Credit Cards 101

TLDR: Credit cards can be a great tool, or significantly impact your ability to live a comfortable life – read this article to gain a better understanding of credit cards and how you can benefit from one.

Key Take Aways:

• Credit cards are a great tool to build credit for big purchases down the road
• When used irresponsibly, credit cards can hurt your ability to buy a house and live a comfortable life – credit card debt adds up quickly!
• Don’t buy what you can’t afford and live within your means to live a comfortable life

Credit Cards 101:

Assuming you use them responsibly, credit cards can be a convenient way to purchase items and build credit for financing larger purchases down the road. On the other hand, if credit cards are used irresponsibly, they can significantly impact your ability to borrow money in the future. This drop outlines what a credit card is, how they work, reasons to get one, and the costs associated with a credit card.

What is a credit card?

A credit card is a physical piece of plastic or metal that represents a line of credit offered by a bank. It can be used to purchase goods and services that are sold by businesses or individuals that accept credit card payments.

A line of credit is a defined amount of money (or limit) that a bank agrees to lend you at any point in time. The borrower (you) can use the money as needed until you reach the limit. Every time you pay for something, you borrow money from the bank to cover your purchase. Over time, you are required to pay the money you borrowed back to the bank. Typically, credit cards require payment at the end of each month.

How does a credit card work?

The Credit Limit

When you apply for a credit card, the bank that offers the credit card will conduct an assessment to determine how much you will be allowed to borrow. This assessment will depend on your income, any debt you have, and how much credit you’ve used on other credit cards, among other factors. After the assessment, the bank will authorize your credit limit, which is the maximum amount you can borrow. You can use this amount as you please, but be cautious, because you must pay back what you spend.

When you make purchases on a credit card, you are required to repay the amount you borrow on a monthly basis. If you do not repay the money, you won’t have access to the line of credit.

For example, if you are authorized a $5,000 credit limit, and you purchase a pair of Red Bottoms for $750, you now have access to $4,250 of credit. Until you pay back the $750 you borrowed to impress your date, your credit limit will remain at $4,250.

Interest and The Bill

At the end of each month, you will receive a bill from the bank that issued you your credit card. You will have the option of paying a minimum amount (~$25), the full balance, or any amount in between. Here is the catch with credit cards – interest.

Interest rate or annual percentage rate (APR) is the rate that you pay for borrowing money. This is how the bank makes money on issuing you a credit card. The average credit card interest rate or APR is around 18%. Interest rates and APR are intentionally confusing, and usually in the fine print hidden behind the 10,000 points you get for free when you open a credit card. Here is an example of how interest rates and APR can bite you in the a$$.

Let’s say you entered the month with a $1,000 balance remaining on an account with a 15% APR. Your end-of-day balance after the first day would be $1,000. Assuming you make no payments or purchases, your balance at the end of the second day would be $1,000 + ($1,000 x (15%/365)) or $1000.41. At the end of the third day, your balance would be $1,000.41 + ($1,000.41 x (15%/365)). This process repeats itself everyday for the rest of the billing period. Although $0.41 looks like a small amount of money after the first day, this happens daily and adds up over time.

It is best to pay the full balance on your credit card at the end of each month. If you pay your full balance at the end of each month, you won’t be charged any interest at all – which means you are borrowing money for free!

The Credit Report

A credit report is a statement that contains a summary of your credit history, current credit situation (student loan debts, mortgages, etc.), and the status of your credit card accounts. Lenders use these reports to help decide if they should loan you money, and at what interest rate (or APR) they will loan you money at. Your credit report may also be used to determine whether to offer you insurance, rent you a house or apartment, provide you with cable TV, internet, a cell phone, etc.

Bottom line – your credit report is extremely important.

Credit reports are summarized in a 3-digit credit score that indicates how risky it would be to lend you money. Credit scores range from 300 (bad) to 850 (excellent). To avoid damaging your credit score and making it more difficult to live a comfortable life down the road, you must pay the minimum balance on your credit card. This is a bare necessity when it comes to credit cards! Although paying the minimum will cost you in interest expenses, it will help you build a good credit score in the long run.

Why get a credit card?

Credit cards help you build credit for future purchases (like that house you’ve always dreamed of). In addition to building credit, credit cards offer:

• Ongoing Rewards: points or cash back for each dollar you spend
• Sign-up Bonuses: points or cash that could help you start an emergency fund or finance a trip
• Flexibility: Credit cards allow you to pay for big purchases over time, or finance big purchases

There are many benefits to using a credit card, but in order to cash in on the benefits, you must use it responsibly.

The Costs of a Credit Card:

Using a credit card responsibly, by paying the minimum or full balance each month, will help you avoid most of the costs associated with it. A few of the major costs of a credit card are:

• Interest Payments or APRs: the interest charged to you for borrowing money – this can be avoided by paying off the full balance every month
• Annual Fees: Some credit cards charge you an annual fee (e.g. $95 for basic credit cards, up to $500 for high rewards credit cards) just to use the card. Annual fees can be worth paying if the rewards or perks make up for the cost. In most cases, you shouldn’t choose a credit card with a fee if you won’t make more money than the fee in rewards.
• Late Payment Fees: Credit cards charge a fee if the minimum balance is not paid by the established billing date. These fees are capped at $27 for first time late fees, and $38 for a second late payment within 6 months (2018). Late fees can’t cost more than the minimum balance – so pay the minimum and avoid these all together!
• Foreign transaction fees: If you travel internationally, you will likely be charged a 1% to 3% foreign transaction fee. Travel rewards cards generally wipe these fees.

Each of these fees will be outlined in the agreement you sign when the bank issues you a credit card. Read the fine print when getting a new credit card to understand what fees you might be responsible for.

To explore what credit cards are available to you, NerdWallet can be a great resource. Check out NerdWallet’s page on credit cards here.

Our best advice to avoid falling into credit card debt - don’t buy what you can’t afford. Although credit cards give you power to purchase up to your credit limit, don’t change your lifestyle just because you have access to more money. Live within your means and you’ll have a much better chance at long term financial success.

Learn something new. 

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