We all have heard of credit cards and some readers already use them. How do credit cards work? This article is written to give a better understanding of credit cards and how to use them. For beginners, consider this an introductory note on Credit cards.
Credit Cards
This is a type of credit facility provided by banks that allows customers to borrow funds up to a set credit limit. It allows customers to make purchases of goods and services.
The issuing company determines the credit limit based on factors such as income and credit score, both of which are determined by the credit card company.
How do Credit Cards Work
Credit cards can be used to pay bills and make online or in-store purchases. When you pay with your card, your card information is sent to the merchant’s bank. The bank then obtains authorization from the network of credit cards to process the transaction. Your card company must then verify your information and approve or decline the transaction.
If the transaction is approved, payment is made to the merchant, and the transaction amount is deducted from your card’s available credit. Your card issuer will send you a statement at the end of your billing cycle that includes all transactions for that month, your previous balance and new balance, your minimum payment due, and your due date.
The grace period is the time between the date of a credit card purchase and the due date listed on your statement. During this time, if you pay your bill in full by the due date, no interest will be charged.
However, you may be charged an extra interest if you carry over your balance from month to month. The annual percentage rate (APR) on your credit card reflects the cost of carrying a balance on an annualized basis. Your APR includes your interest rate as well as any additional fees, such as an annual fee if your card has one.
The variable APR on most credit cards is tied to the prime rate. This means that the APR on your card may change over time, though the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009 establishes strict guidelines for when credit card companies can and cannot increase your rate.
Different Types of Credit Cards
Before you can make your choice of credit cards, it is necessary you know the different types and how each of them work.
Business Credit Cards
These credit cards enable cardholders to separate their personal and business expenses while earning rewards on all business spending.
Some of them do have generous rewards programs, the ability to track expenses, and features that help them increase their bottom line. Rewards can be redeemed for cash or airline miles.
Rewards Credit Cards
These credit cards provide cash back and travel rewards on everyday purchases, making them an excellent choice for day-to-day expenses.
Cash Back Credit Cards
Cash back credit cards provide a range of rewards, from flat rates to bonus points in specific categories. Most of them come with no annual fee, however some with more generous bonus offers and rewards schemes charge annual fees.
Student Credit Cards
Student credit cards are “starter credit cards” designed specifically for young people with little or no credit history. In other words, because the application requirements are less stringent, it is easier to get approved.
Most student credit cards do not have an annual fee, and many offer additional perks for good grades as well as rewards for every dollar spent. Signing up for a student credit card can help young people build credit and develop good financial habits if used responsibly.
Co-Branded Credit Cards
These credit cards are store or brand credit cards offered by traditional card issuers that provide solid rewards that are often more valuable than cash back.
Travel Credit Cards
Travel credit cards provide travel-related rewards such as flexible travel credits and points that can be transferred to airline or hotel programs. Airport lounge access, annual travel credits, and credits for Global Entry or TSA PreCheck are all available with luxury travel credit cards.
Secured Credit Cards
Secured credit cards require a cash deposit to secure a small line of credit, usually a similar amount. They are the simplest type of credit card to obtain and can help you build credit from scratch or repair credit after a financial setback.
Store Credit Cards
Store credit cards are issued by retailers to allow customers to charge purchases and pay them off over time. They have higher interest rates and deferred interest, but if they are paid off on time, they can provide perks and rewards programs.
How do Credit Card Payments Work
Making regular, monthly credit card payments is a good way to establish a credit history and a high credit score. When you use a credit card to make a purchase, the amount you pay is added to the total amount you owe, which is known as your credit card balance.
The card issuer will notify you at the end of each monthly billing cycle of how much you owe, the minimum payment required, and when that payment is due. It is preferable to pay more than the minimum and, ideally, to pay off your entire balance each month.
Your credit utilization ratio is also a significant component of your credit score, so if you have a credit limit of $6,000 on your credit card, try not to let your balance exceed $1,800.
Credit Card Interest Rates
Credit card interest is calculated monthly by dividing the annual percentage rate (APR) by 12 and is applied to your outstanding balance. Some cards have multiple APRs, which are specified in the credit card terms.
Credit Card Fees
Credit cards have a lot of fine print when it comes to fees, penalties, and other charges. Late fees, over-limit fees, annual fees, cash advance fees, and returned payment fees are examples of these.
Late payments can cost as much as $28 for the first one and up to $39 for subsequent ones. Over-limit fees can range between $25 and $35, depending on how frequently you exceed your limit. Annual fees may include reward programs that provide a high return on your purchase. Cash advances can be expensive.
Credit Cards vs. Debit Cards
Debit and credit cards have different effects on credit scores. Debit cards have no effect on your credit score, whereas credit cards can have a direct impact on your credit score. Credit cards have more fraud protections under federal law than debit cards.
With credit cards, you do not spend your own money but that of the credit card’s company. This case is different for debit cards. They are linked to your checking account. So money is directly deducted from your bank account when you make a purchase.
How You Should Compare Credit Cards
We all are looking for the most favorable things with the best results. If you are about to get your first of this type of card, its best you look for a card that favors you in the following factors.
- Variable APR for purchases.
- Annual Fees
- Bonus offer terms
- Reward programs
- Balance transfer APRs
- Promotional APRs terms and conditions
Why Use a Credit Card
Credit cards can provide cardholders with convenience, security, rewards, and the opportunity to establish a good credit history. They do, however, necessitate taking risks, which can result in rapid debt accumulation and damage to one’s personal credit history.
To avoid debt and improve credit scores, cardholders should keep track of their balances on a regular basis and only pay for things they can afford with cash they already have.
They also provide welcome bonuses and rewards that can be used to purchase travel, dining, cash, or everyday items. Cardholders should avoid “churning and burning” cards for the bonuses, as this can raise red flags on future applications.
Some credit cards provide substantial cash back rewards for purchases made at grocery stores, gas stations, pharmacies, and other retailers. The Discover it® Cash Back card gives you 5% cash back on everyday purchases and an unlimited 1% cash back on everything else.
Travel insurance, extended warranties, buy protections, and partnerships with select merchants are among the other benefits. The most important advantage of owning and responsibly using a credit card is the ability to build credit.
Making on-time payments and keeping credit utilization low can demonstrate to lenders that an applicant will not be a risky borrower.
The Best Ways to Build Your Credit Score With Your Credit Card
Using your credit card right helps you get a very good credit score. Here are some of the best tips to help you build your credit score with your credit card;
Make Credit Card Payments on Time
Making all payments on time is the most effective way to build credit with a credit card. To avoid interest charges, pay at least minimum by the due date each month as well as set up automatic payments.
Check Your Credit More Often
Credit management entails monitoring your credit report and score to ensure that everything is correct and that your good credit habits are moving your score upward.
Sign up for free credit monitoring to check your credit score and automate the process. Unrecognized activity and early dispute are signs of identity theft.
Make Use of Budgets
Getting your first credit card is a great way to start building a positive credit history and a higher credit score, but it can also be a gateway to debt. To avoid this, treat your credit card like a debit card by creating a budget, using it for only one or two bills per month, and paying your balance in full each month.
This will assist you in avoiding debt, avoiding interest charges, and maintaining a low credit utilization ratio.
Keep Your Accounts Open
If possible, keep your credit accounts open, even if you’ve switched to a new card. Examine the terms of your credit card to ensure you’re making the best decision for your finances and credit. To avoid a credit hit, you can downgrade a credit card with an annual fee to a different card from the same lender.
Avoid Opening Multiple Accounts At The Same Time
To avoid adding multiple inquiries to your credit report, avoid using multiple credit cards in a short period of time. This can make you appear risky to lenders. Stick to one credit card for a while. Also, be selective about which card you apply for when you’re ready for an upgrade or a card with different features. Allow at least six months between new credit card applications.
Make Sure your Utilization Ratio is Always Low
The credit utilization ratio is the percentage of available credit on a credit card. To calculate the percentage, divide the balance by the card’s limit and multiply by 100.
To maintain a healthy credit ratio, it should be less than 30% and less than 10% for very good scores. Increasing available credit can be beneficial, but the best way to do so is to pay off the balance each month in order to establish a payment history and avoid paying interest.
Conclusion
I believe this is a very good overview. There are very good ways to maintain good credit. However, you can fall into bad debt if you are not cautious with credit cards.
