Ready to sign up for your first credit card and need a primer on how they work? Do you already have a credit card but you find yourself a bit confused about how credit card interest is calculated? This guide will cover everything you need to know about getting and using a credit card, including the benefits and perks of responsible credit use.
Credit cards are essentially a line of credit that you can use repeatedly as you pay off your balance. If you have never used a credit card before, they can seem a bit intimidating at first -- especially if you've heard how easy it is to accumulate a lot of debt. At the most basic level, though, credit cards are simply a financial tool that can be invaluable for building credit, financing purchases, and enjoying benefits like purchase protection on what you buy.
Here's how credit cards work and how they're used to establish and build credit.
Credit cards are basic financial tools that give you a line of credit you can use either at a specific merchant or anywhere the credit card network (Discover, Visa, Mastercard, or American Express) is accepted. The credit card has encoded information that ties it to your credit card account.
Credit cards are a type of revolving credit which means you don't borrow money all at once like an installment loan, such as a mortgage or car loan. Instead, you make purchases with the account and borrow against your credit limit, the maximum amount the credit card issuer will allow you to borrow at once.
All transactions are posted to your account. This balance represents money you have borrowed but not repaid yet. You can reduce your balance at any time by making payments to your account which makes an equal amount of your credit limit available again for new purchases.
Every month, you will be required to make at least the minimum payment to keep your account in good standing. This minimum payment must be paid by the due date every month. Your minimum payment is calculated based on your balance and it's usually 2-3% of the balance or the outstanding interest plus 1%. If you have a $1,500 balance, your minimum payment will probably be $30 to $45.
Because the minimum payment is just a tiny fraction of your balance, paying only your minimum payment every month means it can take you many years to pay off your balance. You'll also face hundreds in interest charges that will likely exceed the original balance.
Rather than making minimum payments, you have the option of simply paying your bill in full each month. This allows you to avoid interest charges and helps your credit score because your balance and credit limits are reported to credit bureaus. Lenders want to see low balances which shows you use credit responsibly and aren't facing any financial hardship.
Applying for a credit card is a simple process that's usually done online, over the phone, or in a store. The application will require personal information to establish who you are, how much you earn, and what your credit profile looks like to determine if you qualify for the credit card and the terms you will receive.
The information you provide will be verified by checking your credit from one or more credit bureaus: TransUnion, Equifax, and Experian. The credit card issuer will want to see your credit score, overall level of debt, payment history, and whether you have applied for other forms of new credit recently -- a potential red flag.
After verifying your credit, the issuer will consider your income to determine if you can afford a credit card and what credit limit to give you.
It's very important to be honest on your credit card information. It may be tempting to exaggerate your income, but if the credit card issuer discovers you knowingly provided false information, you can be charged with credit card fraud.
Unless you are applying with a paper application, your application can be processed in just a few minutes.
It's a common misconception that you're limited to a certain number of credit cards. Actually, you can have as many as you like, but credit card issuers may limit the number of accounts you can have open.
Every time you apply for a credit card, the card issuer will check your credit report. Too many open accounts -- especially if you carry balances -- can get you turned down for a new card. For example, Chase has a well-known 5/24 rule: if you have opened five or more new credit cards in the past 24 months, Chase will not approve you for a new card.
As a general rule, you ideally want to have at least one credit card, but having a few can be a good thing, too, if you use them responsibly. You may have one low interest credit card for financing major purchases, for example, and a rewards card for when you travel. Too many credit cards can adversely affect your credit, though, and make it difficult to avoid late payments and debt if you aren't careful.
There are three types of credit card transactions: purchases, cash advances, and balance transfers. You'll probably use your credit card most often to make purchases in-store and online, but you can also transfer a balance from another card or use your credit card to withdraw cash.
Cash advances should be avoided as a general rule. When you use the convenience checks from your card issuer or take out cash from an ATM, you'll face a lot of costs:
If you have high-interest debt on another credit card, you can usually transfer it to another credit card. This generally only makes sense when you transfer the debt to a card with a lower interest rate and/or a low promotional interest rate. You'll usually pay a balance transfer fee to do this, but it can be a great way to save on interest charges and pay down your debt faster.
Opening and using a credit card can affect your credit score in many ways. Your credit score is determined by five important factors:
All credit cards work in the same basic way but there are many types of credit cards today to fit different types of spending habits and credit scores. To get the most benefit from a credit card, it's important to choose the right type for your needs.
Here's how each type of credit card works and who they're best for.
There are two broad types of credit cards: secured and unsecured.
A secured credit card is one that requires a deposit that determines your credit limit. Essentially, you are funding the account with a refundable deposit. If you don't make payments, the credit card issuer can close the account and take your outstanding balance from the deposit.
Secured credit cards are easier to get than unsecured credit cards because they're backed by collateral, much like a car loan or a mortgage. If you have bad credit or you're working to build credit, you may need to start with a secured card.
An unsecured or standard credit card is probably what you think of when you think of a credit card. You may or may not pay an annual fee, but you otherwise don't need to fund the card. Your credit limit is instead determined by your credit score and ability to repay.
Both types of credit cards can be divided into further categories. Both may come with rewards, for example.
If you tend to carry a balance from month to month, a low interest credit card will probably serve you best. This type of credit card typically doesn't offer rewards but it does come with an interest rate that's significantly lower than average. As a general rule, you need a very good credit score to qualify for a low interest card.
Most credit cards allow you to transfer a balance, but a balance transfer credit card is unique because it offers a very low introductory rate on transferred balances. For example, you may get a 0% intro APR for up to 21 months. In this case, you pay no interest on your transferred balance for the term of the promotion, potentially saving you hundreds or thousands in interest.
Transferring an existing balance to a balance transfer credit card can be a smart way to pay down your debt faster -- but only if you don't rack up more debt. Keep in mind it usually isn't free to transfer a balance from one card to another. There's usually a balance transfer fee of 3-4% of the balance, but some balance transfer cards do waive this fee for a limited time.
Business credit cards are standard credit cards designed for business use. A business credit card can be used to help small business owners build business credit which can make it easier for the business to qualify for loans, terms from vendors, office leases, credit lines, and business insurance.
There are a few ways in which business credit cards can differ from personal credit cards, although this depends on the card issuer:
A student credit card is a credit card that's designed for and marketed to college students. In general, student cards usually have lower credit limits but they're easy to get, even with limited or no credit history. To get approved for a student credit card, you usually need to be enrolled in a college, university, or trade school.
Many credit card issuers today include features designed for students. Bank of America, for example, partners with Khan Academy to offer education on how to use credit responsibly. The Discover it Student card offers a statement credit for students who maintain a GPA of 3.0 or higher.
These credit cards are typically fee-heavy cards that target consumers with subprime or bad credit scores. With a subprime credit card, you can expect hefty fees, lower credit limits (often just $300 to $500), and higher interest rates.
A rewards credit card is a credit card that earns some type of rewards on purchases. These cards usually require good to excellent credit and earn rewards in the form of travel perks, cash back, or points.
Rewards credit cards can be further divided into many categories like cash back cards, hotel rewards cards, airline credit cards, and general travel rewards cards. We'll go into more detail about rewards credit cards in the next section.
One of the most popular types of credit cards is a rewards credit card. These cards offer some type of reward program to earn travel benefits, points, or cash back. When used responsibly, a rewards credit card can help you save a lot of money on your purchases. They can also make it easier to accrue debt -- especially if you carry a balance -- as even a few days' worth of interest can eat up the rewards you are earning.
Rewards credit cards come in many varieties:
Credit card rewards are usually fairly simple. When you make a purchase with your card, you earn rewards automatically that are calculated and added to your credit card account.
Every transaction has a merchant category code that's used by the card issuer to know what type of spending the transaction is and the percentage of cash back (or number of rewards points) it qualifies for.
These merchant category codes make it easy to determine when your spending qualifies for a boosted reward rate such as 5% cash back rather than the standard 1% cash back.
Card issuers pay for these rewards programs when merchants pay interchange fees on transactions. When you pay a retailer $100 for merchandise with your credit card, they may only receive around $97.
Some cards give you a flat rewards rate on all spending which may be 1% to 2%. Others give you a higher rewards rate on set or rotating categories like gas stations, department stores, or groceries.
Tracking the rewards you earn is easy: when you log into your credit card account online or on an app, you should see your current rewards balance. The rewards for pending transactions generally won't show up until the transactions post.
You can also use an app to track credit card rewards across multiple accounts. Points.com offers a Points Loyalty Wallet to track, transfer, and redeem miles and points by consolidating your various memberships into one dashboard.
You can redeem the rewards you earn online through your credit card account. With most rewards, redemption is as easy as entering how many points (or how much cash back) you want to redeem for an automatic statement credit. Most rewards programs also have shopping and travel portals for redeeming points for merchandise, airfare, and gift cards. With hotel and airline rewards cards, you can book airfare and hotel stays by logging into your loyalty account that's linked with your credit card.
A credit card allows you to carry your balance forward from one month to the next, but failing to pay off your balance in full each month means you will pay interest. Credit card interest is charged on a daily basis to affect not only the existing balance on your account but any new purchases that post. The interest you are charged becomes part of the balance that accrues even more interest the next day.
Credit cards tend to have very high interest rates, especially when compared to other consumer loan products. That means carrying a balance can get expensive very quickly.
Here's how credit card interest works, including what that introductory rate really means and how you can avoid interest completely.
A credit card has an annual percentage rate (APR) which is different but related to an interest rate. You can determine the interest rate by dividing the card's APR by 365, the number of days in a year, to see how much interest you are charged every day you carry a balance.
If you have an APR of 29.99% -- a common rate if you have bad credit and/or have a store credit card -- the interest charged daily on your revolving balance is 0.82%. With an APR of 10%, the daily interest rate drops to 0.27%.
That may not sound like a big difference, but it adds up over time. This interest rate is applied to your principal balance and the interest that's been applied every other day before. The higher your balance, the higher the interest charges you will face.
Let's say you have a $2,000 balance. If you carry the balance forward with a 29.99% interest rate, you'll start paying that 0.82% interest rate per day. The first day, it'll be $16.40. That will be added to your balance and the next day the 0.82% interest rate is charged on the balance of $2,016.40, adding $16.53 to the principal.
If you take 5 years to pay off the balance, you'll pay $1,630 in interest on the initial $2,000 balance.
There are two main types of APR you may have: a fixed APR which means the APR remains the same and only changes in specific circumstances like a late payment, or a variable APR which changes with the prime rate. The prime rate is the interest rate used by banks and it's a benchmark rate used to set rates for everything from credit cards to mortgages.
That isn't the whole story, though.
Credit cards usually don't have just one APR that's applied to all charges. Here are the different APRs you may be charged:
Your credit score is the biggest factor that determines the APR you receive when you are approved for a credit card. If you have an excellent score of 750 or higher, you will probably qualify for the lowest rates the credit card offers. With bad or fair credit between 550 and 699, you will probably be on the higher end of the scale.
Rewards credit cards usually have higher interest rates than standard credit cards. Card issuers use these higher APRs to help pay for rewards.
Here's an example of typical interest rates by credit card type and credit score:
A grace period is a time in which you can pay a credit card bill without paying interest charges. It's the gap between the end of your billing cycle and the date payment is due. As a general rule, grace periods only apply to new purchases, not balance transfers or cash advances. Most credit cards have grace periods and, when they do, they must be at least 21 days under the Credit CARD Act of 2009.
As long as you pay your bill in full, you won't pay interest on new purchases made during the grace period.
Here's how it works.
If you pay off your balance in full by the due date and have no balance that's being carried forward, you get a grace period on new purchases during the current billing cycle.
If you have a $500 balance and pay off $450 but leave $50 unpaid, all new purchases made during the current billing cycle -- plus the unpaid balance -- are charged interest.
Even if you can't pay off the balance in full, it's still important to pay off as much as possible to reduce your overall balance that will be subject to daily compounding interest.
As long as you pay your credit card bill in full each month and pay off purchases within the grace period, you can completely avoid interest charges. You will lose your grace period if you don't pay off your balance in full one month which means you now have a revolving balance. You will no longer have a revolving balance if you have paid the full amount on your statement by the due date for the last two bills.
If you sign up for a rewards credit card, keep in mind that any rewards you earn will be eaten up within days by interest charges.
Depending on the credit card and your spending habits, you may pay nothing at all to use your credit card -- or you may pay fees in addition to potential interest charges.
Before choosing a credit card, it's important to understand the fees you may be charged and compare your options. Even with bad credit, for example, you can qualify for a credit card with very low fees rather than turning to an expensive subprime credit card.
Here's a look at the credit card fees you should watch for and when they're charged.
Some credit cards come with an annual fee that's charged automatically every year. The annual fee can be anywhere from $25 to $450 for premium credit cards. Many cards do not have an annual fee and some will waive it during the first year.
Annual fees are most common with rewards credit cards. An annual fee can definitely be worth it if the rewards will outweigh the cost but make sure you are realistic about how much you will realistically earn -- and make sure you pay your bill in full each month for the rewards to actually pay off. With some cards, the annual fee is offset by perks like a free annual night stay with a hotel rewards card or a companion flight ticket with an airline credit card.
If you get a cash advance with your credit card, either by using the convenience checks from your issuer or withdrawing money from an ATM, you will be charged not only a higher APR on your balance but also a cash advance fee of 3% to 8%. You will also pay interest on the cash advance right away with no grace period.
This fee may be charged when you transfer a balance from one credit card to another. With most credit cards, the fee is 3-5% with a minimum fee of $5 or $10. If you sign up for a balance transfer credit card with a 0% introductory APR, make sure you check for a balance transfer fee which will be added to your new balance.
Even with a balance transfer fee, it can still be worthwhile to transfer a balance if you'll save in the long run and pay off your debt faster.
For example, let's say you have a $3,000 balance on a card with a 17% APR and a $1,200 balance on another card with a 23% APR. You transfer both balances to a new card with a 0% introductory APR for 15 months and a regular APR of 15% after the promotion ends. You need to pay a 3% balance transfer fee of $126 but, if you pay off your balance during the promotional period, you save $517 in interest.
If you pay less than the minimum due or pay your bill late, you will probably be charged a late payment fee. This fee can be as high as $38, although some credit cards waive the fee for the first late payment or have no late fees at all. Under current laws, late fees are capped at $27 for the first late payment and $38 for the second late payment within the next six billing cycles. The late fee can't exceed your minimum amount due, either.
If you travel outside of the country, you may face foreign transaction fees of around 3-4% when your purchase must be converted to U.S. dollars. This fee, once standard, is becoming less common. Many travel rewards credit cards do not charge foreign transaction fees.
This fee of $25 to $35 is charged if your balance exceeds your credit limit. If you try to make a purchase that would exceed your limit and you have not opted in for over-limit charges, your card will probably be declined. Some card issuers may allow the charge but ask you to pay the amount over the limit right away.
This fee is completely optional.
The only way you can be charged this fee is if you opt in to over-limit charges. It's generally not a good idea to opt-in for over-limit transactions. This change, courtesy of the Credit CARD Act of 2009, has made over-limit fees rare today but they once cost consumers billions every year.
This fee of up to $38 is charged if your payment to your credit card issuer is not honored by your bank. If your payment is considered late because of a returned payment, you may also face a late fee.
While your card issuer cannot charge to you make regular payments online, by an automated phone system, or by mail, you may face an expedited payment fee if you need help from a customer service representative to make a payment.
There are even more fees you may be charged. Most of these additional fees apply to subprime credit cards that target people with bad credit. Just be aware that even with bad credit, you may qualify for a credit card without a long list of hefty fees. A secured credit card, for example, may not charge fees for increasing your credit limit or account maintenance fees.
One of the biggest changes the Credit CARD Act of 2009 introduced to the credit card industry was limited to many fees that credit cards can legally charge. Some fees are capped, no longer allowed, or require that you opt in.
For example, fees can't be charged automatically when you exceed your credit limit; you must opt-in to allow charges over your limit that will trigger a fee.
When it comes to late payments, a mailed payment can't be considered late if the due date is on a non-business day and your payment is received on the next business day. You must have until at least 5 pm on the due date in your time zone to make a payment without being charged a late payment fee.
The biggest changes were made to the fees charged on subprime cards. It used to be very common for a subprime credit card to come with a $300 and $185 in initial fees. Today, you can't face fees that exceed 25% of your initial credit limit during the first 12 months -- but this protection will not apply after the first year.
When used responsibly, credit cards can offer a host of benefits and perks that can actually save you money. Credit cards offer more than a way to finance a large purchase; most include at least some benefits that you may overlook like extended warranty protection and concierge services. It's a good idea to find out what type of benefits come with your credit card because they may just save you a lot of money, especially when you travel.
Here are some of the most common credit card features.
One of the most common credit card benefits is rental car coverage. Most cards offer secondary coverage that kicks in after your primary car insurance to reimburse you for your deductible, but some cards offer primary coverage so you don't need to involve your own insurance provider.
This benefit essentially extends the manufacturer's warranty on eligible items you purchase with your credit card by 1 to 2 years. With this benefit, you can waive the costly extended warranty offered in-store on appliances, electronics, and more.
This feature allows you to file a claim with your credit card network if something you buy with your card is stolen or damaged. American Express, Mastercard, and Visa offer purchase protection for up to 90 days and up to $1,000 per claim.
If you pay for your itinerary with your credit card and need to cancel your trip or your ongoing trip is interrupted, your credit card provider may give you a refund. This perk covers nonrefundable prepaid expenses like airfare up to a limit for covered events.
Many travel rewards credit cards come with free concierge services that can be helpful for getting hotel recommendations, restaurant reservations, event tickets, and more.
With free lounge access as part of your credit card perks, you can enjoy airport lounges without being a business-class or first-class flier. airport lounges often provide free beverages, alcohol, snacks, Wi-Fi, workstations, and showers. Some even offer massages and sleep rooms.
These expedited security screening programs are often included on travel rewards credit cards. TSA PreCheck allows you to go through special security lanes for faster screening. Global Entry does the same thing as TSA PreCheck with expedited entry through U.S. customs when you return to the U.S.
Knowing how credit cards work and what they can offer is only half the story; you also need to know how to use a credit card responsibly to support a good credit score and enjoy the benefits that credit can offer.
Here are the tips you need to use a credit card to your advantage and not let it become a source of debt.
Learn how to tell yourself "no" when you're tempted to buy something on credit that you can't afford to pay in full by the end of your billing statement.
It can be easy to think of a credit card as "free money" but resist the temptation to buy wants and things you can't really afford. A credit card is best used for needs, including major purchases, regular spending, utilities, or emergencies.
The single-best thing you can do for your credit is making bill payments on time. Even if you can't pay off your credit card in full, at least make the minimum payment on time. Even a single late payment can significantly damage your credit score, especially if you don't have much credit history yet.
Credit cards can be great budgeting tools as long as they're paid off each month. If you make all of your purchases with your credit card, you'll know exactly how much you've spent over the month. This can help you identify areas where you need to cut back spending.
One of the biggest elements of your credit score is your credit utilization ratio and how much you owe. To maintain good credit, keep your balance below 30% of your credit limit. This applies to the balances of individual credit cards and all of your credit cards together.
Be sure to review your transaction history at least once a month. This will help you stay well below your credit limit and spot suspicious transactions that may be fraud. If you spot unauthorized transactions, report them right away to your card issuer.
Sometimes it's fine to carry a revolving balance. After all, that's an important benefit of using credit: being able to finance necessary purchases over time. If you can't pay your bill off at the end of your billing cycle, have a plan to pay it off as soon as possible. At the very least, make sure you make the minimum payment on time.
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