How Credit Cards Work
Credit cards may seem straightforward, but the nuances of things like understanding your billing cycle and checking your credit score may help ensure you’re not making any mistakes that could have negative consequences down the road. Before learning how to use a credit card, there are a few basics to understand.
Simply put, credit cards allow you to access an agreed upon amount of money between you and your card issuer, but instead of getting the money in full up front, you get it as you need it. Every time you swipe your card, you’re borrowing money against your credit limit. Your credit limit is the maximum amount a credit card company will allow you to charge on a single card. This number is set based on things like your credit rating, income level, and loan repayment history at the time you apply for the credit card, but can increase over time with continued on-time payments. If you’re worried about overspending, increasing your credit limit might not be right for you. However, if you’re using your card responsibly, a higher credit limit may actually help your credit score by lowering your credit utilization percentage. Credit utilization is the ratio of your credit card balances to credit limits. For example, if your balance is $400 and your credit limit is $1,000, your credit utilization is 40%.
Before you start making purchases you should familiarize yourself with your payment date and billing cycle. The billing cycle is simply the amount of time between billing periods. For example, it may start mid-month on the 15th and run through the 15th of the next month or it could start on the 1st and run through the 30th. Billing periods are typically between 28 and 31 days, and many credit card companies will allow you to change your billing period.
Upon your set payment date, you must make a minimum payment which is the lowest amount you can pay to avoid incurring any fees. This amount is typically calculated as a percentage of your outstanding balance plus interest. It’s best to pay your balance in full rather than just the minimum, but if you are unable to pay your balance in full, you should be considerate of your annual percentage rate (APR). APR is the interest rate of the loan plus lender fees and closing costs expressed as a percentage. Because the APR is a reflection of the true cost associated with borrowing money, the lower the APR the better.
Benefits of Using a Credit Card
- Build your credit score. Credit cards aren’t the only thing that affect your credit score, but they make up a large portion, especially for younger people who don’t have a longstanding credit history. Making on-time payments can help you build a strong credit score.
- Earn rewards. Many credit cards offer unique rewards systems in the form of travel points or even cash back. Find one that fits your spending habits, and you could potentially start earning around 1-2 percent back on every purchase.
- Protect yourself from fraud. Credit card fraud is still something to be cautious of, but with $0 liability the threat to your finances is minimal.
- Feel secure knowing you’re equipped to handle an emergency. Having access to a line of credit can help you feel like there is a plan in place for sudden emergencies.
The Do’s & Don’ts of Using a Credit Card
- Pay off your balance in full every month. Paying off your balance in full may help you maintain your credit score and avoid any fees. It’s the only way to guarantee you don’t find yourself slipping into debt.
- Keep your credit utilization low. Using too much of your credit limit can actually hurt your credit score. Instead of maxing it out, try keeping your total balance below 30 percent of your total limit. That means if you have a limit of $1,000 you shouldn’t charge more than $300 before paying off prior purchases.
- Monitor your monthly statements. Be vigilant when it comes to checking your monthly statements. This way you’ll avoid fraud and keep track of your spending habits.
- Charge only what you can afford. This goes back to the importance of paying off your balance in full. Make sure you’re only charging as much as you know you can afford by the end of your billing cycle.
- Choose a payment date that you’ll remember. Many credit card companies allow you to change your payment date. Choose one that you’ll remember, whether that’s on payday or a day that other bills are due. To make it even easier on yourself, set up auto-pay so you’ll never miss a payment due date.
- Take advantage of any perks offered. Make sure you familiarize yourself with your credit card’s rewards. It can be a great way to make passive income that you can put towards savings—especially if you have a cash back card.
- Shop around before choosing a credit card. There are a lot of credit card offers out there. Find one that works for you and check your credit score to find out if you’re eligible. Take a look at things like the interest rate and rewards before you make your decision.
- Sign up for too many credit cards. You don’t have to stick to one card, but try to avoid opening an excessive number of credit cards. While the number of cards you have doesn’t directly hurt your credit score, having too many cards may make it more difficult to balance payments and can make you more likely to use a large percentage of your credit utilization. Instead, carefully evaluate the pros and cons of each card before applying.
- Take cash advances on your card. Cash advances are one of the most expensive credit card transactions due to associated fees and higher than average interest rates.
- Skip a payment. Missing a payment could result in a late fee, penalty interest rates and a negative impact to your credit score. Auto-payments are a great way to avoid this.
- Close your credit card. Closing a credit card can be more detrimental than keeping it and using it every once in a while. For example, closing a credit card may lower your available credit which could throw off your percentage of credit utilization. Closing your first credit card might even change your credit history and negatively impact your credit score. If you feel strongly about closing a credit card, be sure to follow the instructions from your credit card company rather than destroying it yourself.
- Increase your credit limit if you can’t pay it off. You can ask your credit card issuer to increase or decrease your credit card limit at any time, but increasing could lead to more debt if you’re not careful. Again, if you want to increase your credit limit, just make sure to continue making all your payments on time.
- Finance a large purchase before making a plan to pay it off. Make sure you’ve established a habit of paying your bill in full before you make any large purchases, but if you must, make sure you can pay the amount back within at least 15 months.
Building a good credit score takes time and in many cases self-discipline, but don’t worry. When in doubt, try thinking of your credit card is to treat it like a debit card and only spend what you can afford.
Sources:Nationwide | Money Under 30 | ValuePenguin | New American Funding | NerdWallet | The Balance
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Why You Need to Use Your Credit Cards
There are two primary reasons why you should consider how often you use your credit cards:
- So your cards won’t be closed for inactivity
- To make sure that you’re getting enough value from the cards, if they have annual fees
Reason number 1 will apply to every credit card (or charge card). Reason number 2 will only apply to cards with annual fees.
First we’ll go over everything you need to know about preventing your cards from being closed for inactivity (also known as dormancy). Then we’ll discuss how to offset a card’s annual fee, and to make sure you’re getting your money’s worth.
Most personal finance advice regarding how often to use your cards focuses on inactivity. But if any of your cards have annual fees, it will be just as important to make sure you’re getting enough value from them to offset the cost.