Understanding credit cards can help transform the small piece of plastic in your wallet into a potent financial tool. You can use it to improve your credit, earn valuable rewards, and take advantage of helpful cardholder perks. But you’ll want to start with a basic understanding of how credit cards work.
1. You borrow money every time you use a credit card: Although credit cards and debit cards look similar, one of the most important things to know about credit cards is what happens when you make a purchase.
If you use a debit card, the money comes directly from your checking account. With a credit card, you’re borrowing money from the card issuer to buy something and agreeing to pay the money back later. You’ll also have to pay interest unless you repay the loan in full each month.
2. How interest works on credit cards: Most credit card companies charge interest daily. The card issuer multiplies your daily rate by your end-of-day balance, and then adds the interest charge to your balance. As a result, the interest charges compound (you get charged interest on your interest) throughout the month.
To determine your daily rate, you can divide your card’s annual percentage rate (APR) by 365 (some credit card companies use 360.)
If you pay your entire balance by the due date each month (i.e., the grace period-see 4 below), you will not accrue interest.
Remember, your credit card could have different APRs for purchases, balance transfers, and cash advances.
3. Credit cards typically have variable interest rates: Credit cards often advertise a range of variable APRs, such as 15.99% to 24.99%. Your credit-worthiness can impact the rate you initially receive; the higher your credit, the more likely you will be charged a lower APR within the range provided. But with variable APRs, your interest rate on new purchases can also rise or fall over time, as it fluctuates with the rate index it is tied to (usually the prime rate as published by the Wall Street Journal).
4. Your credit card’s grace period: Many credit cards offer cardholders a grace period, at least 21 days between the end of your billing cycle and your bill due date. If you pay your balance in full during the grace period, the issuer waives the accrued interest on your purchases.
What this means is that the credit card company will send you your bill 21 days before it is due. If you pay your entire balance during this time period (i.e. the grace period) then you won’t accrue interest.
5. How credit card payments work: Paying off your balance each month lets you avoid paying interest, but it isn’t always possible. When you can’t afford a full payment, be sure to pay at least your minimum amount due, which may be a percentage of your balance, or a set amount, such as $25 or $30.
You can also set up automatic payments for the minimum amount, or the full balance, to avoid accidentally paying late.
6. What happens when you pay late: The issuer will charge you a late payment fee (or a penalty APR if you’re 60+ days late) if you don’t make at least the minimum payment by the due date. Your card issuer may also report your late payment to the credit bureaus, which can hurt your credit score.
7. How to find the best first credit card: When you’re looking for your first credit card, you may want to look for a card that has few fees and is designed for beginners. Student credit cards, available to college students, or secured cards, for people who’re building or rebuilding credit, are two options.
8. The difference between secured cards and unsecured credit cards: Secured and unsecured credit cards work the same way. However, when you get a secured credit card, you’ll give the issuer a refundable security deposit that’ll be equal to your credit limit.
The security deposit isn’t for your monthly payments, be sure to make those. Rather, the issuer can take it if you default on the card. This limit’s the issuer’s risk, which is why it’s easier to get a secured card if you have a poor or no credit history.
9. What to look for in a credit card: Before applying for a credit card, consider your likelihood of getting approved, the card’s rewards program, cardholder benefits, and the card’s fees. Credit cards are not a “one size fits all” proposition – the “best” card is going to depend on your circumstances, goals, and financial habits.
10. Cards can have a variety of fees: Look out for fees no matter which card you choose. Here are a few common ones:
- Annual fee: A fee you pay each year to keep the card open. Some cards waive the annual fee the first year to attract new cardholders. Others don’t have an annual fee. Check to make sure that the benefits you get from the card (i.e. rewards/miles/cash back) outweigh the fees
- Late payment fee: Charged if you don’t make at least a minimum payment by the due date
- Balance-transfer fee: If you transfer a balance onto a credit card, you may have to pay an additional 3-5% of the amount you transfer
- Cash-advance fee: You may have to pay 3-5% of the balance if you withdraw money from an ATM or bank with your credit card
- Foreign transaction fee: A fee for making purchases outside the U.S. or in non-U.S. dollars. It’s often 1-3% of the purchase amount
11. Credit cards can affect your credit score. Your credit card issuer will report your payments, or lack of payments, to the major consumer credit bureaus. By making on-time payments, you can build a positive credit history, which can help your credit score.
Also, try to only use a small portion of your overall available credit, as your utilization ratio — your reported balance divided by your credit limit — is a major factor in credit scoring.
12. How authorized users work: A primary cardholder can choose to add an authorized user to his or her credit card account. You can add anyone as an authorized user, but be careful because, in the end, the primary cardholder is responsible for the debt. The arrangement might be best suited for parents who want to give a child a credit card to use at college or spouses who share an account.
13. When to use a credit card: Credit cards may offer cardholders several benefits over paying with cash or debit, including zero liability for unauthorized purchases made with your card.
Some credit cards can also give you valuable rewards, which you can redeem for cash back, free travel, or other rewards. And cards may offer other perks, such as extended warranties on your purchases and trip, baggage, and rental car insurance while traveling.
However, you don’t want to use a credit card for non-essential purchases if you can’t afford to pay off the balance later. You could wind up paying more in interest than you earn in rewards.
14. Your rights as a cardholder: Several federal laws give you certain rights and protections, including the Truth in Lending Act, Fair Debt Collection Practices Act, Fair Credit Billing Act, Fair Credit Reporting Act, and The Credit CARD Act.
These include the rights to see the card’s terms, limit your liability for unauthorized charges, allow you to dispute incorrect charges and mistakes on your credit reports, and prevent card issuers from raising the interest rate on outstanding balances.