Credit cards are a great way to make purchases when you don’t have or don’t want to use cash. A credit card is basically an amount of money (sometimes called a line of credit or credit line) that you spend, repay, and spend again provided by a lender (like a bank, credit union, or some other company). A credit card can be used on pretty much any purchase from a cup of coffee to a family vacation.
If you’re not careful though, it’s easy to rack up debt on a credit card, but when used responsibly, it can be a great financial tool with lots of benefits.
How it works
So how do credit cards work, anyway? And what’s stopping people from buying a new car or making other major purchases that they can’t afford on a credit card?
For starters, credit cards come with a spending limit (sometimes called a credit limit). When you first apply for a credit card, the credit provider will take a look at your financial profile to determine how much this amount should be. It’s worth mentioning that your financial profile includes your income, credit score, credit history, and sometimes even your payment history with rental or utility providers.
Then the credit issuer will provide you with a plastic credit card. You can use this card anywhere that accepts credit card transactions (which is most places) and spend up to the card’s credit limit.
Keep in mind that you’re using borrowed money that you will have to pay back, just like a loan. But unlike a loan, you can pay back what you owe when you want rather than doing it on a predetermined schedule. This can be the minimum monthly amount, a partial payment here and there, or the full amount owed.
Credit Card Interest
The important thing to remember is that credit cards come with an interest rate, which is the price you pay for borrowing money to credit card companies. The interest rate you get for your credit card will also depend on your financial profile and will be specified once you’re approved for a credit card.
When applying for different credit cards, always pay attention to the interest rate offered as a high interest rate will make paying off your debt even harder. For example, the average interest rate on credit cards is about 15%. That means if you charge $1,000 on a credit credit and then make payments of $25 per month, it would take you 56 months to repay your debt and you will pay $395 in interest over the life of the debt. However, if the interest rate is 20%, it will take you 67 months to repay this debt. That’s a full YEAR longer!
Every time you make a purchase using your credit card, you’ll have what’s called a grace period to pay back the money before you’re charged interest. This is usually around 20-30 days. The best thing you do is pay off the credit card purchases before you’re charged interest.
How to use a Credit Card Responsibly
No matter what interest rate you’re able to lock in, there are plenty of smart ways to use your credit card so that it’ll primarily benefit you (the card holder) and not the credit card issuer.
Stay on top of your spending
It’s incredibly easy to rack up debt on your credit card. Those little purchases add up! Stay in control of your spending and keep track of what you owe so your debt stays manageable. If you were to charge $1,500 on your card and pay back $25 per month, it will take you 112 months to repay the debt. That’s double the amount of time it would take you to repay the $1,000 in our example before!
Make payments on time
If you cannot repay the credit card balance during the grace period, making credit card payments on time every time is crucial. Not only will it help boost your credit score, it will also help you avoid paying late fees that could be as much as $28 the first time you’re late and $39 for subsequent violations. Late fees occur when you don’t pay your minimum payment by the due date. Making payments late can also result in an increase in your credit card rate of interest. You can find out what the minimum payment amount is by checking your credit card statement.
If you go 30 days or longer without making your minimum payment, your credit card issuer will report the late payment to the credit bureaus. This means it will be on your credit report and stay on there for seven years. Your credit report is a statement that holds information about your credit history. It’s important because it shows how responsible you are with your debts, which lenders care about and use in their determination of credit limits and interest charged on your future debts.
Maximize your repayments on highest interest cards
Keep in mind that you’ll still be on the hook to pay interest charges even when making minimum payments on your credit card, which can add up fast. If you can’t pay off your credit card balance in full within the grace period, try your best to pay more than the minimum payment amount, starting with the card which has the highest interest rate.
For example, if you can pay back $50 per month instead of $25 per month, you will be able to repay the $1,000 debt in just two years instead of nearly five.
Increase your credit card limit
While increasing your credit card limit may tempt you to spend more than you can afford, it can be beneficial by providing you with money for a special purchase. It can also boost your credit score! While your credit limit by itself doesn’t do much for your credit score, your credit utilization ratio does have an impact. This is the number you get (percent) when you divide your credit card balance with your credit card limit. So if you have a credit card balance of $1,000 and a limit of $5,000, you get a credit utilization ratio of (1,000/5,000) = 20%. The key thing to remember is that the lower this percentage is, the better it is for your credit score.
Be careful with store credit cards
You may want to think twice before signing up for your favorite store’s credit card. They often come with annual fees and high interest rates, making it not worth the reward points you get. This isn’t always the case, of course, so just be sure to read the fine print to see if it’s worth it.
Don’t cancel your credit card unless it comes with fees
If you’ve just finished paying off your credit card and are ready to close out your account, don’t (unless your credit card carries an annual fee)! While closing an unused or recently paid off credit card is tempting, it can cause a dip in your credit score if you aren’t careful.
Remember how we said a credit utilization ratio can help your credit score? Well, by closing a credit card account, you’re basically eliminating an available line of credit. Unless you limit your spending, it can increase your credit utilization ratio.
The age of your credit accounts is another factor that can affect your credit score. Closing a credit card that you’ve had for years could lower the average age of your accounts.
In short, it may be better to keep your account open, even if there’s no balance, unless it has an annual fee.
Use the protection
Many of the credit cards have rental car insurance or purchase protection benefits built-in. When making a major purchase, you should always check whether your card provides additional protection.
Reap the rewards
Points are big in the credit card world, as are other forms of credit card rewards, such as miles and cash back.
Credit card points are earned with certain credit cards when you make purchases that can be turned into rewards like airline tickets or converted into cash. Some credit card issuers will even let you earn points by inviting friends or spending a certain amount within a specified time-frame. This is usually a promotion that credit card companies will offer when first signing up.
Best Case vs Worst Case Credit Card Use
Credit cards have plenty of pros and cons about them, most of which we’ve covered already. Some people use them as a form of cash advance on purchases, others simply use them for the rewards, and others use them for getting through times when money is short.
We want you to know what you’re getting into, so we wrote two examples highlighting the best and worst case scenarios. We want you to be in the best case but we understand if you’re in a tougher spot. Most people are somewhere in between, so don’t worry if you don’t fit either of these scenarios.
Best Case Scenario
You use your credit card to make purchases and pay off your balance in full within every grace period. This earns you lots of credit card points and rewards without paying any fees or interest on your credit card.
Worst Case Scenario
You use your credit card to make purchases but only make the minimum monthly payments. Interest on your growing debt continues to build up and you’ve maxed out your credit card limit. You’re unable to pay off your debt and you are forced to file for bankruptcy.
We understand that most people use credit cards because they need to—not just to earn credit card points and other rewards. Even so, there are ways to be smart with your credit card so it works in your favor.
Always stay on top of your credit card usage, pay more than the minimum when you can, optimize your repayments by starting with the highest interest card, always pay on time, and be careful about high interest rate and fees that come with some credit cards. Doing so will allow you to borrow responsibly and make your credit card debt manageable.
Life happens and we know that credit cards can be a great tool to help you through those hard times. We also know that credit card debt can grow quickly, even if you’re not spending more money. We saw from our examples how your interest rate and monthly payment can really impact the amount of money you’ll end up paying the credit card company.
Now that you know how credit cards work you can develop a plan and, remember, planning gives us a strategy and a way to fight issues head-on.
Don’t worry, though, we’re in this together. Unidos.