Before you start swiping your plastic, it’s important to understand how credit cards work. A credit card gives you the flexibility of using a revolving line of credit to make purchases, transfer balances and withdraw cash that you can pay back later — either in full or by making minimum monthly payments over time. Here, you’ll learn what a credit card is, how credit works and how to properly use a credit card.
What Is A Credit Card?
A credit card is a payment tool that allows you to borrow money from a bank to make everyday purchases, transfer balances and take cash advances. People use credit cards to purchase things they need and want, earn rewards and points, improve their credit rating, consolidate debt, and pay for emergency expenses.
There are two types of credit cards to consider: a secured card and an unsecured card.
Types of Credit Cards
Secured credit cards
As the name implies, a secured credit card is backed by money you deposit with the lender to open an account. The amount of your deposit usually determines your credit line. So, for example, if you deposit $500, you’ll have a $500 limit. With a secured card, the lender can take possession of your deposit if you don’t repay the loan. This type of credit card may be ideal for someone who’s looking to establish or rebuild credit.
Unsecured credit cards
Unlike a secured credit card, an unsecured credit card doesn’t require a monetary deposit to open an account. Instead, the lender assigns a credit limit based on their assessment of your credit risk — which may involve taking a look at your credit score, payment history, debt to income ratio and other indicators of your stability and ability to make payments.
Some unsecured credit cards offer rewards that can earn you cash back or points that can be redeemed for things like travel and entertainment.
How Does Credit Work?
Borrowing money from a credit card or through an installment loan can help you build good credit if you understand how credit works. Lenders report information like payment history, debt usage, credit inquiries and age of your credit accounts to three credit bureaus: Equifax, Experian, and Transunion. These credit reporting agencies use the reported data to calculate your credit score, which helps future lenders determine if you’re a credit risk.
Is Having A Credit Card A Good Idea?
A credit card can help you establish a good credit history if you use it wisely and make payments on time. What’s more, having good credit may help take the stress out of life’s financial challenges — making it more likely for you to qualify for a loan, get lower interest rates, get hired for certain types of jobs and more.
In addition to building good credit, credit cards can offer the following benefits:
- Convenience and saving time
You can easily make online purchases, use credit cards in other countries and set-up recurring charges on a credit card.
- Rewards and Perks
Some credit cards offer perks like cash back, frequent flyer miles, sign-up bonuses and more—giving you the chance to save money while you spend.
You can check transactions online as often as you’d like, and may receive a year-end summary of your credit card transactions.
- Protection and Peace of Mind
A credit card can give you the peace of mind of having the means to pay for something in the event of an emergency. Additionally, many credit cards offer purchase protection, fraud protection, and travel and car rental insurance.
- Convenience and saving time
Understanding Credit Cards
6 things you should ask yourself before applying for a credit card:
- How Do Credit Payments Work?
Credit card issuers require you to make a minimum monthly payment on your account to avoid late fee charges and past due payments from being reported to the credit bureaus. The minimum payment — generally a small percentage of your total balance during the billing cycle — will appear on your credit card statement. In order to maintain good credit and avoid unnecessary fees, you should make at least the minimum payment each month and keep your balance below your credit limit. While credit card issuers offer flexibility in repayment terms, paying more than your minimum monthly payment may help you pay off your debt sooner than later.
- What Is A Credit Card Limit?
A credit card limit is the maximum amount of credit a financial institution allows you to spend on your credit card. It’s important to know your limit. Exceeding it can result in negative consequences like over-limit fees, a decrease in your credit line and a potential increase in your interest rate. Making more than your minimum payment may help you reduce your balance and increase your chances of getting a credit line increase. Credit card issuers periodically review accounts and those in good standing may qualify for an automated credit line increase.
- What Is A Credit Card Balance?
A credit card balance reflects the total amount you spend, including any fees and interest charges on your account. Your monthly payments are calculated as a small percentage of this balance. One of the easiest ways to improve your credit score is by keeping an eye on your credit limit and keeping your balances low. Part of your credit score is influenced by debt to credit ratio — which looks at how much you owe versus your credit card limit.
- What Is A Minimum Payment On A Credit Card?
A minimum payment on a credit card is the lowest amount you need to pay each month to avoid late charge penalties and keep your account current. Credit card issuers set these payments at either a fixed amount like $25 or a percentage of your balance like 1% or 2%—whichever is higher. Making these small payments on time can help you avoid late fees but may not help you make progress on paying off your balance. If you miss a payment or pay less than the minimum, you may be charged a late fee and lose any promotional interest rates you have on your balance. Additionally, your account could be reported past due to the credit bureaus.
- What Does Available Credit Mean?
The available credit is the amount you have left on your credit line to spend. In simple terms, it’s your credit line minus the balance you owe. Going over your the available credit line could hurt your credit score. It puts you at risk of being charged over-limit fees, having your credit line reduced or even worse — having your account closed by the lender.
- Do Credit Cards Have Fees?
Some credit cards have fees and others don’t. The good thing is that many fees are avoidable if you know what they are and why they’re charged. Look out for these fees when applying for a credit card:
- Annual Fee:
Not all cards come with annual fees but you may decide the rewards and benefits on a credit card are worth the fee. Do the math to determine if you’ll earn enough points and rewards each year to outweigh the cost of the annual fee.
- Balance Transfer Fee:
The fee for a balance transfer can run anywhere between 3% and 5% of the amount you transfer. Many cards offer 0% interest on balance transfers for a year or more. This is another fee that could be worth the expense if the amount you save on interest makes up for the cost of the fee.
- Cash Advance Fee:
When you borrow cash from a credit card, expect to pay a fee of 2% to 5% of the amount you borrow. You should also consider ATM fees and the interest rate charged on cash advances—it may be higher than the interest rate charged for making purchases.
- Finance Charge:
You can avoid finance charges by paying your balance in full by the due date each month.
- Foreign Transaction Fee:
A foreign transaction fee is a charge of 1% to 3% added onto purchases that you make outside the U.S. Be on the lookout for this fee — some cards like travel cards don’t charge it.
- Late Fee:
Avoiding a late fee is easy if you make at least your minimum payment by the due date each month.
- Over-limit Fee:
If you go over your credit limit you could be charged an over-limit fee. The simplest way to avoid this fee is to stay well under your credit limit.
- Returned Payment Fee:
A returned payment fee is charged when your payment is rejected by the credit card company for insufficient funds. The best way to protect yourself from being charged this fee is by making sure you enough money in your account to cover your payment.
- Annual Fee:
How to Start Using A Credit Card
If you’re thinking about using a credit card, use it safely and wisely. Keep your financial health in good shape by following these smart tips.
- Make your credit card payments on time.
- Keep track of your spending. Create and stick to a budget.
- Make more than your monthly payment or pay the balance in full.
- Check your credit card statement frequently to look for fraudulent charges.
- Understand the terms of your credit card agreement to avoid potential fees.
- Use credit responsibly by borrowing only what you can pay back.
- Don’t go over your credit limit.
- Take a look at your credit report once a year
Before you commit to using a credit card, you may want to consider other options. Think about your financial big picture and immediate financial needs before you make a decision. If a credit card isn’t right for you, a personal loan may be a better solution. Our Compare Personal Loans to Credit Cards page may help you choose the right financial option for you.