Credit Cards 101
More and more, our society is moving toward a system where credit reigns supreme. Whereas cash used to be king, credit now dominates our purchasing habits, especially with the growth of e-commerce operations.
When was the last time you bought an airline ticket by going to the airport and paying for it at the Delta or United Airlines gate? Nowadays you simply peruse tickets online and punch in your credit card information to order.
Unfortunately, very few adults have a formal education when it comes to managing credit. It is a travesty that most young adults graduate from high school and enter the adult world never having had a single lesson in basic finance, including writing checks, keeping books, or creating a budget, much less investing or using credit cards wisely.
Most of us have to figure it out the hard way, which is perhaps why problems with debt are so prevalent in this country. The good news is that you can learn plenty from the foibles of others and get on track for good credit from the start. Here is a basic rundown of what you need to know about having, using, and getting the most out of your credit cards.
What is a Credit Card?
In the most basic sense, a credit card is simply a piece of plastic that contains a magnetic strip. It features your name, a unique credit card number assigned to your credit account, an expiration date, and sometimes an additional code for security purposes.
The magnetic strip holds information about your account, and when it is swiped in a card reader, vendors can access funds to pay for your purchases. The money available in your account is not yours, though. It is on loan and the amount of credit you maintain is based on your credit score, which is calculated by your spending and payment history.
Spending on credit is essentially taking a short-term loan, although there is no deadline attached to paying it off. You simply have to make minimum monthly payments based on the amount you borrow and the interest tacked on. It sounds simple enough, but there’s still a lot more you need to know before you start accepting credit card offers.
What is Interest?
When credit card companies approach you with offers (or you approach them to open a credit account), they will calculate your relative creditworthiness. This means they look at your credit score and your history to determine the risks involved in lending you money. Will they get it back?
If you have a top tier credit rating, it shows that you have a strong history of repayment when you borrow funds, and/or that you pay your bills on time. If you haven’t been very prompt with payments, you fail to pay with some frequency, or you’ve filed for bankruptcy, just for example, your credit score is bound to be a lot lower and your risk factors go up.
This information is used to determine whether you are eligible for a credit card, as well as the amount of interest you’ll be charged. Those with top tier credit tend to have the lowest interest rates, while those with poor credit ratings are charged more interest for the privilege of having a credit card.
Interest rates could range from, say, 5% up to 20% or more on average. In addition, there are often stipulations regarding late or missed payments. Not only could you face penalties for paying late or missing payments, but most companies reserve the right to increase your interest rate to a prearranged percentage for such failures.
You might start at 8% interest and if you miss a payment your interest could go up to 18%, just for example. You should also speak with your credit card company about how interest is accrued. Models vary by company and there are often stipulations about late or missed payments here, as well.
Your best bet where interest is concerned is to pay your credit card in full and on time each month to avoid interest payments and penalties altogether. If you must pay over the course of several months, try not to add more charges or you can easily fall into a cycle of revolving credit that’s difficult to escape. Then you’re paying a lot more money for every purchase thanks to accruing interest.
Who Offers Credit Cards?
While all credit cards perform the same essential function, you might be surprised by the variety of options available to you when you begin shopping for the right card. Not only are there a number of credit card companies (VISA, MasterCard, American Express, etc.), but you can also get cards through countless partner organizations such as airlines, hotels, and retail stores.
Most credit card accounts these days come with some kind of rewards program whereby you earn points or “miles” for every dollar spent. The main reason to sign up for a card through a partner business is to gain access to additional rewards associated with the brands you patronize most.
Types of Credit cards
Travel and Retail Rewards Cards
You’d be hard pressed to find a credit card these days that has no rewards. Before you decide on a card willy-nilly, you need to shop around to find the rewards program that’s going to provide you with the greatest personal benefit.
For example, a Delta Airlines rewards card confers “miles” with every purchase, and you’re bound to get additional rewards for travel or other related purchases. These miles can generally be redeemed for travel with Delta, allowing you to purchase discounted or free tickets at set intervals (when you earn enough miles). You could also get free seat upgrades or other perks as part of your membership.
The same is true for credit cards obtained through hotels, gas stations, retails stores, grocery stores, and more. Think about where you spend most of your money and take the time to look at benefits and bonuses. This should help you to select the card with the rewards program that best suits your lifestyle and your spending habits.
Cash Back Credit Cards
Who doesn’t like free money? When you open a cash back rewards card you earn cash for each purchase you make. It’s not exactly as great and easy as it sounds, however. These cards often have annual fees and tend to come with a high APR, so if you carry a balance forward each month you will quickly be paying more in interest than any amount of “free money” you make from your rewards.
Cash back cards are great if you have excellent credit and can secure the lowest possible interest rate. If you pay off your balance in full at the end of each month then you can reap true rewards.
Secured Credit Cards
The easiest way to get started with your first credit card, is to take out a secured, or essentially prepaid, credit card. You can often get them through your bank and all you have to do is offer collateral in the amount of the credit limit granted (say, $500.00).
This money is held by the lender for a set period of time (6-12 months, usually) in case you fail to pay for your credit card purchases. At the end of the term you will get your collateral back with interest, provided you’ve paid off your card, and you’ll also get to keep the card, unsecured. This is a great way to begin building credit.
Credit Cards for College Students
Your credit worthiness and overall risk factor determines if you are approved for a credit card, and at what interest rate. These risk factors are compiled in your credit report, along with a score that rates your risk of defaulting on a loan or credit card against average borrowers.
If you are a college student and never had the occasion to borrow money, then you might not have any credit history at all or, if you do, a rock-bottom credit score. Some lenders have created credit cards specifically for college students in this situation to provide easy access to credit. This allows young adults the ability to prove their financial acumen and develop a strong credit score as a full-time student.
These credit cards often require a co-signer, such as a parent, before an application is approved. This way, if the student stops paying their bills on time then the co-signer will become equally responsible for paying the debt. This helps assure the credit card companies that they will limit their exposure to losses by holding another party accountable for unpaid charges.
As mentioned, a credit card, in essence, is an open line of credit that allows you to borrow money from a lender to make purchases and repay at a later date. You can also use your credit card as a more traditional way of loaning yourself money, commonly to pay off existing debt that you accrued from past purchases, with a balance transfer.
Instead of swiping your card at the local grocery store to pay for cereal and milk, you would use a designated balance transfer check (or the digital equivalent) to pay off an outstanding loan, such as another credit card bill. You can even write the check to yourself and add extra cash to your bank account for other financial priorities.
There are a few reasons why a balance transfer could make good financial sense. The most appealing benefit to a balance transfer is the promotional interest rates and discounts credit card companies commonly advertise. You might see an offer for 0% APR for 6 months. If, for example, you have another credit card with a $2,000 balance and 16%APR, then you could save a considerable amount of money in interest payments by taking advantage of this promotional rate.
As with anything else related to personal finance and money, it’s not quite so simple. If you don’t repay the full balance transfer by the end of the promotional period, then you could be faced with an interest rate far higher then the 16% you were trying to eliminate in the first place.
Credit card companies don’t offer these promotions out of the kindness of their hearts to try to help their customers save money. They exist as a way to encourage consumers to accumulate more debt that is subject to a profitable interest rate. Be aware of what your are committing to if you hope to save money with these types of transactions.
How to Use Credit Responsibly?
One of the most important concepts to understand when using credit is that it is NOT cash in your pocket, even though it can feel that way. Just because you have a $1,000.00 credit limit does not mean you have a thousand extra dollars to spend. Taking this money is like taking out a bank loan, one that you have to pay back with interest, and you should think about this every time you swipe your card.
When used responsibly, credit cards can help you to build credit and improve your credit score. When used improperly they can have the opposite effect. For this reason, you should keep a low credit limit that you can manage on your salary and you should try to pay off your card in full each month.
In addition, make sure to check your credit report at least annually. Fraud and identity theft are a very real threat, so keep your card safe, don’t let others use it, and use online banking to check your charges each month so that you can report any fraudulent activity immediately. Responsible behavior will help you to gain the most benefits when using credit cards.