Credit cards can be your greatest ally or your worst enemy. Some people use credit card rewards to travel for free. Others use credit irresponsibly, digging themselves into an insurmountable financial hole.
As we move towards a more cashless society, it’s important to understand how credit cards work. After all, using credit responsibly is often the difference between living in a constant state of financial stress and having financial abundance.
What Is a Credit Card?
Here are a few basic facts about credit cards.
- A credit card is issued by a bank or other institution and allows you to buy goods and services based on credit.
- Credit cards come with a credit limit, which is the maximum amount of balance you can carry on the card. If you go over your credit limit, your purchase may get declined and you’re likely charged a fee.
- Credit cards typically have an interest rate (known as the APR) on the balance owed, as well as a minimum payment amount. Most often, credit cards come with a variable APR, which means the interest rate is subject to change.
- Some credit cards may have an introductory interest rate, which only applies for a limited time (until the end of your intro period).
- If you pay off your balance in full each month, you won’t pay any interest.
The most important reason to use credit cards is because they help you build your credit score, which is an indicator of your creditworthiness that’s used for loan approvals. If you pay your bill on time every month and keep your spending within the limit, credit cards have the potential to make managing your money easier and help you save money (by getting lower interest rates) when you’re ready to make a big purchase like a car or a home.
How Payments Work on a Credit Card
After you make a purchase with a credit card, one of two things can happen:
- You can pay the minimum payment (or some other amount less than the full amount you charged). If you do this, you’ll make payments toward what you owe and your purchase will end up costing you more than the sticker price because interest will be added every month that your card still has a balance.
- You can pay the whole amount you owe. This is the best choice because you won’t be assessed any interest — your purchase will cost whatever the price at the store was.
Let’s look at how much of a difference paying the full amount of a credit card purchase can make to your bottom line.
Let’s say you bought a $500 television using a credit card that has 18% interest and minimum payments of $20 per month.
At that rate, it would take you two years to pay off that $500 purchase. And by the time you’re done, you’ll have paid $173 in interest, meaning your $500 TV will end up costing you $673.
|Initial Cost||Final Cost|
|If paid in full:||$500||$500|
|When making minimum payments:||$500||$673|
How Credit Card Companies Make Money
Credit card companies make money in a variety of ways.
First, they earn a portion of the purchase price, known as a credit card processing fee, which is usually a 1-4% fee paid by merchants. But they also make money off of you, and that’s their real treasure trove.
In fact, there are a ton of fees associated with credit cards.
Here are some to be familiar with:
- Annual fee. Some credit cards charge you just for having an account. How much you’ll pay depends on the specific credit card.
- Balance transfer fee. A fee that you incur when transferring the balance of one credit card to another. How much a balance transfer fee costs depends on the credit card issuer and the amount of the transaction.
- Cash advance fee. If you use your credit card to withdraw cash from an ATM, you’ll usually pay a cash advance fee. In most cases, you’ll also pay a higher interest rate on the cash you borrowed compared to the rate you’d pay on a purchase.
- Foreign transaction fee. A smaller fee, typically 1-3% of a purchase price, which some cards charge for making international purchases. Keep in mind that this is in addition to any currency exchange markup your card provider may charge.
- Interest charges. This is the main way credit card companies make money.
- Late payment fee. If you can’t even make the minimum payment on time, you’re charged a late payment fee, which can get as high as $50.
- Over-limit fee. If you purchase a good or service that makes your credit card balance go beyond the limit set by your card issuer, you’ll be charged an over-the-limit fee that’s usually in the $30 to $40 range. What’s often the case is that the credit card company will allow one purchase to go through, charging you a fee, and then decline you on further purchases.
- Returned payment fee. If you make a payment on your credit card and that payment doesn’t go through — perhaps because there wasn’t enough money in the account you used to make the payment — you’ll be charged a fee.
Now, if you’re the type who pays their bill in full every month, these fees and interest rates aren’t going to affect you. But as you can see, they can be a debt trap for those who make late payments or only make the minimum payment.
To avoid racking up fees, you’ll want to track your finances, which you can do for free using one of the popular budgeting apps. In addition, make a financial plan so you’re aware of your income and monthly expenses.
Credit Cards vs. Debit Cards
The primary difference between credit cards and debit cards is that with a debit card, the money is taken directly out of your bank account. In other words, you’re paying for your purchase instantly, instead of later like you would with credit cards.
That’s why, for many people, debit cards come with less risk than credit cards in terms of allowing you to overspend.
However, there are two notable drawbacks to carrying debit cards and not credit cards:
- Debit cards don’t allow you to build credit. Unlike credit cards, debit cards don’t affect your credit score.
- Debit cards don’t come with the rewards that some responsibly-used credit cards do. For example, many credit cards offer cash-back of 2% to 5% on purchases.
Credit Card Pros
- They help you build credit, which can save you thousands of dollars over the course of your lifetime. That’s because a high credit score equates to lower interest rates on big-ticket items like your mortgage and car loans.
- They come with valuable rewards. Cash-back credit cards can generate as much as 5% in savings on your purchases.
- They’re convenient. Credit cards are one of the easiest ways to pay for things, whether you’re home or traveling.
- They come with perks like warranties and purchase protection. Here’s a story to illustrate this point: I got married in 2009, right after the Great Recession. After paying the photographer in full up-front, he showed up on our wedding day, but a couple of weeks later, we got a notice saying he was going out of business and wouldn’t fulfill his obligations. I contacted the credit card company and they refunded us the full cost.
Credit Card Cons
- They charge interest. If you don’t pay off your balance in full each month, the amount remaining will accrue interest. This compounds over time, meaning you can end up paying significantly more for your purchases.
- They have numerous fees. These fees can stack on top of each other. Plus, they get added to your account balance, where they accrue interest.
- Studies show that credit cards cause people to spend more. That’s because when you pay for something with a debit card, you have to pay attention to your checking account balance. But with a credit card, nothing is drawn from your account immediately, so there’s less psychological resistance to overspending.
- They can hurt your credit score if used irresponsibly. For example, if you carry too high of a revolving credit card balance, your credit score will take a hit. You can also damage your credit by missing payments.
Is Dave Ramsey Right About Credit Cards?
Dave Ramsey is one of the most popular financial gurus in the world, and he says to close your credit card accounts and live off debit cards and cash.
It’s not an insane idea when you consider how much of a burden credit card debt can be, and is for many people. The average U.S. household carries $6,125 in credit card debt, which is significant. But many households carry even more, and that can be crushing.
So Ramsey is right to at least some extent: in theory, you’ll be better off sticking with debit cards and cash. Doing so will force you to live within your means, which is what your grandparents and other older relatives used to do.
However, I think there is a role for credit cards. And you could even make the case that using them responsibly is an important part of improving your financial situation and building wealth.
That’s because our financial system is designed to reward responsible credit usage. If you don’t build a good credit history, it will be much more difficult to buy a car or a house, or to pay for other big-ticket purchases down the line. Even if you’re able to get loans for these things based on your income alone, chances are you’ll get a worse interest rate than if you had a solid credit score — and that will end up costing you many thousands of dollars.
Of course, the question is whether you can control your spending. You know yourself better than anyone else does. If you’re the type with great self-control, there’s no reason not to take advantage of credit cards. They can offer great rewards and perks that can actually save you money in the long run.
But if you’re not a fiscally responsible person — and there’s no shame in admitting you have issues with your spending — then avoiding credit cards may be a smart move.
How Do Secured Credit Cards Work?
Secured credit cards are different than regular credit cards. With these, you have to pay a deposit upfront before you can use the card. That cash is then your card limit.
Secured cards are specifically designed for building credit. You put up the collateral (in the form of a cash deposit), which means the credit card company has very little risk. In return, they report your account usage to the credit bureaus so that you can improve your credit score.
Secured cards work the same as regular credit cards and are accepted at all the same places.
Keep in mind that if you don’t pay your bill when it arrives, they can use the money from the deposit you’ve made. However, they will often not do that and, instead, assess the same types of fees associated with regular cards, including late payment fees and over-limit fees
How to Use Credit Cards to Your Advantage
- Don’t use them if you can’t pay in full. There’s no way to win in this situation. If you can’t pay the full balance each month, it’s best to simply avoid using credit cards at all.
- Understand that fees and interest rates add up. Know these fees and make sure you’re not hit with any of them.
- Have a low (but not zero) credit utilization ratio. One of the things that helps build your credit score is having credit available to you – but the key is to not use too much of this available credit. You want to keep it fairly low (such as under 25%).
- Use balance transfers responsibly. Balance transfers can be a godsend when you have a troubling amount of credit card debt, because they can help you reduce your interest rate. But this only works if you avoid racking up more debt on the card you just freed up.
- Get a minimum of 1.5% back on every purchase. There’s no reason you can’t get at least this much cash-back on your credit card. Some even pay 5% cash-back in certain categories.
- Have a way to track your credit card spending. You can do this easily with software, such as Truebill or Mint.
With these tips in mind, you’ll be one of the few who understand how credit cards work (and who use them responsibly).
How to Find the Right Credit Card for You
There’s no one best credit card for everyone. When comparing cards, the goal is to find the best credit card for your goals and current financial situation.
Good questions to ask when evaluating a card, include:
- Do you have the recommended credit score to be approved for the card?
- What fees are associated with the card?
- Will the credit limit be enough for your spending?
- How can you maximize the benefits, such as the travel rewards, of the card?
- Is there a good welcome bonus for the card?
Ready to see what’s out there? Browse the available credit cards available right now at CardRatings.