Credit cards have become a ubiquitous instrument in today’s modern society. They provide convenience, security, and several other advantages. However, they also come with extremely high, almost predatory, interest rates. So understanding how credit cards work is critical for making informed decisions and avoiding unmanageable debt.
In this article, we will introduce the fundamentals of credit cards and the different types of credit cards. By the end, you should be able to assess whether to get a credit card, and which card to go for.
What Exactly Is a Credit Card?
A credit card is a financial tool that allows people to make credit-based purchases. A plastic card provided by a financial organisation, such as a bank or credit union, offers users a revolving line of credit. In simple terms, it offers you some money to borrow for making purchases. Some cards allow limited cash withdrawals too, but not all.
Unlike a debit card, which deducts funds immediately from a linked bank account, a credit card allows users to borrow money from the card issuer to make purchases. Of course, the expectation is that the borrowed amount will be repaid later.
The card issuer pays the merchant when a credit card holder purchases something. Following that, the cardholder receives a monthly statement outlining the transactions done throughout the billing cycle, a month typically.
How Credit Cards Work
Here’s a quick rundown of key related terms and concepts to understand how credit cards work:
Credit Limit
Each user is given a credit limit, which is the maximum amount they can borrow on the card. It is mainly decided by the applicant’s credit score. As you build your credit score and continue to pay off your credit card balance, providers will automatically offer you credit limit increases. You can also request a credit limit increase, which will be assessed in light of your repayment history, annual income and credit score.
Card Usage
Cardholders can use their credit cards to make purchases at various shops, both in-store and online. The card should be widely accepted unless it is an American Express card. Some credit cards allow you to withdraw cash as well, but not all. Finally, some cards have a balance transfer facility, which means you can use the card to pay off another credit card for a fee.
Billing Cycle
Credit card transactions are classified into billing cycles, which normally last one month and are used to record purchases. If you plan on paying off your credit card, you only need to pay off the balance at the end of the billing cycle. This means that credit cards can give you up to a month to pay off a purchase before accruing interest.
Users receive a statement at the end of each monthly cycle that details their transactions, minimum payment amount, and due date.
Payments
Users can avoid interest charges by paying the outstanding balance by the due date. However, failing that, users are expected to make a minimum payment that is calculated based on your balance. The balance carried forward will be subject to interest, which tends to be high.
It is very important to know that the minimum payment is not enough to pay off the balance. This means that the balance will continue to grow despite making these minimum payments. Best practice is to set up a direct debit to pay the balance in full every month, avoiding the interest charges altogether.
Credit Utilisation
Credit utilisation is the amount of used credit as a percentage of your available credit limit. Maintaining a credit utilisation of 30% or less helps maintain a high credit score. Note that credit utilisation is calculated based on all your available credit, so if you have multiple credit cards, you can utilise more than 30% of one of the cards as long as the total borrowing remains below 30% of all your available credit.
Types of Credit Cards
Credit cards are classified into several types, each designed to meet specific demands and financial situations. Here is an overview of the most common credit cards:
- Standard Credit Cards: These are typical credit cards with a set credit limit based on your creditworthiness. They offer convenience for routine purchases and can be used at most retailers globally.
- Rewards Credit Cards: These cards provide benefits based on how much you spend. These incentives include cashback, travel points, airline miles, and other benefits. Individuals who frequently use credit cards for purchases and wish to earn rewards may consider using a rewards card.
- Secured Credit Cards: Secured cards are intended for people with a limited credit history. They require a security deposit as collateral for the credit line. Secured cards can help establish or rebuild credit by demonstrating prudent credit utilisation.
- Balance Transfer Credit Cards: These cards are useful for people who need to consolidate high-interest debt. Balance transfer cards let you transfer balances from one credit card to another, typically at a lower or zero interest rate for a limited time and a fee (percentage of transferred balance). They can help you save money on interest payments and pay off debt faster.
- Student Credit Cards: Student credit cards are made for college students with little or no credit history. They frequently have reduced credit limits and special perks like cashback on student-related expenses or prizes for appropriate credit behaviour.
- Business Credit Cards: These cards are designed to meet the demands of small business owners and entrepreneurs. They offer features such as increased credit limits, spending tracking software, awards for business-related expenses, and separate financial reporting for businesses.
- Travel Credit Cards: These cards cater to frequent travellers. They provide travel advantages like airline miles, hotel incentives, travel insurance, and access to airport lounges. Credit cards with no foreign transaction fees may also be available, making them perfect for overseas travel.
Choosing the Right Credit Card for You
Choosing the best credit card is an important decision that can greatly impact your financial well-being. With so many options and types available, evaluating many things is critical to ensure you get the right credit card for your needs.
Begin by examining your spending habits and financial objectives. If you make regular purchases, a rewards credit card with cashback or travel benefits is a no-brainer, but they tend to require good credit scores. Secured credit cards might be a fantastic option for those trying to develop credit or repair a low credit score.
Examine the yearly fees, interest rates, and other fees linked with the card. Low-interest credit cards can save you money in the long term if you plan to carry a balance. You may be tempted to get a store-credit card, such as the ones offered by Amazon or M&S, but these may not be the best option and they tend to have very high rates. You may choose to opt-in for multiple credit cards to meet all your needs. But make sure you don’t make credit applications in in consecutive months as this will negatively impact your credit score.
If you run into financial hardship and you have a decent credit score. Fear not, 0% credit cards and balance transfer cards can come to the rescue. Find all about them here.
Disclaimer
We felt the need to remind our readers that the interest rates, also referred to as APR (Annual Percentage Rate) on credit cards are horrendous. Please let us illustrate:
A good APR is 25%, but they can literally be as high as 65% for a rewards card. This means that your debt can double in 2 years only. You can calculate how much your balance will grow given the APR by calculating the future value using our calculator or guide. In short, you should pay off the balance in full every month. If you are prone to overspending, do not get a credit card until you have financial discipline. To build financial discipline, you need to have a budget, and you need to stick to it.
Conclusion
Credit cards have become an important aspect of modern financial transactions, providing convenience, security, and a variety of other advantages. Understanding the how credit cards work is critical for making sound decisions and avoiding unbearable debt. We’ve looked at everything from how credit cards function to how to use them responsibly.
You may choose the best credit card for your needs and financial goals by understanding the various credit cards available, such as basic cards, rewards cards, secured cards, debt transfer cards, and more. Consider your spending habits, credit score, interest rates, annual fees, and other benefits to make an informed decision.
Read Next: The Complete Mortgage Guide
