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Credit Card Basics
Credit cards are quite a controversial topic. Millions of consumers use credit cards for most of their purchases, yet critics claim they encourage overspending and lead to vicious debt cycles.
Of course, credit cards are neither good nor evil. They’re tools. Like any other tool, you can use credit cards to build, but you can also use them to destroy.
The key to using credit cards to understand how they work. To that end, the guide below teaches you the basics of credit cards and what to avoid. First, let’s clarify what a credit card is.
What is a Credit Card?
Credit cards are a type of revolving credit, meaning they don’t have fixed, regular payments like a loan would. You can borrow with your credit card whenever you want — up to a specified credit limit — by swiping it for in-person purchases or entering the card information for online shopping.
Once you use your card, you accumulate a balance. In theory, you can pay down your balance whenever you’d like. That said, your card issuer requires you to pay a minimum amount each month. Most cards have a $25 or $35 minimum payment. Paying this on time keeps you safe from late fees.
However, credit cards charge high Annual Percentage Rates (APRs) — your interest rate and fees — on their balances. APRs are usually 16.99% and above. If you don’t pay your balance in full, you’re charged interest, which is then added to the balance. Your next minimum payment will also be higher as a result.
How do Credit Cards Differ From Debit Cards?
Whereas debit cards pull funds from your checking account — money you have – credit cards let you borrow money you don’t have, with the expectation that you’ll pay it back later. If you don’t pay it all back, there’s interest.
Debit cards let you spend only the amount of cash in your checking account before your bank denies the transaction or charges you overdraft fees. With credit cards, you can spend up to the specified limit. If you exceed your limit, you’ll either be charged fees or have your transaction declined, depending on the card company.
Either way, the debit card has an advantage: it’s harder to put yourself deep into debt. However, responsible credit card use can help you financially as well because they help you build credit.
Credit score is a crucial component of your overall financial picture. A clean credit report and high score make it easy to find the best loan offers, get low interest rates, buy homes, and rent apartments.
Responsible credit card use builds your credit score slowly but steadily. Using your card on regular purchases and paying down the balance each month, you can expect to see credit card improvement.
Along the way, you’ll also benefit from credit card rewards.
Credit Card Rewards
Most credit cards entice new customers with rewards programs. The two most common types of rewards are cashback and travel:
- Cashback rewards cards let you earn rewards points for qualifying purchases. Earnings are based on a percentage of the purchase price — 1% and 1.5% are typical numbers. Many cards offer higher percentages for specific categories. For example, they may offer 2% or 3% cashback for gas, groceries, or online shopping. Some cards have quarterly rotating 5% categories. One quarter it might be groceries, while the next, it might be Amazon purchases.
Most card companies award you the points you’ve earned at the end of each billing period. In some cases, you can redeem them right away. Some cards make you reach a minimum point threshold, though. You can redeem your points for gift cards, a statement credit, a check/deposit into your bank account. Of course, a check or direct deposit is ideal for most, as you have more flexibility than a gift card. Sometimes, you can save on travel using your cashback points. But If you’re an avid traveler, then a travel rewards card might suit you better.
- Travel rewards cards pay you in miles every time you spend on travel. You can redeem these miles for free or discounted flights and accommodations. You can get travel rewards cards from airlines or traditional card companies. The former will pay off if you’re loyal to one airline, while the latter will earn you more if you don’t mind who you fly with. Higher-level rewards cards bring you various exclusive perks, such as an annual travel statement allowance, hotel concierge services, TSA PreCheck, access to VIP Lounges around the world, and more. These cards tend to require excellent credit, high income, and a specific net worth in some cases.
One thing to keep in mind: points can expire on some cards. Consider this when shopping around for a new card. If points expire on your current card, use them as soon as possible.
Earning money for your purchases is fantastic, but fees can eat up your cashback or miles if you aren’t careful.
Credit Card Fees
Card companies tack fees on to your balance. If you aren’t vigilant, you might rack up a few fees and not notice until your balance has grown. By then, you’ll owe extra interest on those fees. Keep an eye out for these fees, whether you’re applying for a new card or looking for ways to save money.
- Annual/Membership Fee: About 30% of credit cards charge an annual membership fee. This fee averages around $110. That’s not substantial if you spread it out over a year, but it’s an unwelcome surprise when you have 12 months to forget about it.
Some cards don’t charge an annual fee the first year, so you might not even realize it’s coming. If you want to avoid annual fees, read all the terms of any card you’re considering.
With these things in mind, your annual fee grants you access to several perks that lower-level cards don’t offer. These may include lower APRs, better cashback/travel rewards, price-matching perks, loss protection insurance, and extended warranties on purchases. Weigh the annual fee against the benefits of these perks before opening a card with an annual fee.
- Late Fees: When you fail to pay at least the minimum by your due date, your card issuer assesses a late fee, usually about ~$30. Paying late damages your credit, too. Stay on top of your credit card statements.
- Balance Transfer Fee: A balance transfer involves moving a balance from one or more cards to another card. Several cards are designed for balance transfers, offering 0% APRs on your transfers for a long time (such as 12 months). These cards are an excellent tool to escape high-interest debt and simplify your finances. However, they charge a fee for this convenience. Most balance transfer cards charge a balance transfer fee of 3%-5%, with minimum fees of $5-$10.
Let’s say you open a balance transfer card with a 3% balance transfer fee, then move $1,000 each from three other cards. Your card company would add $90 (3% x $3,000) to bring your balance transfer card’s balance to $3,090.
A balance transfer may be worth it, though. If paying that $90 means you avoid more than $90 of interest on other credit cards, you’re saving yourself money.
- Cash Advance Fee: Cash advances let you withdraw cash using your credit card. However, they also charge interest and fees. Cash advance fees are either a percentage of the amount you borrowed or a flat fee. In either case, they’re exorbitant.
Credit Card Pitfalls to Avoid
Only Paying the Minimum Payment
Paying the minimum keeps late fees and credit damage at bay, but you’ll accumulate a balance. As your minimum payment increases, it’ll be harder to dig your way out of credit card debt. Ideally, you should pay off your full balance on every statement.
Using Cash Advances
Cash advances sound appealing in a pinch, but they’re just loans with remarkably high interest (higher than your regular APR) and fees. All your interest and fees go to your card balance. If you’re already carrying a balance, a cash advance could put you over the edge into debt.
Not Reading the Terms
Credit card companies aim to make money from you, even if it seems like they’re rewarding you for spending. Be on the lookout for fees, penalty APRs, clauses that allow your card company to hike rates, and other terms that benefit the issue at your expense.
Overspending to Get Rewards
Credit cards already make it easy to swipe your way into debt. The gratification of earning cashback on purchases only worsens the problem. Your 1%-5% rewards will never outweigh the 15% or higher APR your card will charge you. If you’re prone to overspending, you may want to stick with your debit card.
Underusing Your Card
Using your credit card too infrequently is better than overspending, but it’s not ideal. Card companies expect you to use your cards and will close them after extended inactivity. This can adversely affect your credit history age — one of the five credit score factors — and lower your score.
Use all of your cards for something, even if it’s one $10/month subscription service. Doing so will keep the card open, help you build credit, and earn a few cents in cashback rewards.
Being Lazy With an Intro APR
Credit cards often offer introductory purchase 0% APRs for 12-18 months alongside balance transfer APRs. These cards are fantastic for making large purchases and earning cashback without paying interest. Some may even pay a $150-$300 signup bonus.
The problem comes when you get lazy with paying these cards off. If you wait for the intro period to lapse, you’ll start incurring a lot of interest. To avoid this, make sure you have a plan for paying down your new card before the promotional APR ends.
If you’ve run into any of these problems, you might consider canceling your card. Before we wrap up, we’ll explain how to do so.
How to Cancel Your Credit Card
Canceling isn’t tricky, but there are a few steps involved.
- Pay down your balance: You can’t close a card unless it has a $0 balance. If you can’t pay off the balance, you can request a freeze on the card so no new charges can be made. Then, you can focus on reducing the balance.
- Redeem your rewards: Make sure you redeem your rewards point. If you can’t (perhaps due to not meeting a threshold), see if you can transfer them to your new card.
- Call and cancel: Call the customer service line on the back of the card and explain that you’d like to cancel. Expect the representative to try and sell you on staying. It’s up to you to change your mind if they propose better terms if you stay. If you still want to close the account, stand your ground. Tell the rep you want a note on your account stating you requested the closure. Otherwise, the credit bureaus might think the issuer closed the account, resulting in credit score damage.
Credit cards are fantastic tools when used wisely. They let you borrow money on-demand and earn cash or travel rewards for your purchases. Promotional introductory APRs and signup bonuses help you afford large purchases. Plus, you can use credit cards to build your credit history and open future financial doors.
But credit cards become a nightmare when used irresponsibly. Failing to pay off your card can lead to deep debt as you accumulate interest and fees. Making the minimum payment becomes harder with each passing month. Eventually, when you can’t make the minimum, you’ll incur more fees and suffer credit damage.
The best way to use credit cards is to act like they’re debit cards. Use them only for your regular expenses. Only make large, discretionary purchases when you have a promotional APR and a plan for paying it off. By following this simple strategy, you’ll reap the rewards of credit card use and enhance your finances.