Credit Cards

Credit Cards
A credit card is a plastic card issued by banks, businesses, and other financial institutions that enables a borrower to make purchases “on credit” and pay for them at a later date.

What is a Credit Card?

A credit card is a modern and convenient way to spend against one’s line of credit provided by a bank or financial institution.

How do Credit Cards work?

Credit cards can be obtained through banks, financial institutions like credit unions, and other businesses. You’re probably used to seeing credit card offers on TV, hearing them on the radio, and receiving them in the mail. They’re everywhere, and most Americans have at least one credit card.[1]

Unlike a debit card, credit cards are not linked to existing funds. When you purchase an item with a credit card, the credit card company covers the cost and you agree to pay them back at a later date. Typically, you can pay off the balance on your card online or through the mail.

Credit card purchases are essentially small, short-term loans. This means that interest will accrue on your purchases. However, many credit card companies offer a grace period, which is a certain amount of time after your purchase before interest will start to accrue. If you pay off the card during a grace period, you’ll avoid paying any interest on your purchases.

The maximum amount you can spend on a credit card will depend on the specific card, the company that issued it, and your credit history. A better credit score will often mean higher credit card limits.[2]

Interest rates and terms

The first term you’ll need to understand in order to grasp credit card interest rates is ‘annual percentage rate (APR)’ which represents the total amount of interest you would pay on a loan in one calendar year. With most loans, the APR includes interest and all other fees associated with borrowing. With credit cards however, there may be multiple APR rates. Here are the most common credit card APRs to watch out for when shopping for a credit card:

Purchase APR: This is the interest rate charged on all purchases made with the credit card. It will most likely be the APR that the credit card company advertises.

Cash advance APR: This is the rate you’ll be charged if you use your credit card to withdraw cash. This rate is typically higher than the purchase APR and comes with no grace period.

Penalty APR: This is the interest that you would be charged if your account becomes delinquent. If you fail to make your payments for a certain amount of time (typically 60 days) then your balance will begin to accrue interest at a higher rate. This is the penalty APR.

Balance transfer APR: If you transfer a balance from one credit card to a new credit card, the interest charged on the new credit card balance is referred to as the balance transfer APR. This rate is usually no higher than the purchase APR.

The APR that you receive will likely be based on how “creditworthy” you are—having a high credit score will result in a lower APR and a higher credit limit. It’s important to note that a bank or financial institution is not allowed to raise or lower your interest rate without notifying you beforehand, unless your account is delinquent.

The good news is that credit cards usually come with a grace period of about 30 days. If you’re able to pay off the balance on your card before the grace period is up, you’ll avoid interest being added. At the end of each month, the credit card company will add the agreed-upon interest to your total balance. This is why it’s always a good idea to pay your credit card balance in full each month.[3]

Some banks or credit card companies will also charge a monthly or annual finance fee. Make sure you find out all the charges associated with a card before you agree to take it.

Types of credit cards

There are several different kinds of credit cards to choose from. Some offer incentives and perks like airline miles or other rewards programs, and some even offer zero percent interest for a certain amount of time after signing up. Below are the most common types of credit cards available to consumers:

Major credit cards: These include the most common types of credit cards such as Visa, Mastercard, American Express, and Discover. Usually, you can get a major credit card through a bank or credit union. Many of them carry certain perks like cash back and rewards programs that allow you to redeem points for gift cards and merchandise. Make sure you do your research, as the interest rate will likely go up after a few months.

Store credit cards: Odds are you’ve been offered a store credit card while checking out at a department store or other business. Many companies will allow you to open a credit card that you can use within their store in order to create brand loyalty. These cards are typically easier to get than a major credit card and may entitle you to certain deals at that particular store.

Secured credit cards: Typically used by consumers with poor credit, a secured credit card will require some sort of collateral to obtain. The borrower will most likely need to put up a cash deposit to get a secured credit card. This deposit may also act as the initial credit limit for the card. Using a secured credit card is a good way to build your credit so you can one day get a regular credit card, assuming you make your payments on time.2

What are the risks and benefits of Credit Cards?

Credit cards can be useful in many situations. Oftentimes they allow consumers to pay for big-ticket items that they don’t have the cash to cover at the time of purchase. As long as you make on-time payments and you’re responsible with your spending, there are several advantages to having and using a credit card.

Although it’s highly recommended to have an emergency savings account, credit cards come in handy for many people experiencing financial setbacks. For instance, if you get into a fender bender and don’t have the $500 to repair your bumper, a credit card might be the next best option.

The perks and rewards programs offered through credit cards are another advantage. Many people accrue thousands of airline miles just for consistently using a certain credit card. In addition, if you know how to take advantage of zero percent APR offers, you may be able to consolidate your credit card debt onto a new card and save money on interest.

However, as beneficial as it may be to use a credit card, there are also risks. The total credit card debt owed by U.S. consumers as of 2016 is $953 billion.[4] One cause of such high credit card debt is surely their accessibility and ease of use.

Credit card offers are everywhere, and many people who don’t have a firm grasp on their finances are still able to get one. In addition, credit cards are very easy to use. Swiping or tapping your card at the checkout is quick and simple, whereas using cash may cause a consumer to think more about their spending choices.

In any instance it can be dangerous to spend money that you don’t have. Credit cards make this easier than ever. It’s always wise when using a credit card to make sure you have the funds to cover every purchase. If you carry a balance on your card by not paying off every purchase right away, you run the risk of accruing an outrageous amount of interest.

Whether you currently have a credit card, or you’re thinking about getting one, make sure to do your homework. Read the terms and conditions for your specific card, know the perks associated with it, and know how much interest you’re paying on all your purchases and cash advances.

References:

  1. “Credit Card” Business Dictionary. Accessed December 5, 2016 from http://www.investopedia.com/terms/s/soft-inquiry
  2. “Credit Card” Investopedia. Accessed December 5, 2016 from https://www.valuepenguin.com/understanding-credit-card-apr-interest-rates
  3. “Understanding Credit Card APRs & Interest Rates.” ValuePenguin. November 28, 2016. Accessed December 5, 2016 from http://www.investopedia.com/terms/s/soft-inquiry
  4. Gonzales, Jamie and Holmes, Tamara. “Credit Card Debt Statistics.” CreditCards.com. Accessed December 5, 2016 http://www.creditcards.com/credit-card-news/credit-card-debt-statistics-1276.php