit. This cycle of usage is the reason why credit cards are also known as open-ended accounts or revolving accounts.
Credit card vs. other cards
Credit cards should not be confused with debit and prepaid cards that have some similar features as a credit card. Credit cards are loans extended to you by your issuer.
A debit card, on the other hand, will deduct money from your checking accounts whenever you pay for purchases. For a prepaid card, you load the money in the card before making any purchase.
When you pay for purchases using the prepaid card, the amount is deducted from the money that is already in the card.
Credit cards terms
Now that you know what a credit card is and how it works, it is time to learn standard credit card terms.
Credit limit - it is the maximum amount of loan or card balance that your card issuer will extend to you at any point without charging you penalties.
Your card issuer determines your credit card limit. It is affected by your credit card history and your income level. Also, the better you manage your credit card limit, the better your credit history.
Credit card balance or balance - this is the total amount you owe your issuer. If your credit card limit is $100 and you pay for goods worth $60, then your balance is $60. This will be your balance as long as you have not repaid it or purchased anything else.
If you make a new purchase of $20 without repaying the old debt, your balance is $80 ($60 + $20).
Available credit - it is the available money in your credit card that you can use without hitting your credit card limit. Using our earlier example, since your balance is $60, your available balance is $40 ($100 - $60).
In case you repay $30, then your new available credit is $70.
Billing cycle - it is a set period within which you can make purchases with your credit card. Once it is over, your issuer will bill you for repayment.
Statement date - this is a date in your credit card bill that you must pay at least a minimum payment for the issuer to keep using your credit card.
Annual Percentage Rate (APR) - it is the yearly interest charged for any outstanding debts on your credit cards.
Minimum payment - it is the lowest amount of any amount owed to the issuer that you can pay without accumulating any penalties.
The minimum payment is a small percentage of the total balance on your credit card. A delay of the minimum payment will affect your credit rating, a report that can last up to 7 years in your credit scores.
Interest charges and fees
When you ask how do credit cards work, you should also factor in any interest fees and fees. If not well managed, these interest charges and fees and spiral out of control, and you end up in debt.
Most issuers will only hit you with interest payment only when you fail to repay your credit card full balance before your card's due date.
The average APR for new credit cards is currently at 17.3%. Failure to pay your balance would mean paying hefty amounts as interest, amounts you would have saved.
Apart from the interest rates, you need to be aware of these fees:
- Annual fee - some cards will have a yearly fee as a charge for enjoying the benefits of the card. If you are shopping for a credit card, look for one that does not charge an annual fee to keep your fee payments as low as possible.
- Late fees - issuers will charge you late fees when you fail to pay the minimum payment by the due date of your statement.
- Fees on cash advances - it will apply when you withdraw cash from your credit card. The fee is usually very high, so avoid withdrawing money from your credit card.
- Fees on foreign transactions - confirm if your issuer charges any fees on foreign currency purchases. Some do, and some don't. It would be wise to confirm, especially if you travel a lot.
- Fees on balance transfers - you can transfer a balance from a different credit card. The APR for this is 0%, but you will have a transfer fee equivalent to a percentage of the balance you transfer.
- Fees on credit card cheques - credit card cheques are not that popular, but you can get one if you ask your issuer. However, their fees are much higher since your issue will treat it like a cash withdrawal. Also, a credit card cheque does not enjoy the same protection that your purchases enjoy since they are not under section 75.
Types of credit cards
There are other types of credit cards apart from the regular credit card you might get from your banker. These include:
- Secured card - most credit cards in the market are unsecured, meaning you do not need any security deposit to obtain one. A secured card, on the other hand, requires a security deposit amount. This amount acts as your credit card limit.
- Rewards card - a rewards credit card offers rewards to the user. These offers include cash backs, points for hotels or flights, or statement credits.
- Charge card - unlike the regular credit card with a monthly credit limit, a charge card has a limit on your purchases at any given time. Also, a charge card does not allow you to carry forward any balances for the following months. Your credit card balance must be paid in full by the due date.
Features to look for in a credit card
Since you are shopping around for a credit card, it is ideal to know the essential features that will help and protect you. These features include:
- APR - APR is an annual rate and is the cost of accessing the credit. Some cards have a variable APR, so ask for more information on when and how it will change.
- Periodic rate - it determines your card's finance charge on your card's balance each billing cycle.
- Annual fee - it is a fee you pay to the card issuer for enjoying the card's services. Not all credit cards have annual fees, so confirm with the issuer when getting your credit card.
- Other fees - apart from the annual fees, beware of additional fees your card has like late fees, cash advance fees, or monthly fees.
- Grace period - it is a safe period within which you can pay your full balance without incurring any charges. Without a grace period, it means you have to pay interest immediately your purchase is posted in your account or from when you use your card.
- PIN and chip - some cards use PIN and chip security features with magnetic strips or an embedded chip. An embedded chip card is better for an international traveler.
- Security features - look for a card with security features like receiving fraud alerts, switching the card on or off, or receiving alerts of your purchases immediately.
- Reward programs - go for a card with reward programs like when you use the card to pay at hotels, gift certificates, flights, or cash backs.
- Finance charges - most credit card issuers use average daily account balance to calculate finance charges. This is the average of what you owe the issuer ever day in a particular billing cycle.
When shopping for a credit card, look for one where the issuer uses the adjusted balance instead of using the previous balance. An adjusted balance will subtract any payments you make every month from your cards beginning balance. It also has the lowest finance charges.
Pros and cons of credit cards
- A credit card is safer than cash. In case you lose it, you can call your issuer for cancellation. Also, if anyone uses your card fraudulently, there are chances you might get a refund.
- Credit cards are easier to carry around. Most, if not all businesses, accept credit cards more accepted in most places compared to prepaid cards.
- Credit cards offer protection like travel insurance for a particular situation like a delay of trips or lost luggage. With a credit card, you can buy an item you badly need even if you do not have cash rather than waiting for payday. Also, this amount will be interest-free if you pay it back before the due date.
- A credit card allows you to build your credit score record. A good credit rating makes it easier for you to access other services like bank loans or mortgages and even renting an apartment.
- Credit cards might get you into an avalanche of debts if you fail to make your balances in time.
- Additional fees on credit cards will make it more expensive for you at the end of the day. If you travel frequently, it is also wise to get a card designed for travelers to avoid incurring hefty foreign transaction fees.
- Pre-authorizations and deposits will affect your credit card limit. Some businesses like hotels or car rental might request a pre-authorization on your card in case you break anything or use the mini-bar. Pre-authorizations take care of these bills in case you leave without paying.
Now that you know how credit cards work, is it right for you? Well, a credit card is an excellent financial tool for you if you can manage your personal finances well.
If you cannot pay the balances in time, then a credit card is not for you. You will be digging a debt hole for yourself, one that will affect all aspects of your financial and personal life for years.