How do credit cards work? I saw this question, and it got me thinking.
Many people know about credit cards even before they begin to use them. Seeing someone using a credit card can be very deceiving.
Watching someone swipe their credit card and walk away with what they bought may come out as magic.
Credit cards are made using great technology, but the cards are not magical as you will still need to pay for your purchase, only that you make the payment later.
Before I delve into how credit cards work technically, let’s first get to understand what they are.
What is a Credit Card?
A credit card is a tool for debt. Simply put, you borrow money from a bank and use it to buy goods and services.
This is somewhat different from the way debit cards operate.
When reviewing credit vs debit, debit cards simply allow you to buy goods and services using money that is already in your bank account.
Acquiring a credit card highly depends on your credit score and slightly on your general income.
An important difference between an auto loan and a credit card, for instance, is that many credit cards are not secure.
This means that you do not need to offer collateral to get a card, whereas an auto loan lender may use the automobile’s title as loan collateral.
Credit Card Terminologies
Discussed here are some of the terminologies that will aid in your understanding of how credit cards work.
This is the amount you have spent on your card and are yet to pay back; it is also referred to as credit card debt.
If you have bought stuff worth $450 and have not paid for that yet, then $450 is your credit card balance.
This is the amount you can freely spend on your card in one sitting or the much you owe in your present loan.
This depends on the credit card issuer.
When your credit is better and you have a higher income, your credit card limit may be higher.
You can read and research more on how to increase your credit limit.
This is the amount you can possibly spend before getting to your credit limit.
If your limit is $2,000 and your balance is $400, then your available credit is $1,600.
If you pay $600, your available credit will increase to $2,200.
This is the reason why it is referred to as a “revolving” line of credit.
Statement Due Date
It is a date on your statement or credit card bill, showing when you are required to have paid at least the minimum payment to maintain your account in good standing.
This is your period of making purchases.
When this period is over, you are served with a bill and are expected to pay up in a month’s time.
APR (Annual Percentage Rate)
When you fail to pay your statement balance fully every month, you are required to pay this interest rate on the debt that remains after the statement’s due date.
This is the amount you should pay each month as per your credit card; it is normally a small percentage of your total balance.
When you fail to pay this amount by the set date, the bill issuer can charge you a late fee.
When the payment is late enough, a “late payment” may be reported to the credit bureau, and this is a mistake that could remain on your credit reports for seven years.
Even as you ensure that you make at least the minimum payment, it is advisable to pay your statement balance fully to evade interest charges.
How Do Credit Cards Work?
If you decide to pay for your purchase using a credit card and you give it to a cashier or give your card number on a safe internet connection, the merchant you’re dealing with authenticates your account and checks if the bank will allow the purchase to happen.
When all is verified, your purchase is added to your credit account.
Most companies are involved with each swipe of a credit card, and money exchanges hands among these companies every time a card is used.
Merchants pay some fees to accept credit cards, and in the end, the card-issuing banks get part of this fee as income.
Once each month, the bank accumulates your credit card purchases and sends a bill to you.
The most recommended way of handling the bill is paying in full by the set due date.
When this is not possible, you should pay a minimum amount, determined by the bank, so as to avoid extra fees.
Even when you evade extra fees, you will be charged an interest fee on the amount you owe the following month.
Interest accumulates fast, and you may end up paying $200 or more for a $100 purchase really fast.
If that happens, it will take more than just a time shift; it would be like taking you 60 minutes to wait and watch your 30-minute recorded show.
When you clear your debt fully and on time, your bank views you as a well-behaved customer and proceeds to report this behavior to other companies that check if you’re a good borrower.
It is important for these companies to consider you a good borrower, as it may lead to financial implications later.
Banks, who are credit card issuers, don’t intend that all users be well-behaved customers.
That is because companies profit most from customers who do not pay bills in full but are hardly late since of all the profit, some of which is taken from merchants and stores are often left with no option but to increase prices for everyone because of the rise in use of credit cards.
Has this section answered your question of how do credit cards work?
I hope so.
Now that you are aware of how credit cards work, we can move to the benefits that they bring along.
Advantages of Using a Credit Card
There are various advantages of using a credit card.
It helps you in achieving the following:
You get purchase protection
In addition to a credit card being convenient, it also provides you with additional legal protection in the event that the company you’re buying from goes out of business or fails to deliver on its promises.
There is also protection in case something else goes wrong, like the goods being faulty.
Costs of big-ticket goods can be spread out
In case you wish to plan a vacation or buy a new sofa, you could use your credit card to purchase and pay the balance later over several months.
You are prepared in case of an emergency
You can use a credit card to cover repairs and unplanned expenses.
You grow your credit rating
When you have no credit history, it means that banks cannot weigh how well you can manage debt.
Using a credit card can help you build a good track record of being able to pay off debt.
When you ever need to apply for bigger loans like a mortgage, your record can help prove your ability to handle the loan.
How to Choose a Credit Card
I normally think that you can only choose an appropriate credit card based on your needs.
Having the right credit card is determined by your circumstances.
When you are an employer with employees who require frequent travel, you may want to go for a card that offers the most attractive travel rewards.
If you’re a college graduate who wishes to grow credit for the future, you should get a secured card until you can advance to an unsecured card.
No matter your situation, credit cards are a good beginning towards bigger and better things.
When you own a card, you plan well for mortgage or personal loan qualification.
Using credit cards well can help your bottom line by rewarding every purchase with points or cashback to lower or pay up costs.
Issues with credit cards begin when extravagant spending leaves huge balances that are hard to pay for immediately.
Such balances can result in high interest costs, and when late or missed, that can ruin your credit profile and make it difficult to access loans in the future.
Factors to Consider When Getting a Credit Card
Before you apply for a credit card, you ought to think of the following:
Your Spending Habits
If you’re determined to fully clear your bill each month, you may not have to worry about the interest rate, and therefore you may go for a credit card with the lowest annual fee.
Should you carry on a balance, however, you can go for a card with the lowest possible interest rate.
Remember that you don’t intend to set yourself up with long-term debt and you should therefore avoid carrying debt.
How you’ll Handle Temptation
A credit card may have you spending much more than you are comfortable with.
Before you take one out, think of the way you will manage any temptation and if it is a good move for you.
When you finally feel you need a credit card, you may set some rules to manage your spending.
Such rules may include setting a certain amount to spend monthly and purpose not to spend more unless an emergency comes up.
Annual Percentage Rate
APR is how lenders describe the cost of borrowing money in a year, considering the purchase interest rate and fees in relation to a credit card (as mentioned above).
As you choose your preferred credit card, you may check the representative APR to get insight on how much it may cost you.
Fees and Charges
There are credit cards that charge an annual fee.
Some even charge a fee when you go beyond your credit limit or pay your bill late.
This may negatively impact your credit.
The Golden Rules of Credit Cards
- With a card that pays you to spend, purpose to always pay the complete balance to avoid interest which can counter any gains.
- In the worst-case scenario, always pay at least the minimum payment, or you risk losing any special offers and being slapped with extra fees.
- When you use a card for new borrowing, know that the money has to be paid back and should not be overspent. You also need to pay at least the minimum monthly to keep the 0% period.
- If you’ve a 0% deal, always strive to clear the card fully by the end of the 0% period. You could also do a balance transfer or end up paying the far higher representative APR interest.
Conclusion on How Credit Cards Work
I think this post has answered numerous questions like how do credit card payments work, how does credit card debt work, and how do credit card rewards work among others.
These are just but a few of the questions I have encountered in the past.
You should note that, if used wisely, credit cards will help you create favorable credit.
Paying your bills on time, keeping your balance low, and just taking out credit cards when absolutely necessary will all help you create and retain good credit.
Also, remember that paying your credit card bill in full each month is the best way to prevent interest charges.
If you still have questions about how credit cards work, just shoot me an email.