Credit Cards 101
10-minute readOctober 15, 2020
A credit card can be a great tool if you use it responsibly. Proper credit usage can result in some pretty nifty consumer protections, help finance new purchases, earn you rewards and help build good credit.
However, if you’re not careful, your credit card usage can have serious consequences to your finances. For example, if you tend to overspend and don’t make timely payments, you could find yourself owing a lot of extra money in interest charges, or your credit score could go down.
Understanding what a credit card is, how it works and how to manage your credit card usage wisely is key to improving your finances. Let’s take a closer look at some credit card basics.
What Exactly Is A Credit Card?
A credit card is given to you by a company or a bank (also called an issuer) –through payment networks such as Visa, Mastercard, Discover and American Express –that lets you borrow money against your line of credit, or your credit limit. To get a credit card, you’ll need to go through an approval process, which typically involves you filling out an application and the issuer assessing your creditworthiness.
How Do Credit Cards Work?
You can use a credit card to pay for goods and services at participating retailers. These transactions will then appear on your bill. You’re essentially borrowing money from the issuer to cover your purchase, which you’ll need to pay back at the end of each statement period, which is usually each month. As the credit card holder, you’ll need to approve your purchases, either by signing the retailer’s receipt or entering on your zip code when prompted on a machine (like at a gas station).
You can use your credit card as often as you’d like (also known as a revolving line of credit) as long as you stay within your credit limit, which is the maximum amount you’re allowed to borrow. That amount is at the discretion of your credit card issuer and will depend on factors such as your income, credit history, other loans and the balance on any other credit cards.
Let’s say you have a $2,000 credit limit. You can make as many purchases as you want up to that limit. If you want to make more purchases, you’ll need to pay down some of that balance. In some cases, you can ask for a credit limit increase, but that’s also at the discretion of the issuer.
Depending on the type of credit card, you may be able to get other types of consumer perks and protections. For example, some credit cards offer cash-back rewards (we’ll cover this in more detail below) and extended warranty protection. Some may charge an annual fee for the privilege, while there are many that are free.
When you receive your credit card bill, you can pay off the entire balance or another amount of your choosing. Your statement should have a section where it indicates the minimum amount you need to pay each month –doing so will help you avoid late payment fees and other consequences like a lower credit score.
Your credit card issuer gives you a grace period to pay your bill –this period can be as long as 30 days – where you can avoid accruing interest as long as you pay off your purchases in full. Your credit card activity is reported to the major credit bureaus, shows up on your credit report and can help determine your credit score.
Requirements To Get A Credit Card
To qualify for a credit card, you’ll need to be at least 18 years old and have some sort of established credit history or proof of income. An established credit history includes proof you have other loans or credit cards in your name and that you’ve been making timely payments on them.
Typically, the higher your credit score, the more likely it is you’ll be approved for credit cards. That said, there are credit cards for those who want to build or rebuild their credit. If you’re unsure of your credit score, you can track it for free at Rocket HomesSM. If you’re under 18 years old and you want a credit card in your own name, you can consider having a parent or legal guardian adding you as an authorized user (where you’re under their account) or having them co-sign an application.
This can work for other folks who may not have an established credit history or a good credit score. Some are secured credit cards –you put down a refundable cash deposit that acts as your credit limit. When you keep making on-time payments, you build positive credit history and can eventually ask the issuer to upgrade your credit limit.
There are also unsecured credit cards –typically for students and those with fair credit history. Many of these will require you to have a certain income threshold and could charge you an annual fee. The use of these credit cards is set up so that your activity will be reported regularly to the major credit bureaus, and often offer you a way to get credit-limit increases.
Different Types of Credit Cards
There are many types of credit cards, from options for those who don’t have a lot of established credit history to ones for people who have excellent scores. Let’s take a look:
Secured credit cards – As mentioned above, these are credit cards for those who have no credit or less-than-stellar credit. You’ll need to put down a security deposit that acts as your borrowing limit. Once you upgrade to an unsecured credit card, you can get this money back. Some secured credit cards may also have an annual fee.
Unsecured credit cards – These types of credit cards are available to people who have fair to excellent credit and may or may not charge an annual fee. For people with average credit, these credit cards don’t come with many perks other than the ability to build a positive credit history. Some might offer rewards (more on this below) but the set monthly limit is typically not as high as cards for those with excellent credit.
Student credit cards – If you’re a college student, this kind of card might be a good choice as it doesn’t require an excellent credit score (typically you’ll need an average score and proof of income). There are more competitors cropping up, offering rewards such as cash back and other types of bonuses.
Low-interest credit cards – In many cases with these cards, you won’t receive rewards or other perks except for the lower interest. They usually come with a 0% introductory APR offer which can run anywhere from 6 to 18 months. Some offer this low interest on purchases as well as balance transfers. You usually need good to excellent credit to qualify, and the issuer may charge a balance transfer fee.
Rewards credit cards – That’s right. Credit card issuers want to reward you for your purchases. There are different kinds of rewards: cash back, travel incentives, store credit perks and airline miles. Cash-back cards give you a little kickback on each item you buy, typically a percentage of the purchase amount, which you can redeem for cash or a statement credit. Rewards points or miles are typically for flights, hotels or other types of travel expenses. Many are branded credit cards, meaning you can only use rewards towards a specific airline or hotel chain. Others offer the ability to transfer points to various rewards programs. These cards are usually only for those who have excellent credit.
How Are Credit Cards Different From Other Loans?
Credit cards are different from other types of loans in that this type of debt is usually considered “bad debt.” In other words, it doesn’t necessarily help you build equity (like you would with a house) and it has a higher interest rate than other types of loans.
For example, a credit card’s APR is typically in the double digits (with the except of introductory rates) which is much higher than say, a mortgage. If you have a secured credit card, or an unsecured one for those with no to low credit, you will find that these APRs can be at least 20%.
If you’re late or miss a payment, some credit card companies will start charging you a penalty APR. This can sometimes be higher than the regular APR.
How To Get A Credit Card
Now that you’ve nailed down the basics of a credit card, let’s talk about how you can get one.
Tips For Getting Your First Credit Card
Before applying for a credit card, familiarize yourself with some of the more common terminology you’ll come across. Then, get to know your credit score intimately, including what has the most impact on it.
For example, your payment history is one of the biggest indicators of your creditworthiness, so it counts for 35% of your score. Your credit utilization rate –how much available credit you have versus how much you’ve used up –also takes up a big chunk: 30%.
Once you know where you stand, you can take a look at the credit offerings out there. If you’re just starting out on your credit-building journey, you may need to consider secured credit cards or ones earmarked for those with no to fair credit. Otherwise, there are options such as having a co-signer or being added as an authorized user on another person’s credit card.
Benefits Of A Credit Card
Aside from the ability to build credit, here are a few other benefits of credit cards:
Borrowing at lower rates – Once you’ve established a positive credit history, you may be able to take out other types of loans at much lower interest rates.
Earning rewards – Some credit cards earn you rewards for each purchase, like a certain amount of cash back or points and miles toward merchandise or trips.
Getting sign-up bonuses – Many rewards credit cards offer sign-up bonuses that can be worth hundreds of dollars if you spend a certain amount within a specified time frame.
Consumer protections – You can be protected from fraudulent purchases –meaning you’re not on the hook for items you didn’t buy.
Flexibility – Think of credit card use as a temporary loan that can offer you a 0% interest rate, assuming you pay off the balance in full each month.
Dangers Of A Credit Card
Yup, there are downsides to using a credit card as well:
Paying Interest – Interest rates on credit cards are notoriously high if you decide to carry a balance. If you decide to take out a cash advance, interest starts to accrue as soon as you take the money out, and the resulting APR can be higher than the regular purchase APR.
Balance transfers aren’t free – Those 0% introductory APRs come at a price. Some offer flat fees to transfer your balance from one credit card to another, while others charge you a percentage of the transfer amount.
May not be travel friendly – Some credit cards charge a foreign transaction fee, which is a certain percentage of your purchase and can be as high as 3%. This is on top of whatever exchange rate you’re subjected to, and that can add up.
Paying annual fees – Sometimes it might be necessary if you need to establish credit but paying an annual fee can get expensive. However, some might be worth it if they offer valuable perks beyond what you’re paying. Check carefully to see if that’s the case.
Fees for late payment – It depends on your credit card issuer, but you could pay a late fee if you miss a payment. In some cases, your APR could go up as well.
When To Close A Credit Card
Closing your credit card is a personal choice. In some cases, maybe you’re paying an annual fee but aren’t taking advantage of all the perks, or maybe you no longer need a secured card because your credit score is high enough to qualify for a rewards option.
Before you go ahead and close your card, think about what can happen. You might be concerned that closing a credit card can affect the length of your credit history, but closed accounts will stay on your credit report for up to 10 years. The more concerning issue is in your credit utilization ratio – this is what could lower your credit score.
Your credit utilization ratio is your available balance compared to your credit limit. Typically, creditors like to see this number stay below 30%.
Let’s say your credit cards combined give you a credit limit of $10,000 and you currently have $2,000 in purchases on these cards. Your credit utilization is therefore 20%. If you close a credit card, your available limit goes down, therefore increasing your credit utilization.
Using the above example, if you close a credit card that has a limit of $5,000 and you still have a $2,000 balance, then your credit utilization is now 40%.
If you do want to close a credit card, think carefully about how it can affect your credit utilization ratio.
How To Use A Credit Card Wisely
Learning how to use a credit card wisely is crucial because you want to be able to reap the benefits of responsible usage. While little mistakes here and there aren’t the end of the world, if you continue to develop habits that aren’t beneficial, there could be major consequences.
First, make on-time payments. As mentioned previously, this is one of the major factors that counts towards your credit score calculations, so paying even the minimum balance will help prevent any dings on your credit report. Also, don’t spend what you can’t afford –try to make purchases you can pay off with your bank account balance each month.
If you’re after those rewards credit cards, it’s only worth it if you pay off the balance in full each month. Otherwise, the interest you’ll be paying will offset any rewards you earn. Some cards have sign-up bonuses, so be sure to follow the requirements carefully in order to be able to qualify for these.
Other tips for using your credit card wisely include keeping your balance below 30% utilization ratio; waiting at least a few months between new credit card applications; reviewing your credit card statements to make sure there aren’t any fraudulent transactions; and keeping your credit cards active (put a small purchase on it each month) to avoid them being closed.
Understanding credit card basics is helpful so you can be aware of what behaviors help or hinder your credit-building efforts. When applying for a credit card, know what your credit situation is like and apply for a card that offers you a high chance of approval. That way, you don’t risk having too many dings on your credit score and you can get on your way to being a responsible credit user.
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