Credit cards are pretty common around the world. They are thin rectangular pieces of plastic or metal and are issued by banks or other financial institutions. This card allows you to borrow money from them within a pre-decided limit, which you have to pay within the due date.
Let’s make it simpler
Consider a store in your neighborhood. Since you visit the store frequently, you don’t want to pay every time you buy something. So what do you do? You make an agreement with the store owner to let you buy goods from his store and pay all the money on the 30th of each month.
The owner agrees but puts a limit on the number of things you can buy. Every month on the 30th, you pay your dues to the owner. This is simple and convenient.
This is basically how credit cards work. Of course, it gets complex with the different terms involved. But before getting a credit card, you need to understand them well.
So, here is a complete guide to how credit cards work, the terminology associated with them, and some more useful information that can help you make optimal use of credit cards.
Important terms related to credit card
Before getting down to the nitty-gritty of credit cards, let us first understand the different words associated with it:
- Billing cycle : It is the period between the issue of two consecutive credit card billing statements. The end of a billing cycle is called the due date.
- Credit limit : It is the limit set for your card exceeding which you cannot spend through your credit card. This limit is updated every billing cycle.
- Interest : If you fail to pay back the balance that you owe to the bank within the due date, then you will have to pay an additional amount per day at a particular rate of interest.
- Minimum payment : This is the lowest amount you are allowed to pay each billing cycle, to avoid your bill reported as late. But, this does not exempt you from the interest you have to pay on the remaining balance.
- Credit score : A credit score is a number that tells the bank how punctually you paid off the bills of your credit card. A better credit score can positively impact your chances of getting better credit cards, loan approvals, etc. The best way to keep a good credit score is to pay your credit card bills on time.
How do credit cards work?
As discussed earlier, a credit card is issued by a bank or financial institution where you have an account. They can be used for paying bills, online shopping, in-store purchases, or cash withdrawals. Each time you make a purchase using a credit card, the bank pays on your behalf. This balance is stored on your credit card. The bank only pays till you reach your credit limit. Beyond this, the card doesn’t let you make purchases.
On the due date, you will be given a statement of all your expenses during that billing cycle.
Your statement includes the following:
- Remaining credit limit
- Minimum payment amount
- Payment due date
- Additional fees charged if any
- Payment options
You have to pay the balance to the bank within the due date. If you fail to do so, for each day starting from the due date, the bank will levy interest on the outstanding balance. It is almost like taking a very short-term loan from the bank every month. Depending on the time you take to make your payments, your credit score also changes.
Credit Card v/s Debit Card
Many people get confused between credit cards and debit cards. They look like the same thing (after all, they are cards, right?), but they function quite differently.
For instance, credit cards don’t use your money to pay bills. Instead, they use the balance from your bank or financial institution. Debit cards on the other hand require you to have some balance in your account. If you buy something using your debit card, it is directly deducted from your account balance.
Debit cards also have no impact on your credit score whereas credit cards can increase or decrease your credit score based on the payments you make.
The Different Types of Credit Cards
There are credit cards for all kinds of requirements. Go through the list below to find your ideal card:
- Standard Credit Cards : These are the most basic cards and offer almost no benefits or rewards. If you want to begin with credit cards and do not want anything complicated, then this card is for you. The credit limit is usually low for such cards, and just like any other credit card, interest is applicable if payments are delayed.
- Balance Transfer Credit Cards : Most cards allow balance transfer but they also come with a high transfer fee. Balance transfer cards are dedicated cards that offer low or zero transfer fees. This is especially useful if you want to move your balance from a high-interest card to a low-interest one. A good credit score is all you require to opt for a business credit card.
- Rewards credit cards : Rewards cards are specifically meant for getting rewards on credit card purchases. There are three types of reward cards:
- Cashback cards : These cards give back some amount of money for every purchase you make.
- Points cards : These cards offer some points when you make credit card transactions. These points can be later redeemed for cash or merchandise.
- Travel cards : These cards reward you with a discount on flights, hotel bookings, and other travel-related expenses. No wonder, they remain a favorite of frequent travelers. Capital One Venture Reward Credit Card is one such card that gives travel rewards for the transaction you make.
- Student credit cards : If you are a student, you will know the difficulties you face while paying bills. So these cards are designed to provide a lower rate of interest and other additional rewards to assist students in building their credit score. These cards are also easier to apply for than any other type of card. Usually, a person needs to be enrolled in a course at a university to be eligible for application.
Discover It Student Chrome and Chase Freedom Student Credit Card are popular choices in the US. They come with a $0 annual fee and are open to students with no credit history.
- Charge cards: If you have an excellent credit history, then banks can issue charge cards. These cards do not have a credit limit so you can use them all you want. There is no minimum payment at the end of the billing cycle. Whatever outstanding balance you have accumulated, needs to be paid in full.
- Secured credit cards: If you have a poor credit score or a damaged credit history, then you can still avail of a secured card. These cards require you to pay an initial security deposit. Usually, the credit limit is equal to the security deposit. These cards can be used to build your credit score.
Open Sky Secured Visa Credit Card is the best secure card as it requires no credit history.
- Limited-purpose cards: These cards can be used only at certain places. One example of a limited-purpose card is a store credit card.
- Business credit cards: These cards are meant for business owners. They can maintain their business and personal transactions separately through these cards. Depending on your needs, you can either go for a standard business card or a charge card. Business cards can be availed if you have a good credit history.
Ink Business offers an Unlimited Credit Card which has zero annual fees.
Advantages and disadvantages of credit cards
If you are wondering whether you should apply for a credit card or not, then these pointers might be worth considering:
- Improving credit score : Credit cards can help to improve your credit score and financial situation even if you have a bad credit history. Credit score building is all about responsible borrowing of money. If you have a bad credit score, you might be issued a card with a higher rate of interest. But if you make your payments on time, you won’t need to pay even a single extra penny. And the icing on the cake, consistently paying off your dues on time will positively impact your credit score. This can help you get good interest rates on loans and mortgages, while also making you eligible for better credit cards!
- Convenience : If you are a frequent shopper or traveler, you might be very well-acquainted with the hassle of paying cash everywhere you go. Credit cards can come in handy in such situations as you can simply buy and make all the payments at once, provided it is within the credit limit. Special cards for travelers make traveling not only easy but exciting as well (think of all the rewards from travel cards)!
- Interest-free money : Even though credit cards have a rate of interest, it is only applicable if you do not make your payments on time. This means that whatever you borrow and clear off within the billing cycle is free of any additional costs. Even if you can’t make the full payment at the end of the billing cycle, making the minimum payment can still get you interest-free credit.
- Purchase protection : Credit card purchases are usually protected. If you make a purchase using your credit card, and later discover that something is wrong with the product or company, you can claim a refund from your card issuer. A debit card offers similar protection, but you will have to wait till the issue is resolved and the company refunds you the money. There is also a possibility that the company or person turns out to be a fraud and you lose your money forever.
- Cash backs and rewards : As discussed earlier, certain credit cards reward you for making credit card transactions. If you use your credit card frequently then this is an ideal type of card for you.
- Record of expenses : Every time you make a purchase using a credit card, the details of that transaction are recorded in your monthly statement. This can not only help you track your purchases and limit your spendings, but also help in tax records.
- Chances of debt : A credit card is loaded with benefits. It does not require you to pay upfront and sometimes also offers rewards for the transactions. This can tempt people to keep spending, sometimes much beyond what they can payback. Even if you manage the minimum payment, your outstanding balance can be subjected to a higher rate of interest as it increases.
- Credit score : Just like how a credit card can help you build a credit score, it can also hamper your credit score. A good credit history requires you to make consistent payments within the due date. If you are not able to pay the money that you borrowed from the bank, this can be marked as a late payment which adversely affects your credit score.
- Hidden fees : Credit cards are highly beneficial but also have a few fees like annual fees and late payment fees. These should be minor as compared to the benefits you get.
- Fine print : Credit cards seem lucrative when they are first issued to you. There may be very low-interest rates, low balance transfer rates, or great rewards. But, most credit cards give these benefits as promotional offers only. Check the terms and conditions properly and be aware of any changes in the interest rates.
How to use your credit card efficiently?
Credit cards are very useful, but some people find them a little complicated. If you are worried you are going to make a mistake, or you have trouble understanding how credit cards function, then here are some tips that can help you make the best out of your credit cards. These can help you maintain a good credit history as well.
- Don’t carry the monthly balance : One big misconception about credit cards is that carrying your monthly balance improves your credit score.
A study showed that about 43 million Americans think that their outstanding balance positively impacts the credit score.
A credit score is used to determine how likely you are to pay off your debts from any financial institution or bank. Having an outstanding balance only shows that you are unable to pay it. This negatively impacts your credit score. To avoid this, keep paying off your monthly balance as soon as possible.
- Don’t make only minimum payments : Most credit card statements have the minimum payment written on top of the statement. Most people confuse it with the total due amount and pay only that much. This can ultimately damage your credit score history. The best way to avoid this mistake is to read your statement and find the total payment.
Remember, minimum payments only stop your outstanding balance from being reported as late payment. You will still incur a rate of interest on the remaining balance. Try paying as much as you can even if it is not the total due amount. Do not stick to the minimum amount.
- Don’t miss a payment : If minimum payments are bad, missed payments are worse. A payment is reported as missed if you haven’t even paid the minimum amount for over 30 days from the due date.
According to FICO, a 30-day delay in payment can lead to a reduction of 17 to 83 points, whereas a 90-day delay can lead to a reduction of 27 to 133 points of your credit score. But, if you pay the dues later than the due date but within 30 days, your payment will not be reported as missed. You may still incur late payment fees and interests.
- Try to stay within the monthly limit : Using your credit card for major purchases is a good idea. But if you opt to pay from your card for every small thing is not a good idea. If you can pay your due balance on time, then it won’t make much difference. But a small payment for groceries can end up being way too expensive if you let the balance accumulate over time. This can soon utilize all your allowed credit. This shows that you have a high utilization rate which can negatively impact your credit score.
- Let the rewards come naturally : Credit card rewards are meant to be given on your expenses. They should be a part of the other benefits you receive. Spending with an aim to get the credit rewards is a huge mistake many people tend to make. Sure, these rewards may seem attractive, but spending more than your payment capacity can ultimately make the reward more expensive than it actually was.
Another thing people do for rewards is to sign up for multiple credit cards. This isn’t a good option either, especially if you can’t manage your existing credit cards. More cards don’t just mean more rewards, they also bring in with them high annual fees and interest rates. If you do not pay off your balance on even one of the cards, it can cost you more than all the rewards put together while also reducing your credit score.
- Read the billing statement every month : How many times have you simply seen the total amount and paid it off, conveniently ignoring your transaction history? Credit card statements carry important information such as a change in the rate of interest, a change in credit limit, etc. Another reason to go through your credit card statement is to avoid credit card fraud. Though not very common, credit card frauds are still a reality. Someone can steal your credit card number and make unauthorized purchases on your card. These purchases are reflected in the statement, which can come to your notice only if you go through the transactions carefully. If you report them to the bank and the fraud is proved, all the fraud transaction amounts will be reimbursed to you and you won’t need to pay a penny.
- Report the lost or stolen cards immediately : If your credit card is lost or stolen (or you don’t know which), do not waste your time trying to find it yourself. The more time you wait, the more the thief can spend on your expense. Report the lost card immediately to your lender. If you report the card before any fraud, then you won’t be considered liable for the transactions that take place next. This can save you from any big purchases that the thief might make.
Understanding what a credit card is and how it functions can help you when you opt for a credit card. If the above information is a lot to take in for you, then here is a quick summary of all the points:
- Credit cards are cards issued by a bank or financial institution. They enable you to make purchases within a credit limit and pay the balance at the end of the billing cycle.
- Delay in credit card payments can lead to an increase in the balance due to the interest rates and late payment fees. This can simply be avoided by paying on time.
- There are different types of credit cards that serve different requirements. You should choose a credit card by carefully studying all the types.
- Like anything else, credit cards have both pros and cons. But if you use the card wisely, it will give you loads of benefits.
- By using your credit card efficiently and avoiding common mistakes, you can manage your finances well. After all, credit cards provide credit at zero interest rates.
Getting a credit card is an important milestone in our lives. We hope that by going through this guide, you are better equipped to manage your card now that you are going to get one!