How Do Credit Cards Work? | The Basics Made Simple
Credit cards can be a benefit or a detriment to your finances. It all depends on how you use them.
If you swipe your prized piece of plastic carelessly and avoid payments, you could kill your credit score and rack up some nasty debt.
On the other hand, if you wield your card wisely and make consistent payments, you can boost your credit and reap the full benefits a credit card has to offer.
To get the most out of your credit card use, you need to understand how credit cards work and what they can offer you.
Consider this post as Credit Cards 101 for beginners and anyone looking to maximize the benefits of credit cards.
Table of Contents:
- What Are Credit Cards & How Do They Work?
- Benefits of Credit Cards
- How To Get A Credit Card
- Debit Card vs. Credit Card
- Types of Credit Cards
- Tips to Get the Most From Your Credit Card
What Are Credit Cards & How Do They Work?
Let’s start with the basics. When you get a credit card or any other form of credit, you enter an agreement with a financial institution, promising to pay later the money you borrow from them now.
Banks, credit unions, and lenders attach an interest fee to your agreement. If you fail to pay an established amount of the balance you owe at the end of each month, you’ll be charged interest.
That’s why making timely payments is crucial. Do that, and a credit card can be a major asset to your finances.
Benefits of Credit Cards
When you use your credit card smartly, here are some of the rewards you can expect.
- Building your credit: One of the quickest ways to give your score a boost is to get approved for a credit card. Consistent, responsible use strengthens it, even more, solidifying a strong credit history on your report.
- Accessing lower rates: A by-product of improving your credit score, using your card the right way could even help you get access to other types of credit in the future and score lower interest rates.
- Earning rewards: Some of your credit card’s rewards are more literal. A lot of credit cards come with cashback rewards on purchases like gas and groceries. Others give you travel miles, rewards points, and discounts.
- Getting emergency coverage: When things go wrong, and repairs, unexpected surgeries, and other emergencies arise, a credit card can be a real lifesaver.
How To Get A Credit Card & Use It The Right Way
Here’s a quick breakdown of the credit card process, from applying for a card to making your payments.
Credit Card Application
Credit card offers are everywhere, from your favorite morning radio show to your mailbox. You can apply for a credit card from just about anywhere, like your local bank, credit union, or an online lender.
During the decision-making process, a bank will look at your credit score, credit history, and income to decide whether or not to approve your application.
A platform like Credit Karma can help here, providing you with free access to your credit score, as well as your approval odds for top credit cards.
If and when you get approved for a credit card, the bank will set a credit limit, which is the maximum amount of money you can borrow. This limit will be based on some of the factors from your application, as will your interest rate.
Using Your Credit Card
Once your card is mailed to you, you’ll be responsible for following the accompanying instructions to activate it, which usually entails a quick phone call or online setup.
Then, you’re free to use your card at doctors offices, stores, restaurants, and online, just as you would a debit card.
Many people have fallen into the game of going to an atm to get a cash advance from their credit card. This is just not a good idea, the credit card company will charge you even higher interest rates for cash advances.
When the time comes to pay your first bill, you’ll have a few options, the first of which is to pay the minimum.
What Happens When You Pay The Minimum Balance?
The minimum is just that, the minimum requirement to keep your account in good standing. However, keep in mind that only paying the minimum will cost you in interest.
The ideal strategy is to pay off your full balance whenever you can, which allows you to sidestep interest altogether.
Reporting Your Credit Card Use
As you use your credit card, the issuer of your card will report your payment activity to the credit bureaus which determine your credit score.
With 35% of your credit score resting on your payment history, making payments on time is critical.
As mentioned above, making the minimum payment, at the very least, ensures your credit card use will not harm your score.
Stable credit card payments will improve your score, so be sure to make that 35% count.
What’s The Difference Between Credit & Debit Cards?
Debit and credit cards are comparable in the way that you use them to pay for purchases, but their similarities end there.
You have to apply for a credit card. Whether or not you get one, your borrowing limit, the type of card you’re eligible for, and what interest rates you qualify for, are all determined by your credit report.
To get a debit card, you need a checking account. Rather than borrowing money from a lender when you swipe or insert your card, you’re taking it directly from your bank account.
Since debit cards pull from the money you have in the bank rather than borrow it a lender, they’re unrelated to your credit score.
Because of that distinction, your debit card use isn’t reported to the credit card bureaus like your credit card use is, and it won’t affect your score.
Types of Credit Cards
Not all credit cards operate the same. Instead, there are several different types of cards, each with its own benefits and purposes.
Here are a few of the main types of credit cards on the market, with a little insight into what they have to offer.
Secured Credit Cards
Whereas traditional credit cards are offered based on your credit history, secured credit cards are designed for borrowers with lower credit scores and short credit histories. You pay a deposit upfront which sets your borrowing limit, then use the card to build your score. Once your score is in shape, you can apply for more rewarding cards.
Speaking of rewards, many credit cards are made to offer benefits to cardholders. Take cashback cards, for instance. When you use these cards to buy groceries, eat out, or purchase gas, you could get paid. And travel cards offer points redeemable towards air travel and hotel stays when you make purchases with your card. The travel rewards can be great for a business credit card if you travel a lot for work.
Student Credit Cards
If you’re in your late teens and early 20s, you’ve probably been bombarded with offers for these credit cards, which are made to help students build a strong credit history with responsible use. These cards come with low interest and often have no annual fee.
Balance Transfer Cards
It’s all in the name with these credit cards, which let you transfer high-interest debt from other cards and sources of credit to secure a lower interest rate. If you’re looking for this type of card to help with your debt repayment, you’ll need an impressive credit score. The best balance transfer cards come with an introductory 0% APR for a period of time, like a year.
Weigh the pros and cons with each type of card, and be sure you know what you’re signing up for in terms of rates and fees.
Then, pick the card that will benefit you the most, taking advantage of the awesome perks these cards have to offer.
6 Tips to Get the MOST From Your Credit Card
Here are a few quick pointers to help you maximize the benefits of your card and minimize the risk.
- Keep costs in mind: Interest isn’t the only expense to be aware of as you shop around for the right card. Look out for annual fees, late payment fees, and balance transfer fees when you review your options.
- Focus on your score: Do what you can to build up your credit score so you can be eligible for advantageous rewards cards.
- Consider credit utilization: 30% of your credit score is based on how much of your available credit you use. You want to keep that number at 30% or lower than your maximum borrowing limit to get the best results.
- Keep your cards open: Closing out a credit card can hurt your credit utilization and your credit history, ultimately damaging your score. If there’s no fee and the card has a high credit limit, it’s wise to keep the account open.
- Always pay on time: No matter what, always strive to pay at least the minimum every month. If that means spending less, so be it. The potential fees and damage to your credit score aren’t worth it.
- Track your score and account: Always log in to check your account activity and make sure that any purchases showing up are ones you made. Likewise, check your credit score. If it drops unexpectedly, it could be an indicator of identity theft or a miscalculation on the credit reporting agencies’ part.
Bonus Tip: If you ever misplace your credit card and are not sure if you just left it in your friend’s car, or at the last restaurant you ate at, call the credit card company immediately and tell them that you have lost your credit card. It is much easier to call back and say that you found it and that they can unfreeze the account now, rather than dealing with someone using your card and having to file a claim that it was stolen and that you did not make those purchases!
Use Credit Cards Responsibly
Learning how to use credit cards the right way can transform your personal finances.
The more responsibly you use them, the more you reap the rewards they were designed to deliver, boosting your credit, unlocking higher borrowing potential, and earning rewards you can use today.
If you don’t know your credit score, take a few moments to access it, then you can start shopping for credit cards.
Once you’ve found the right card, start using it to build your financial future, and enjoy the rewards in the meantime.
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