What are Credit Cards?
Some of us at Fig Loans use credit cards with a level of strategy usually reserved for competitive chess games, racking up points, using specific credit cards for certain stores, and so on. Others of us use them simply as a way to build our credit history and manage our monthly spending between paydays. Whatever your approach to credit cards, the facts of a credit card remain the same. In short, a credit card allows you to make purchases with credit, meaning that the money does not get deducted from your account right away.
Credit cards can cause confusion because of the numerous options available, as well as the hurdles some of us face when trying to get a credit card. In this guide, we will break down the basic types of credit cards available, what you should know before getting a credit card, and how credit cards affect your credit score and overall financial health.
Fast Facts on Credit Cards
- Credit cards allow you to borrow money in a revolving way
- Like loans, credit cards carry interest
- What type of credit card you can get depends heavily on your credit score and income
- Credit cards can be very helpful for large purchases or if you have an infrequent payment schedule
- It is easy to fall into debit card debt, however, it can be avoided by building certain habits
Credit Card Basics
When you use a credit card, you charge whatever purchases, bills, etc. to the card. At the end of the billing cycle (your credit card company will tell you your billing cycle), you are responsible for paying off the balance you have racked up, or a portion of it. We will get more into how payments work later in this post, but for now, the main thing to remember is that using a credit card is like running up a tab at a bar.
All credit cards share certain features, including having a credit limit, reporting to the credit bureaus as a revolving credit account, charging interest on any balance not paid off in full at the end of a billing cycle, (it is the main way that credit card companies make money), and charging merchants fees to use their cards.
The credit limit on a credit card determines how much you are allowed to charge to this card and keep as an outstanding balance. In an unsecured credit card (more on that below), credit card companies use your credit report and your reported gross income to determine the credit limit on your card when you apply. They can increase this limit over time as you prove your ability to repay.
Your card's credit limit is important because it affects your utilization, or how much of your available credit you are using; your credit utilization then factors into your credit score. Here's an example of utilization: two people charge $1000 on their credit cards one month. If person A has a credit limit of $2000, and person B has a credit limit of $10,000, the effects on each person’s credit score of spending $1000 in a given month will be very different. The credit companies will see person A as using 50% of their available credit. Person B will have used 10% of their available credit. Most credit bureaus recommend keeping your utilization below 30% to maintain a good credit score.
Cards on Credit Reports
Credit cards will affect your credit report in several ways. First of all, when you apply for a credit card, it goes as a hard inquiry on your credit report and will stay there for years. If, however, you’re not 100% sure that you’ll be approved for the credit card you’re applying for, we recommend doing your research and submitting a few applications for different credit cards on the same day, as the credit bureaus will consider multiple credit card applications submitted within the same time period as one hard inquiry, and this will in turn affect your credit less.
As a credit account, credit cards will also appear on your credit report as a revolving account, meaning that you can keep borrowing a certain amount as you pay it off. For example, if your credit limit is $1,000 on a revolving account, you can have up to $1,000 outstanding on that account at any given time. As you pay down what you've borrowed, you can borrow up to that limit again.
Additionally, you can carry over a debt from one month to the next as long as you make a minimum payment (more on this later in the post!). Revolving accounts differ from installment loans or mortgages, where you cannot keep re-borrowing unless you refinance. It is easier, however, to mount up an unmanageable amount of debt with revolving credit because interest will apply to whatever you do not pay off in a given billing cycle.
One more thing to know about credit cards and your credit report is how the card can hurt or help your score on a monthly basis. First order of business is making a payment every month. Even if you can only make the minimum payment one month, you should make the payment because every missed payment will hurt your credit score. The longer you let a payment remain unpaid, the more it will hurt your score (not to mention it will continue to rack up interest).
Some blogs we've seen recommend making payments more frequently than once a month to help improve your credit. Although this can help, it does not do so by reporting more payments.You do not get more payment history on your credit report by paying your credit card more frequently than once a month. More frequent payments, however, can help improve your credit score by lowering your utilization.
It helps your credit score to have a mix of different account types, including revolving accounts, installment loans, mortgages, and so on. If you currently do not have a revolving account, getting a credit card that you can use responsibly is a great place to start!
Interest and Fees
If you've read our posts on interest and fees as they relate to loans, you will have an advantage when it comes to understanding credit cards. Because a credit card company is basically a lender, it needs a way to make money on the money you effectively borrow by charging purchases to your credit card each month. Credit card companies make money by charging interest on any unpaid balances at the end of a billing cycle, and fees. Both the specific interest rate and the fees depend on the card, however, we will discuss them more generally to help guide your choices.
Credit card interest is what makes credit card debt so dangerous. When you carry over a balance (don’t pay off the full amount you spent that month at the end of the billing cycle), you will be charged an APR. This is essentially like having a loan that rolls over. However, if you keep making the minimum payment every month, you will keep accruing interest on whatever is left unpaid.
For example, let's say one month you rack up $1,000 in expenses, and your minimum payment is $200. Let's also say that your credit card company charges 20% APR on a monthly basis for whatever is left over. That means you will then owe at least $800 plus whatever interest you accrued the following month. If you again make the minimum payment the following month, then on the third month you will owe the original $800 + first month's interest - 2nd minimum payment amount + 2nd month interest. Very quickly, this will balloon. We don’t recommend carrying a balance out of habit because credit card debt can often be far more expensive than that similar debt amount as a low-interest loan.
The interest rates for credit cards vary depending on the type of card, your credit score, and so on. Credit cards that offer more rewards, such as points, credits for certain purchases, and the like often have higher interest rates, whereas those cards with lower interest rates may offer fewer perks. Also, interest rates can be variable, meaning that they change (usually increase) after a certain amount of time after getting the card. You need to read this part of the credit card information very carefully before applying, as well as after receiving the card, to avoid falling into an untenable amount of debt.
Credit cards also charge a variety of fees. The fees, of course, depend on the specific card, but you can expect certain fees standard with every credit card. For example, all credit cards charge businesses a certain amount to process payments using the cards. These are known as merchant's fees, and you generally don't need to worry about them. The only reason you may sometimes encounter a merchant's fee is that some businesses will set a certain minimum on purchases for paying with a credit card or they will add a certain amount to your transaction if you choose to pay with credit card. In those situations, it makes more sense to pay with cash if you can because whatever benefit you would get from using your credit card is canceled out by the extra cost.
You may also pay an annual fee to have your credit card, depending on the card. This is more common for high-rewards cards. Some other common fees are foreign transaction fees, cash advance fees (we really don't recommend doing a credit card cash advance), late fees, balance transfer fees (when you transfer the balance of one credit card to another), and returned payment fees. Be sure you understand the different fees your credit card charges so you can avoid paying any of the avoidable ones!
Types of Credit Cards
There are credit cards for just about anything. You can have an all-purpose credit card, a store-specific credit card, an airline card, a gas card, and so on. We will not get into all the different types of cards in this post, but we will discuss a few important categories: secured credit cards, cash-back cards, and gas cards.
Secured credit cards are secured by a certain amount of money in an account. Like a secured loan, a secured credit card will take whatever security (money or asset you used to secure it) you provided if you fail to pay your card in a timely fashion.
In a secured credit card, also known as a second chance card, you determine the credit limit by putting down a certain amount of money down when you open the account as a security deposit. For example, if you put a limit of $500 on the credit card, then you are only able to max out the card at $500.
These cards are therefore a great option for anyone who has struggled to manage their credit use before or has not yet proven to the credit bureaus their ability to repay large amounts of debt responsibly, meaning they have a bad credit score or little to no credit history. Because they are a safer option for banks, too (they already have your money in case you do not pay), they often do not have any crazy fees, making them a more affordable option if you can put together the money for the security deposit.
Unsecured credit cards are available to people with more credit history and/or higher credit scores. If you fail to pay those credit card bills, your balance will keep increasing, with interest, and the nonpayment will damage your credit score, but you will not lose any money that you put down.
Both unsecured and secured credit cards can offer rewards. These rewards can be categorized as either points, which you can redeem on lots of things, like travel, statement credits, or even certain items. You can also earn cash-back rewards, which means that you get a certain amount of money back on either all purchases or a category of purchases. Most cards will either be a cash-back card or a rewards card, so understand whether you want money coming back to you automatically, or if you are the kind of person who wants to hoard points and blow them on some big expense!
As we mentioned earlier, higher-rewards cards can cost more and may only be available to low-risk borrowers who have longer credit histories and higher credit scores. Within all of the rewards, we have some basic recommendations.
First, choose the type of card that will most reward you for what you spend on the most. For me, I spend the most on food, and I like having points to redeem on travel or whatever, so I chose a points-based card that rewards grocery and restaurant purchases. Many families choose cards that offer a high rewards rate for gas and transit, since that can form a big part of the budget. There are even some gas cards for bad credit. Also, some retailers like Costco and Walmart offer their own gas cards, so if you spend a lot of your money on gas, these are good idea to check out.
Secondly, make sure to choose a card that does not charge high fees for something you will use a lot. If you frequently make purchases abroad, you do not want a card that charges foreign transaction fees. Similarly, if you expect to use a credit card's cash advance feature instead of taking out a payday loan, try to find a card for which the cash advance fee is lower than average.
Whew! You made it to the end. We hope this post has broken down the basics of credit cards so that you feel more empowered to look for a credit card and contribute to your credit history that way. Because digital payments form so much of our financial system these days, chances are, you will need a credit card at some point. Even if you have bad credit, there might be options available for you to benefit from a credit card and rebuild your credit. If you have any questions about credit card basics, please give us a shout at firstname.lastname@example.org, Facebook, Instagram, and Twitter.