Credit cards have been around for a long time. In fact, the first model for the modern day credit card took place in the 1920s, when department stores and oil companies started offering metal charge plates and courtesy cards. In today’s world of online shopping and contactless payments, it’s no surprise that the credit card is still one of the most prominent payment methods in the United States.
In this in-depth look at credit cards, we’ll take a deep dive into what a credit card is, how it works, and how this payment method compares to other popular payment methods out there.
So let’s dive in!
What is a Credit Card?
Just like an auto loan, personal loan, or mortgage loan, a credit card is another way of borrowing money. You apply for the loan, you’ll be approved if you meet the criteria for that loan, and then you’ll agree to repay the borrowed money based on the terms and conditions of your agreement.
The difference between credit cards and many other kinds of loans is that credit cards are a type of revolving credit. This form of credit can be used again and again, as you make purchases and pay them off. In addition to making purchases at a store, online, or for monthly recurring payments you can also use your credit card to get a cash advance at a bank or ATM.
What might just look like a piece of plastic at first glance is actually a very powerful way for you to make purchases, build credit, earn rewards, and so much more! But, as the saying goes, with great purchasing power comes great repayment responsibility.
When you use your card to make a purchase by swiping, inserting, tapping or entering your credit card number online, your credit card issuer agrees to pay for the purchase and you agree to repay the loan. At the end of each billing cycle, your credit card issuer will send you a statement of charges, along with instructions for repaying the borrowed money. You can choose to repay your purchases in full, or in part, and your credit card issuer may charge you interest for any balance you carry on your card.
You’ll always be required to make at least a minimum payment on time for each billing cycle. This is one of the most important things you should do when you have a credit card. In fact, according to FICO®, payment history (otherwise known as your record for making your payments on time) is the most significant factor affecting your FICO® Score – making up 35% of your total score.
Making Credit Card Payments
As we stated above, making your credit card payments on time is the most important thing you can do with your credit card. Your payment history is a critical component of your credit score calculation. And your credit score can impact your future ability to borrow money from other lenders.
As mentioned, your credit card issuer will send you a statement at the end of every billing cycle — the period of time between one month’s billing statement and the next month’s billing statement. This billing statement will notify you of your current total credit balance and the minimum amount of money that you need to pay. If you fail to make at least the minimum payment each billing cycle, you may be charged late fees, suffer credit score consequences, and/or be subject to collections or other legal actions. Your missed payment will also be reported to one or more of the credit bureaus, which can affect your credit score.
Your credit card issuer may give you a grace period to repay your loans — the time between the end of your billing cycle and the minimum payment due date. This amount of time will vary, depending on your lender, but it gives you a chance to organize your finances, evaluate your credit card statement, and arrange to make a payment.
Credit Card APRs
Your credit card’s annual percentage rate (APR) - also known as the interest rate - is the rate used by your credit card issuer to calculate interest on outstanding balances. You can think of APR as the price you pay for borrowing money on your credit card. You get to make purchases on credit. And your credit card company charges interest based on your APR.
You can find your credit card’s APR in the Schumer Box when you’re opening a new credit card and the APR for cards you have right now can usually be found on your card’s billing statement each month.
How is Your APR calculated?
Credit cards usually have variable interest rates. This means that they can change over time. Credit card issuers typically use an index, such as the U.S. Prime Rate, as a benchmark. This benchmark is the variable part of your variable interest rate because it goes up and down based on the current economic market. You can see the current Prime Rate and track changes in the Prime Rate over the last several years to get a good idea of how variable interest rates can change over time.
Your credit card will have a set margin percentage. Your credit card issuer will calculate your current APR by adding the margin (which stays the same) to the benchmark (which fluctuates) to get your variable interest rate. This video can help break down the variable interest rate process for you.
Once your APR is set, your credit card issuer calculates your interest for each billing cycle using a formula to determine a daily or monthly periodic rate. To find a daily periodic rate, your credit card’s APR is divided by 365 days in a year (or 366 in a leap year) and multiplied by an outstanding balance to determine interest owed on a given day. To calculate a monthly periodic rate, the daily rate is multiplied by the number of days in the billing period. That figure is then multiplied by an average balance to determine interest owed in a given billing cycle.
Credit Limits, Available Credit and Credit Utilization
Credit cards typically have a credit limit (also known as credit line), which is the maximum amount of money you can charge to your card. Your credit limit is determined by your credit card issuer and will depend on your credit profile, which the issuer will typically pull from your credit report from one or more of the three major credit bureaus.
Your credit limit can change over time. You may receive credit line increases as you prove yourself to be a responsible cardholder. But keep in mind that each credit card issuer provides credit line increases based on different criteria and at different lengths of time. Some credit card issuers, like Merrick Bank, will offer regular account reviews to see if you qualify for a credit line increase. Some issuers may require you to apply for a line increase.
The difference between your credit limit and your current credit card balance is called your available credit. Available credit is the amount you have left to make new purchases. So, if you have a credit limit of $500 and you’ve already used it to make $100 worth of purchases, your current available credit it $400. If you make a payment of $50, your new available credit will be $450.
Knowing your available credit can help you stay within your credit limit and determine your current credit utilization ratio — the percentage of used to available credit.
To calculate your credit utilization ratio, you add up all of your credit limits on all of your credit cards and then divide that by the balances on all of your credit cards. So, if you have a credit card with a limit of $500 and another credit card with a limit of $1000, your total credit limit is $1500. If you’ve made $50 worth of charges on the first card and $200 of charges on the second card, your total amount you owe is $250. To find your credit utilization, you’d divide $250 by $1500 (1.667) and then multiply it by 100 to get a percentage (16.67%).
Credit utilization is also a factor that can affect your credit score, so it’s a good idea to keep it as low as possible.
Credit Card Issuers and Networks
If you look closely at your credit card, you will probably see the names of two separate companies — one belonging to your credit card issuer and one belonging to your credit card network. Your credit card issuer is the bank or credit union that gave you your credit card. You deal directly with your credit card issuer to pay bills, report suspicious activity, and determine the terms of your loan.
Building and Rebuilding Credit
As you use your credit card to make purchases and pay at least your minimum balance each billing cycle, your credit card issuer will report that activity to one or more of the three major credit bureaus (or credit reporting companies).
When you use your credit card wisely by making your minimum payment (or more) each month, keeping your credit utilization low and continuing these habits over time, you can build or rebuild your credit history.
In fact, revolving credit can be one of the fastest ways for you to build or rebuild your credit. So, if you’re working on your credit score, using your credit card responsibly is going to help you on your journey. One of the best ways to know how to build or rebuild your credit is by learning what factors play a role in calculating your score.
If you’re interested in learning more about credit scores and credit bureaus, you can get a full explanation in this article.
Unsecured vs. Secured Credit Cards
Under the category of credit cards, there are unsecured and secured credit cards. Learning the differences can help you determine which type of credit card is right for you.
Secured credit cards require a cash deposit as collateral, usually equal to your credit limit. With most secured credit cards, you’ll need to pay the cash deposit as part of the application process to receive the card. A secured card is best suited for people who are looking to build or establish their credit for the first time. It’s typically easier to be approved for a secured card than an unsecured credit card, since you have to put down the collateral.
Unsecured credit cards are the most common type of credit cards out there. Unlike a secured credit card, you don’t have to put down a cash deposit to be approved for the card. Instead, you will be approved based on your credit profile.
Comparing Credit Cards to Other Forms of Payment
Credit Cards vs. Debit Cards
While credit cards allow you to borrow money to cover purchases, debit cards withdraw funds directly from your bank account at the time of purchase. Credit cards require you to keep track of balances, make on-time payments (including interest), and be responsible for paying down your debts, but they also give you the added benefit of building credit and the convenience of carrying a balance when needed. Perhaps most importantly, credit cards protect your personal money, allowing you to review all charges for mistaken or fraudulent activity before you pay for them with your personal funds. With a debit card, you may be without your stolen funds while you work with your bank to prove that you’ve been a victim of fraud. This can be difficult if you need that money for other living expenses.
Credit Cards vs. Prepaid Cards
Even though prepaid cards often carry the same network names as credit cards (Visa, Mastercard, etc.), they are completely different in how they work. Again, your credit card lets you borrow and repay money on credit. A prepaid card, on the other hand, lets you load money onto a card before spending it at the store—it’s extremely similar to using cash. While they offer similar convenience in how and when you can use them, prepaid cards have no impact on your credit and don’t offer the protections of reviewing and approving charges before paying for them with your own money.
Credit Cards vs. Cash
Cash is accepted everywhere. In that sense, it’s still king. But credit cards aren’t far behind (remember the nearly 11 million accepted Visa locations across the country). When it comes to convenience, credit cards allow you to make purchases online, over the phone, or from just about anywhere. Plus, once you hand over your hard-earned cash, it’s gone for good. Cash simply can’t offer you the protection and reassurance of reviewing and approving purchases before paying for them with your own money. With a credit card, you do have the added responsibility of managing your spending and making on-time payments, but you can also build better credit in the process.
Conclusion
We firmly believe that the first step in mastering something is to learn as much as you can about it, starting with the basics. We hope this article helps you further understand your credit cards and how you can use them to increase your financial knowledge, build or rebuild your credit, and get you on your well to a healthier financial life.
