What is a credit card? A credit card is a plastic card that is issued by a financial company, such as a bank. It allows the user to utilize the card to make purchases by borrowing money from the issuer. Essentially, it acts as a small personal loan that the consumer pays off at the end of an agreed upon period, known as the “grace period,” or in installments afterwards.
Key advice for owning a credit card
This is perhaps the most important thing to know about having a credit card: pay off your credit card balance in full within the grace period. If you do this, you can enjoy the benefits and convenience of the credit card without being subject to its major drawback: high interest charges. If you do not pay off the balance in full at the end of the grace period, you will end up paying interest on the remaining balance. In 2013, the average interest rate in America is 15% or higher. This is higher than the interest rates for many consumer loans. For example: in 2013, the interest rate for mortgage loans varies around 3-5%, and the interest rate for subsidized student loans is just 3.4%.
How they work
While credit cards vary depending on the plan, the general process can be broken down into a few steps. Let’s use an example to explain a simple transaction. -You apply for a credit card and are approved. You receive your card in the mail, and activate it to begin. -For in-store purchases: -Let’s assume you want to buy a table that costs $100. When you swipe your card through the machine, an electronic system verifies that the card is valid and that you have enough credit left to make the purchase. -Initially, the card issuer takes care of the expense. You agree to pay the issuer by signing the receipt or entering your PIN number. -For online purchases: -When your lamp is ready to be purchased, follow the checkout instructions online. -Like an in-store purchase, the issuer takes care of the expense up front. You agree to pay the issuer by completing the checkout process. – Instead of swiping your card through a machine, the site will ask you to enter specific information. This generally includes your name, address (shipping and billing, if they are different), credit card number, security code (3 digit number on the back of the card), and expiration date.
-By requiring you to include your security code and expiration date, the merchant is trying to reduce the risk of fraud. Since you cannot present the card in person, giving the extra information helps to protect your identity and funds.
For either scenario: -At the end of your billing cycle, you receive a statement with all of your purchases listed in order. You can choose to pay off the balance in full, or pay the minimum payment and allow some of it to carry over into the next cycle. -It is recommended that you pay off your balance in full by the end of the grace period. However, let’s assume you pay the minimum amount due of $25 by the end of the period, and leave $75 to carry over. -The remaining $75 will accrue a finance charge, i.e. interest. If your APR is 15%, many credit card companies will charge a daily interest fee based on this percentage. -If your billing cycle is 31 days and you do not make any other purchases during that time, the $75 will become $75.96. While this may not seem like a large increase, it compounds over time, which could lead to large interest fees over the years. This is especially true if the balance continues to grow.
Benefits of having a credit card
1. Convenience. A credit card allows you to make big purchases without having to carry around a large amount of cash. It acts as a short term loan that can be used quickly. Additionally, not all institutions accept personal checks anymore.
2. Build your credit. Properly managing a credit card can help you build and improve your credit report and score, which may come in handy down the line when you’re applying for a mortgage, housing, etc.
3. Rewards and benefits packages. Some cards offer enhanced product warranties, free loss/damage coverage on new purchase, and reward points for cash, products, airline tickets, and more.
4. Reservations. Today, many hotels, rental agencies, restaurants, etc. require a credit card as a deposit in case something happens.
Negative aspects of credit cards
1. Tendency to overspend. Some studies suggest that consumers are likely to spend more money when they pay by credit card, because the financial impact isn’t felt until later.
2. High interest rates may lead to large debt. CreditCards.com estimated that in 2012, the average American household that has credit card debt has around $15,950 in credit card debt. The “snowball effect” can occur quickly when a consumer is hit by unexpectedly high interest rates. Once the payments get higher, it may become more and more difficult to keep up. According to a 2013 survey by Bankrate.com, nearly 24% of Americans have more credit card debt that money in their savings account. In extreme cases, this imbalance of debt could lead to bankruptcy.
3. Negative impacts on your credit report/score. Late payments and debt can drastically impact your credit report and score. This can affect the rest of your credit activity, i.e. getting a mortgage, buying a car, finding housing, getting a job, etc.