1. What is a credit card?
A credit card is a financial tool that lets you purchase everyday items without cash. Unlike a debit card, however, you’re not using your own money when shopping with a credit card but borrowing from a lender like a bank or credit union.
As you use your credit card to make purchases, you’ll build up a balance. You’ll be responsible for paying back some or all of your balance based on a fixed 30-day billing cycle.
If you pay your balance back in full and on time, you won’t owe any interest charges since you’re not borrowing money for longer than the allotted time. But if you don’t pay it off completely by the due date, you’ll owe extra in interest. The larger your balance and the longer you take to pay it off, the more interest charges you rack up.
As long as you use a credit card responsibly, a credit card can be an easy and accessible way to make purchases, borrow money, and help you build your credit score. Plus, depending on the card you carry, you can earn rewards like points or cash back on your spending. But credit cards are a double-edged sword, and when used carelessly, can lead to overspending, debt, and credit problems. It’s all about how you use them.
2. A deeper dive into how credit cards work
A credit card is a type of revolving credit tool, which means you’re extended a “limit” that you can borrow from, repay, and use over again. You have the flexibility to use as little or as much of the limit as you choose, or not use it all. That’s in sharp contrast to non-revolving credit (like auto or student loans), which let you borrow money upfront that must be paid back in installments and can’t be replenished or used again once they’re paid back.
The majority of credit cards are also “unsecured,” which means you don’t need to provide a deposit or downpayment to get one but just need to undergo a credit check and meet certain financial criteria like earning a certain income level. Since most credit cards are relatively accessible and aren’t backed by deposits, they charge relatively high interest rates (usually around 19.99% annually).
You can keep track of how much you owe on your credit card by checking your financial statement. Every 30 days you’ll receive a statement either online or in the mail outlining your purchases, the total balance, and the minimum payment you must make by a specific due date.
You can see the interest you are charged as a line item on your statement, and that amount is added to your overall balance.
3. Minimum payments
While ideally you’d pay off your credit card in full every month to avoid owing any interest charges, if that isn’t possible, you are required to make at least the minimum payment by the due date shown on your monthly statement.
Making the minimum payment is an absolute requirement and protects your credit score, prevents creditors from charging extra fees for missed payments, and ensures you fulfill your contractual obligations to the card issuer.
In most cases, your credit card’s minimum payment is calculated as either 3% of your balance or $10, whichever is greater.
As a general rule of thumb, it’s always better to pay more than the minimum every month since doing so can help you save a considerable amount of money (and time) having to make interest payments.
4. Credit card interest
As covered above, if you can’t pay off your balance in full at the end of your card’s 30-day billing cycle, you’ll owe interest.
Most credit cards quote their interest rates as an annual rate, and most credit cards charge around 19.99% per year. So for every $1 you owe over the course of a year, you’d have to pay roughly $0.20 in interest.
It’s important to note that while credit card interest is usually stated annually, the interest you owe is calculated daily and charged monthly. In short: you’ll owe interest each day you carry a balance.
Here’s a simplified example of how it works: An annual interest rate of 19.99% would add up to roughly 0.0547% in interest owed daily (19.99% ÷ 365/number of days in a year). Therefore, a balance of $1,000 would result in roughly $0.55 interest per day, $16.65 in interest per month, and $199.99 interest per year. Again, this is a simplified example, but it goes to show how interest can quickly accumulate, especially as you build a larger balance and owe money over a longer period of time.
5. Credit scores
One of the main benefits of using a credit card and diligently paying it back is that it will help you build a good credit score – since it can signal to lenders you can be trusted with borrowed money and make payments on time.
Your credit score is a numerical measure of your creditworthiness that lenders, banks, credit unions, and other creditors use to determine whether they should extend you new lines of credit or loans. The higher your credit score, the more likely be approved for loans, lower interest rates, and better credit cards.
Using your credit card responsibly is an excellent way to establish good credit, as long as you make at least your minimum payments every month and ideally use up only 30% of your card’s credit limit. If you don’t make your monthly payments, or you max out your credit card, you’ll negatively impact your credit score.
6. Credit card types
There are different types of credit cards that are ideal for various purposes. Here are three common types:
- Rewards credit cards: These cards allow you to accumulate either cash back or travel points on your daily spending – the latter of which can be redeemed for hotel stays, flight tickets, or merchandise. Reward credit cards may have an annual fee and often offer insurance coverage and are only a good match if you are diligent about paying down your balance in full each and every month.
- Low interest credit cards: Low interest credit cards have a lower interest rate than the average credit cards (for example, 12.99% instead of 19.99%). These types of credit cards are a smart choice if you tend to carry a balance from month-to-month.
- Secured credit cards: Secured credit cards require a cash deposit equal to your available spending balance – hence the term “secured.” These credit cards are ideal if you have a low credit score or are just starting to establish your credit and don’t qualify for an unsecured credit card.
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