Credit card basics: How credit cards work
It’s nearly impossible to get through life without knowing a little about how credit cards work. Celebrity-studded commercials and ads for these little pieces of plastic are everywhere, possibly even cluttering up your mailbox.
But what are they really, and how do they function? Let’s take a look at the basics of how credit cards work.
Here’s how credit cards work:
Credit cards are a form of revolving credit. In other words, you are extended a line of credit that you can borrow against, and as you repay it, you can borrow from it again.
The amount you’re given for your line of credit is based upon your creditworthiness. So, someone with good credit will get a higher limit than someone with fair credit.
How credit limits work
Say you get approved for a credit card with a $1,000 limit, then you put a $500 purchase for a new television on the card. You have $500 left to borrow.
Once you repay the outstanding $500 debt, you may borrow up to $1,000 again, over and over again, indefinitely. Hence the word “revolving.”
This is very different from student or personal loans. With those types of loans, you are given a set amount of money upfront, and you typically repay it in installments of the same amount each month. Once it’s repaid in full, you’re done. Credit cards, on the other hand, allow you to keep borrowing.
Paying off the balance
Once you make a credit card purchase, you have the option to pay off the entire balance at once. If you do it quickly enough, during what’s called a grace period (time period varies by issuer), you won’t pay interest on it, and your statement will read $0.
But if you can’t afford to do this, you’ll carry a balance and pay a minimum monthly payment that includes your finance charge, or the interest.
A credit card’s billing cycle is often around 30 days, but can be slightly longer or shorter. Once your billing cycle ends, you’ll be charged for any outstanding balances and fees incurred in the previous cycle. This means you pay for your purchases the month after you make them. Your credit card payment will usually be due within around three weeks of the end of the billing cycle.
Your credit card activity is reported to the credit bureaus. On-time payments and a low credit utilization ratio — not spending too much of your credit limit — can help you build good credit.
Late payments can result in bad credit.
When to use credit cards
Credit cards can be a useful convenience when used for day-to-day expenses and paid off at the end of the month, says Chris Chen, a certified financial planner and wealth strategist at Insight Financial Strategists in Boston.
“In some cases, it’s very difficult to function without a credit card — for hotels and rentals cars, for instance,” he says. He adds that they are also useful for online shopping, since credit cards offer far more protections than debit cards.
Credit cards can also be helpful for emergencies. For example, let’s say your car breaks down, but you won’t have the $200 needed to fix it until next month. You can put the purchase on your card and have a working car now, then repay it over the next month or two.
Many credit card companies offer promotions of 0% interest, usually for a year, Chen says. “If you qualify for one of those deals, that could be a good way to afford a necessary purchase or to refinance a current debt.”
Credit cards that have no foreign exchange fees can also be useful for international travel, Chen says. “Banks usually have better exchange rates, and they usually pass it on to consumers,” he explains. “In the case of overseas travel, using a credit card as opposed to exchanging cash can save several percentage points on the cost of a foreign vacation.”
However, using credit cards to live beyond your means or to simply get by every month is a bad idea, Chen warns. “It’s often difficult when you are short of money and you need stuff. However, the long-term cost of borrowing on a credit card is greater than it appears,” he says.
Chen gives the following example: “For instance, if you buy a $1,000 computer on credit, and pay the minimum payments, three years later that $1,000 computer will have cost in excess of 40% more, depending on the credit card, and will be that much harder to pay off.”
You’re almost always better off not carrying a balance, Chen says. And if you do, pay at least the minimum payment, and pay it down as fast as you can.
This is because the minimum monthly payment primarily covers interest — only a portion of it goes to the principal debt. So if you only ever pay the minimum, as shown in Chen’s example above, it can take a very long time to pay off the debt, and you end up paying far more than the original purchase.
Credit card fees
Be aware that some credit cards come with an annual fee, primarily on rewards credit cards.
This is a once-per-year fee that will appear on your statement, which you pay for being a cardholder.
While it’s obviously better to have no fee, Chen says, they can be justified if the card comes with benefits that you’ll actually use. Otherwise, the fee is useless, he says.
Common benefits include cash back, frequent flier miles, free checked bags and priority boarding.
It’s common to see credit card offers where the annual fee is waived for the first year. But there are plenty of credit cards out there that do not charge annual fees, Chen says.
Another common credit card fee is a late fee. If you miss your payment due date, expect to be charged $25 for the late payment. And if you continue to pay your bill late, you may face higher late fees and a higher interest rate. That can bring down your credit score.
When used wisely, credit cards can be a helpful financial tool, allowing you to get by in a pinch, making travel and shopping easier and helping you build good credit.