In the U.S. and most of the developed world, credit cards are a commonly accepted form of payment. In fact, according to data gathered in the last U.S. Census, 70.2% of Americans have at least one general-use credit card.
But while the adoption of credit cards may be widespread, that doesn’t mean those carrying credit cards really know how they work. In fact, only 26% of card holders read their credit card contract, while an overwhelming number of Americans don’t understand how having a credit card can impact their credit — either positively or negatively.
If used correctly, credit cards can be a powerful financial tool for the good. On the other hand, you probably know one or two people who have fallen into the abyss of high-interest credit card debt that they can’t seem to escape. To ensure you don’t fall in with them, it’s important to understand how credit cards work, the pros and cons of having one, and if owning a credit card is right for you.
What Is a Credit Card?
To many, a credit card is just that plastic token with a magnetic strip on the back that lets you buy things. In a sense, that is a simple definition of a credit card, but there’s an added layer of complexity many Americans don’t understand.
When you pay with cash or a debit card, the money comes directly from your bank account. In contrast, when you use a credit card, you are essentially taking out a short-term loan from the credit card issuer. The credit card pays money to the vendor in exchange for goods purchased, with the agreement that you will pay them back when the credit card bill comes due.
Credit Card Terms 101
The way money changes hands when it comes to credit cards is often a mystery. You might get confused when it comes to how interest and late fees work. And what was a balance again?
There are a few general credit card terms you should be aware of if you want to use credit cards responsibly:
Credit Limit: This is the amount of money you can spend on your credit card at one time (or the maximum amount you can borrow), and is determined by the credit card issuer. If your credit score or income improves, the amount usually increases.
Balance: This is an extremely important number to pay attention to, as it is the outstanding amount you owe the credit card company. If you purchase $1,000 worth of items and haven’t paid it back, your balance would be $1,000, plus any interest you may have accrued over time.
Available Credit: This is the dollar amount still available to you to spend. Let’s say your credit card has a $3,000 limit and you spend $1,000. You would still have $2,000 in available credit. If you make a $500 payment, then your available credit goes back up to $2,500.
APR: This stands for annual percentage rate. It’s the interest rate you have to pay on your remaining debt if you don’t pay off your statement balance in full every month.
Billing Cycle: This is usually a month-long period defined by the credit card company. If your credit card billing cycle begins on the 10th of each month, January 10 to February 10 is one billing cycle, and any purchases made within that time frame will show up on your February 10 bill.
Statement Due Date: A date specified by your credit card company, this is the date on your statement or credit card bill by which you have to pay at least the minimum payment to keep your credit card account in good standing.
Minimum Payment: This is the amount that you’re required to pay the credit card company every month. That’s right, you don’t have to pay the full balance due, but financial experts strongly encourage you to do so. If you only make the minimum payment, you will have to pay interest on the balance remaining — which can rack up fast.
Late Fee: If you don’t make your minimum payment by the due date, the credit card company charges you an additional fee on top of the balance that is due.
A Real-Life Example
Let’s look at an example of how these terms might impact you in your day-to-day use of a credit card.
John just got his very first credit card. Because he’s just starting out, his credit limit is relatively low at $3,000, and the card has a relatively high interest rate of 20%. His billing cycle starts on the 10th of each month, and between January 10th and February 10th he spent $1,000, and his remaining available credit is $2,000.
His statement due date for this billing cycle is on March 3, with a required minimum payment of $25 on his $1,000 balance.
If John pays off his credit card balance in full…
In this scenario, assume that John pays his $1,000 balance on his due date of March 3. He was essentially given an interest-free loan on the $1,000 he borrowed throughout the month from the credit card issuer because he paid it back, on-time and in full.
If John pays only the minimum this month…
Let’s say that John is a bit strapped on cash and decides to pay only the minimum payment of $25 this month. Next month, he’ll owe the $975 remaining balance, and he’ll also pay an additional $16 in interest due to the 20% interest rate. He’ll end up paying $1,016 in total on that $1,000 as a result of carrying the balance for just one month.
If John misses his payment entirely…
Now let’s assume he forgets to make the minimum payment on the 3rd, so the credit card company charges him a $15 late fee when he finally pays the bill on March 4, for a total of $40 paid.
His available credit is now $2,025, since he only paid $25 of his balance (the $15 late fee is an added expense). The outstanding balance is still $975, on which he will pay the 20% interest rate. He pays off the $975 remaining balance on the next statement due date, and pays an additional $16 in interest, for a total bill of $991.
In the end, that $1,000 purchase actually cost him $1,031 since he didn’t pay on time and only paid the minimum balance for a month. Now imagine those numbers on a larger scale — maybe $10,000 or $100,000 or paying your minimum month after month — and you can see why credit card debt can be difficult to escape.
Credit Card Fees Explained
Much like John in the example above, many Americans make the same mistake — they don’t pay their balance in full. According to a recent survey, 43.9% of users carry a credit card balance from month to month, only making their minimum payment every month to avoid late fees. The dirty little secret is that this is how credit card companies make their money.
While it might seem like a great deal that you only have to pay $25 on your monthly due date in exchange for the latest personal gadget or designer handbag, this is when it’s important to remember that the balance you wrack up on your credit card is a loan.
Credit card companies don’t lend you that money for free. They make most of their money from the credit card holders who don’t pay their monthly balance in full at the end of the billing cycle.
How can this be?
As with all lenders, the credit card company charges a fee in the form of interest for the use of the money you borrow. As you can see in John’s example above, you only pay this fee if you don’t pay off the full balance every month. Unfortunately for the unwary credit card holder, those interest rates are usually exorbitantly high. In fact, the Federal Reserve found that the average credit card interest rate was a whopping 16.86% in Q4 of 2018. As a result, the consequences of carrying a balance month to month can greatly handicap your ability to create a secure financial future.
Cons of Using Credit Cards If You Carry a Balance
The high interest rate on credit card debt is — arguably — the number one drawback to using this common financial tool. There are many others that arise if you don’t pay off your balance each month.
High Interest Debt
Let’s go back to John’s example where he charged $1,000 on his favorite credit card. Instead of paying off his balance quickly, let’s assume he decides to only pay the minimum payment of $25 every month until that debt is paid off. Assuming an annual percentage rate of 16.86%, it would take him 5.6 years to finish paying off that $1,000. In the process, he would end up paying $661.70 in interest charges — almost doubling the original credit card balance.
Negative Impact on Credit Score
While the high interest rates are a major drawback, the extra money you have to shell out if you don’t pay your balance in full every month is just one negative impact on your financial situation. Ballooning credit card debt can also seriously hurt your credit score.
Now, if you’re wondering what your credit score is and why it matters, you’re not alone. According to one survey, 37% of Americans have no idea how credit scores are determined, or that carrying a credit card balance month to month can lower said score.
Your credit score is a three-digit number that tells potential lenders how likely you are to pay off your debt. The most widely used score is graded on the FICO scale. This rating mechanism assigns a score from 360 to 850 to private consumers, and is calculated based on a number of factors, including:
- Payment history: This is similar to your credit report, which tracks your history of making payments on time.
- Length of credit history: This is the amount of time you’ve been using credit. The longer credit history you have, the easier it is for lenders to determine whether you have a reliable payment history. Opening a bunch of new credit card accounts at one time or closing old lines of credit can cause your credit score to drop drastically.
- Used credit vs. available credit: Your credit utilization ratio is the percentage of available credit you are using versus the total amount available. Usually, personal finance experts recommend keeping your credit use to just 30% of available credit. For instance, if you have a total credit limit across multiple all your open lines of credit is $15K, you should only have $5K worth of debt at any given time.
- Number of accounts: If you have multiple credit accounts open with a long history of payment, that generally boosts your score. However, if you open a new line of credit in a short time frame — or multiple lines — that can lower your score.
- Types of credit used: Aside from credit cards, you can also have credit accounts in the form of mortgages, student loans, personal loans, and auto loans. Lenders like to see that you can manage multiple types of credit responsibly.
Pros of Using Credit Cards
While there are serious drawbacks to credit cards, if you use them responsibly — and that’s a big “if” — they can help you tremendously in your efforts to build a secure financial future. In fact, through the appropriate use of credit cards, you can actually improve your credit score, save money, and protect yourself from fraud and theft.
Build Credit and Improve Your Credit Score
As mentioned in the previous section, the three major credit bureaus in the United States — Experian, Equifax, and Transunion — determine your credit score based on a variety of factors. Having a history of using credit, as well as history of regularly making your monthly payments on time, goes a long way toward creating a good credit score.
Because the interest rate of most loans in the U.S. are influenced by the borrower’s credit score, having good credit — usually that means a score above 700 — can help you get a lower interest rate on mortgages, auto loans, and even personal loans. As a result, a good credit score could save you thousands of dollars.
For example, let’s say you have a credit score of 650 and to take out a 30-year fixed term mortgage loan for $250K at a 4.917% interest rate. Over the course of the loan, you would pay almost $230K in interest. On the other hand, if you had a 750 credit score and took out the same loan amount, the interest rate would only be 4.0% — saving you over $55K in interest payments.
Now, it must be emphasized, the only way to improve your credit and achieve such benefits is to religiously pay off your full credit card balance on time, every time, and don’t carry a balance unless you absolutely have to. You should also avoid cash advances — where the credit card company allows you to withdraw cash at a high interest rate — at all costs.
Aside from allowing you to build your credit and improve your credit score, the responsible use of a rewards credit card can also save you money through the use of cash back offers — think 6% cash back on grocery purchases — or rewards, such as airline miles. An important caveat when using such rewards cards is to find out if there is an annual fee. Many credit cards will charge an annual fee, usually ranging from $75 to $150 a year, to earn such benefits. It should go without saving that you should only open this type of rewards card if you will earn more in rewards than the cost of the fee.
In addition to earning you money through cash back or rewards, credit cards can also save you money. For instance, secured credit cards offer better protection against fraud than a debit card. If your credit card is stolen, the thief is spending the credit card company’s money rather than drawing it directly from your bank account as with a debit card. If you report the theft quickly to the credit card company, you will usually not be liable for any fraudulent purchases. You might not be so lucky if money is taken from your savings or checking account.
That fraud protection is important when it comes to shopping securely online, as well as traveling abroad. In addition to allowing you to safely transact online and abroad, many credit cards will not charge foreign transaction fees, which can save you hundreds — if not thousands — the next time you venture out of the country.
Do You Need a Credit Card?
The advent of the credit card is relatively recent. The first general-use credit cards weren’t issued until 1950 by the Diner’s Club, with the American Express Company following suit in 1958. Humankind lived for millennia without that magic piece of plastic in their wallet.
However, in today’s digital economy, credit cards are commonplace. While there are many pros to using a credit card, you should only open a line of credit if you can pay your balance in full every single time.
If that is not a commitment you can make to yourself, whether because you know you will spend more than you can feasibly repay or you are forgetful by nature, you should avoid credit cards altogether.