Everything you need to know about credit cards, but were afraid to ask
We’ve all heard horror stories of people going into massive debt after borrowing a relatively small amount on their credit card. And yet credit cards remain one of the most popular methods of payment, accounting for 23% of all transactions in the U.S. in 2018, an increase of 5% from just two years prior. So are credit cards a responsible way to borrow money and build credit, or a financial death trap? Learn how credit cards actually work, and how to use them safely.
Table of contentsWhat is a credit card?How do credit cards actually work?What’s the difference between a credit card and a loan?What is a credit card balance?How does credit card interest work?What is a monthly minimum payment and how is it calculated?What are the potential benefits using credit cards responsibly?What are the dangers of carrying a balance on your credit card?What should you consider when comparing credit cards?7 tips for getting the most out of your credit card
What is a credit card?
A credit card is a plastic card you can use to make purchases on credit, or money that you’re authorized to spend with the expectation that you’ll pay it back later. Unlike debit cards, which take money directly out of your checking account, the money you spend with your credit card is money you borrow from the credit card issuer.
How do credit cards actually work?
Now that you know what a credit card is, what exactly happens when you swipe you swipe or insert your card at a store, or hold your phone near the register, or type 16 digits into an online form?
The retailer’s bank asks for payment authorization from your credit card network (usually Visa, Mastercard, Discover, or American Express). Your credit card issuer (such as your bank) validates the details: your card number, security code (CVV), and credit limit.
Your credit card issuer puts a hold on that amount in your account, marking the transaction as pending and decreasing your available balance.
At the end of the day, it’s time to pay. The credit card issuer pays the amount owed to the credit card network, which pays the retailer’s bank. Finally, your credit card issuer sends you a bill.
What’s the difference between a credit card and a loan?
There are two main types of credit: revolving credit and installment credit. Revolving credit typically comes in the form of credit cards and refers to credit that you can borrow repeatedly up to a set limit (your credit limit). Installment credit typically comes in the form of loans and refers to a set amount that you’ve agreed to pay back in installments.
With a credit card, each time you pay off your balance, you can borrow the full amount of your credit limit again. With a personal loan, you’re given a lump sum all at once, and agree to pay back the loan over a set period of time. The other big difference is that credit cards typically carry higher interest rates than personal loans.
What is a credit card balance?
Your credit card balance is the amount of money you owe your credit card issuer. If you pay your balance in full during the grace period (typically 20–25 days), you won’t be charged interest on the money you borrowed.
If you don’t pay in full, that’s known as carrying a balance, because instead of bringing your balance down to zero on the payment due date, you’re bringing your balance with you into the next month. When you carry a balance, you have to pay interest on the money that you borrow—and the longer you carry a balance, the more interest you’ll end up paying.
How does credit card interest work?
Credit cards generally come with a variable interest rate, which means the amount of interest you’ll pay is based on the prime rate set by the Federal Reserve. Credit card interest rates are typically shown as APR (annual percentage rate), which shows how much interest you would pay over the year (excluding fees). When you sign up for a credit card, you might see a range of APRs representing how the interest rate may fluctuate.
Your interest will compound the longer it takes you to pay off your balance. Compound interest means you’ll owe interest on both the principal (the original balance) and the interest itself. Credit card companies compound interest daily, which means that the interest you pay each month will depend on your daily balance.
If your payment is late, not only will you be charged a late fee, but you may have to pay an even higher interest rate, known as a penalty APR.
What is a monthly minimum payment and how is it calculated?
Your monthly minimum payment is the minimum you have to pay the credit card company each month. This amount is typically only 2–3% of your balance. If you owe interest, the minimum payment might be the interest you owe plus 1% of your balance.
If you’re thinking, “It would take forever to pay off your balance if you only paid 1–3% each month,” you’re absolutely correct. To use credit cards responsibly, it’s best to ignore the minimum payment and pay your balance in full before the grace period ends. If you can’t pay in full, pay as much as you possibly can.
What are the potential benefits using credit cards responsibly?
If used correctly, credit cards can be useful financial tools. Some of the benefits of responsible credit card use include:
Protection from fraud: Unlike debit cards, which immediately withdraw cash from your checking account, credit cards add a layer of protection between you and any fraudulent transactions. If someone steals your debit card, or a vendor charges you the wrong amount, it can be difficult and time-consuming to return the money to your checking account. In contrast, if you find unauthorized charges on your credit card, you won’t have to pay for the missing amount—the credit card company will handle the fraud issue.
Build good credit: For most people, getting a credit card is the easiest way to build good credit. If you use your credit card well (i.e. always pay your full balance before the due date and keep utilization at 30% or below), you can improve your credit score, which will make it easier to get a loan or even rent an apartment.
Rewards: Many credit cards offer rewards programs, such as cash back or points that can be redeemed for travel and other purchases. Although you should never overspend on your credit card to get rewards (it’s just not worth it!), with safe credit card usage, these rewards can be a nice perk.
What are the dangers of carrying a balance on your credit card?
If credit cards are so great, then why do 47% of American adults carry credit card debt? Let’s walk through an example of how easy it is to find yourself in credit card debt, and how you can end up paying way more interest than you borrowed in the first place.
What would happen if you found yourself with a $1,000 credit card balance that you couldn’t pay off? $1,000 might not seem like a lot, but with 20% APR and a $20 monthly minimum payment, it would take you 9 years to pay off your debt, assuming you made the minimum payment each month. Over those 9 years, you’ll end up paying a whopping $1,168 in interest alone—more than you borrowed in the first place!
What should you consider when comparing credit cards?
If you’ve weighed the pros and cons of credit cards and decided to get one, here are some features to look into when shopping around.
Interest rates: In an ideal world, you would never carry a balance on your credit card, so the interest rate wouldn’t matter. In reality, credit card debt is a real possibility. The lower the interest rate, the better.
Annual fees: Although there are hundreds of no-fee credit cards, some people choose to pay an annual fee for a card with a higher credit limit, better customer service, or a great rewards program. Some credit card issuers will waive the fee for the first year, but be prepared to pay it—opening and closing cards frequently is not only a hassle, it can damage your credit score.
Credit limit: To maintain healthy credit, don’t spend more than 30% of your limit. This means that if your credit limit is $1,000, you shouldn’t borrow more than $300. The higher the credit limit on your card, the easier it’ll be to keep your usage low.
Rewards programs: Many credit cards offer rewards such as cash back, or points that you can redeem for flights or other purchases. Don’t be tempted into overspending on your credit card to get rewards, but do choose cards offering rewards that make sense for your lifestyle and spending habits.
Eligibility: Before applying for a credit card, check to make sure you actually qualify, to avoid an unnecessary hit on your credit report. If you have bad credit (or no credit score at all), look into student credit cards and secured credit cards, or see if you can become an authorized user on your parents’ account.
Foreign transaction fees: Foreign translation fees used to be a big deal in the credit card world. Most credit card issuers would charge a fee for every transaction made in a foreign country. Nowadays, most credit cards do not charge these fees, but it’s still a good idea to check your card’s policies before traveling. Other things to consider if you are a frequent traveler include whether your card has technology to work in foreign countries (most cards use chip technology) and which exchange rate your issuer uses.
7 tips for getting the most out of your credit card
When we talk about using your credit cards responsibly, what exactly does that mean? Here are some easy, concrete steps you can take to make your credit cards work for you.
Turn on autopay. The best way to make sure you never miss a credit card payment? Turn on autopay, so you don’t ever have to think about paying your credit card bill on time.
Change your due date. If your payment due date doesn’t line up well with your payday or other bills, call your credit card issuer and ask your to move your due date to a couple of days after payday.
Never carry a balance. If you must carry a balance, try to make more than the minimum payment. The more you can pay off now, the less interest you’ll be charged.
Start an emergency fund. 15 percent of Americans say if they had an unexpected $400 expense, they would put it on a credit card. Having an emergency fund means you can cover unexpected costs with cash, protecting yourself from future debt.
Start a budget. Making a personal budget (and sticking to it) can help you spend within your means and avoid credit card debt.
Never take a cash advance. Cash advances usually come with an even higher interest rate than regular borrowing: The average is about 24% APR, which is 8% more than the average credit card APR. Additionally, you won’t have the option of a grace period on cash advances: You’ll be charged interest every time.
Be cautious with balance transfers. Balance transfer credit cards are credit cards designed for people with credit card debt. The idea is that you can transfer your credit card balance (debt) from one high-interest card to a different card with a lower interest rate (or no interest at all). The catch? The low-interest-rate period typically ends after a year or so. If you don’t pay off your debt during this time, you’ll start paying high interest again—or, you’ll search for another balance transfer card, getting stuck in a cycle of opening and closing accounts that can negatively impact your credit score. (Also, keep in mind that you may have to pay a 3–5% fee just to transfer the balance.)
The bottom line? Credit cards can be a useful financial tool, so long as you use them carefully. Paying your balance in full each month might seem obvious, but it’s surprisingly hard to do when faced with life’s financial challenges.
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