Credit cards are one of the most popular ways to pay for purchases, but how do they actually work? In this blog post, we’ll give you a crash course in credit cards 101. You’ll learn about how credit cards work, the different types of credit cards available and how to use them wisely. By the end of this post, you’ll be a credit card expert!
What Is A Credit Card?
A credit card is a plastic card that gives the cardholder a line of credit to use for purchases. When the cardholder makes a purchase, they are essentially borrowing money from the credit card issuer. The issuer then pays the merchant for the purchase and the cardholder repays the issuer, usually with interest.
Credit cards were first introduced in the United States in 1950 by Diner’s Club. The card was initially created for business expenses and could only be used at restaurants. Although there had been charge cards before, but this was the first time a card had been consolidated to be used at multiple merchants. In 1958, American Express released the first charge card which could be used for any type of purchase. In 1966, Bank of America released the first credit card that could be used anywhere.
Since then, credit cards have become a staple in American society. In 2017, there were over 1 billion credit cards in circulation in the United States. Different types of credit cards are now used for a variety of purposes, including building credit, making purchases, and earning rewards.
How Do Credit Cards Work?
A credit card is a small plastic card issued by a financial institution, typically a bank, that allows its owner to borrow money against the card’s credit limit in order to purchase items or withdraw cash.
When you use a credit card to purchase an item, you are essentially borrowing money from the credit card issuer. The issuer then pays the merchant for the purchase price of the item, minus a fee called the merchant discount rate. You will then have to repay the issuer the borrowed amount, plus interest and any other fees, such as annual fees.
If you do not repay the full amount that you have borrowed within a certain time frame, typically 30 days, you will be charged interest on the outstanding balance. The interest rate charged will depend on the terms of your credit card agreement and is based upon your credit rating, but is typically around 15-25%.
To avoid being charged interest, you will need to make sure that you repay the full amount of your credit card balance within the grace period. The grace period is the period of time, typically 30 days, during which you can repay your balance without being charged interest.
If you are unable to repay your balance in full within the grace period, you will be charged interest on the outstanding balance. The interest rate charged will depend on the terms of your credit card agreement, but is typically around 15%.
In order to avoid being charged interest, you should make sure to pay off your credit card balance in full each month. You can do this by making sure that your monthly payments are at least equal to the minimum payment due.
If you are unable to make your monthly payments, you may be charged late fees and your interest rate may increase.
It is important to remember that using a credit card can be a great way to build your credit history. However, if you do not use your credit card responsibly, you may end up with a high interest rate and a large amount of debt. You should ensure you understand how credit cards work before applying for one.
Advantages Of Credit Cards
Now we’ve seen how credit cards work, let’s look at reasons why you might use one. There are several advantages of credit cards including the following;
1. Credit cards can help you establish a good credit history. If you use your credit card wisely and make your payments on time, you can build a good credit history. This can be helpful later on if you need to borrow money for a major purchase, such as a car or a house.
2. Credit cards can give you great flexibility. If you need to purchase something but don’t have the funds available, you can use a credit card instead of cash. Whilst this can be good if you need to make a necessary purchase, but you should ensure you do not spend more than you can afford to repay.
3. Credit cards can help you manage your finances. If you use your credit card to track your spending, you can better manage your finances and make sure you are not spending more than you can afford.
4. Credit cards can give you peace of mind. If you are worried about losing cash or having it stolen, you can use a credit card instead. This can give you peace of mind knowing that you have a backup form of payment if something happens to your cash.
5. Credit cards can help you take advantage of rewards and perks. Many credit cards offer rewards, such as cash back or points, that you can redeem for free or discounted items. Some cards also offer perks, such as free travel insurance or extended warranties on purchases.
Disadvantages Of Credit Cards
There are also several potential disadvantages of credit cards, including the following;
1. Credit cards can lead to debt: When you charge more to your credit card than you can afford to pay back, you will end up with a balance on your card that you will need to pay interest on. This can quickly become expensive, and if you are unable to make payments, you may end up damaging your credit score.
2. Credit cards can have high interest rates: The interest rates on credit cards can be much higher than the interest rates on other types of loans, such as personal loans or mortgages. This means that you will end up paying more in interest over time if you carry a balance on your credit card.
3. Credit cards can have annual fees: Many credit cards come with annual fees that can add up over time.
4. Credit cards can have late payment fees: If you miss a payment or make a late payment on your credit card, you may be charged a late payment fee. This fee can be significant, and it will add to the balance you owe on your credit card.
5. Credit cards can have limits: Most credit cards have limits on the amount of money you can charge to them. If you charge more than your credit limit, you may be charged an over-limit fee.
6. Credit cards can be used to make impulse purchases: It can be easy to charge more to your credit card than you can afford if you use it to make impulse purchases. This can lead to debt and financial problems down the road.
7. Credit cards can be stolen: If you lose your credit card or it is stolen, someone else can use it to make unauthorized charges. This can lead to debt and financial problems for you. Learn how to avoid financial scams.
Recommended reading; Is debt bad for your finances?
What Are The Different Types Of Credit Cards?
When it comes to credit cards, there is no one size fits all option. There are several different types of credit cards that each work in slightly different ways, aimed at different needs and circumstances.
1. Purchase cards:
Purchase cards are credit cards that can be used to make purchases at businesses that accept credit cards. These cards typically have a credit limit and can be used to make purchases up to that limit. Some purchase cards also offer rewards, such as cash back or points, for making purchases with the card.
2. Rewards cards:
Rewards cards are credit cards that offer rewards, such as cash back or points, for making purchases with the card. These cards typically have a higher interest rate than other types of credit cards, so it’s important to pay off your balance in full each month to avoid paying interest.
3. Balance transfer cards:
Balance transfer cards are credit cards that allow you to transfer the balance from another credit card to the balance transfer card. These cards typically have a low or 0% introductory APR for a period of time, which can save you money on interest if you pay off your balance before the intro period ends.
4. Combined balance transfer and purchase cards:
Combined balance transfer and purchase cards are credit cards that offer a low or 0% introductory APR on both balance transfers and new purchases. These cards can be a good option if you need to finance a large purchase and want to avoid paying interest on it.
5. Money transfer cards:
Money transfer cards are credit cards that allow you to transfer money from the credit card to your bank account. These cards typically have a high interest rate, so it’s important to pay off the balance as soon as possible.
6. Credit builder cards:
Credit builder cards are credit cards that help you build or rebuild your credit. These cards typically have a lower credit limit and may have a higher interest rate than other types of credit cards.
7. Travel cards:
Travel cards are credit cards that are suitable for spending abroad. They usually offer a cheaper way to spend or withdraw cash when overseas, and provide the convenience and security of not carrying cash. These cards can be a good option for people who travel frequently.
How To Make Money With A Credit Card
One of the big advantages of credit cards is that for those with good credit, there are ways to make money with a credit card. But how do credit cards work to actually earn you money? We’ll look at 2 options below.
Cashback Credit Cards
If you’re looking for ways to make money, one option is to use cashback credit cards. With these cards, you can earn cash back on your everyday purchases. To get started, simply choose a card that offers cash back on the types of purchases you typically make. Then, use the card for your everyday spending and watch the cash back add up. When used wisely, cashback credit cards can be a great way to earn extra money.
Stoozing
Stoozing is a method to earn free income from the cash borrowed interest free on a credit card. Instead of using cash, you use a 0% purchase card for all of your spending, and move your cash to a high interest savings account to earn a higher rate of interest than your credit card. Now that savings interest rates are beginning to rise, this option can be quite attractive once again. However, any mistakes could lead to damaging your credit score if you do not keep on top of it. We’ll outline the process below.
Firstly, you will need to find the best introductory 0% interest credit card offer, the longer the interest free period the better. To get these, you will likely require a good credit history and high credit score. This card will be used for all of your spending – it means it doesn’t cost you anything to borrow (so long as you can pay it back).
Now use this card to replace all of your other payment methods – cash, debit cards, other credit cards etc. Basically everything you spend should be done solely on this card. But a few points to remember – don’t go over your credit limit, don’t spend any more than you need to, never withdraw cash on the credit card, and always make the minimum monthly repayments (remember this is interest free).
As you are using this card for ALL spending, this means you will now have a lot of cash sat in your bank account. This cash will be used to pay off your credit card debt whilst now earning interest for you. All you have to do is find the highest paying savings account and save this cash into it each month.
Continue paying the minimum monthly repayments and then use the cash in your savings account to pay off the balance in full before the 0% introductory period ends to avoid paying any interest on the debt. As you have been earning interest on your cash savings, you should be left with extra free cash sat in your bank account after the credit card is paid off. This is why it is only a feasible option when savings interest rates are high. The longer the 0% interest period and the higher the savings interest rate, the better as it allows you to accumulate more free interest income.
Now we’ve seen how credit cards work to allow you to stooze, there are 2 key things to remember. First, you need to find the best paying savings accounts, the higher the interest rate the better, but be mindful of the length of term if using fixed rate savings such as Certificates of Deposits.
Compare the best savings accounts at SaveBetter
Secondly, you need to find the longest 0% introductory rate purchase credit card. The longer the interest free period lasts, the longer you can stooze and earn free interest income.
Compare the top credit cards at BestCreditCard
How To Avoid Paying Interest On A Credit Card
Credit card companies make money by charging interest on the balances that cardholders carry from month to month. But you can avoid paying interest on your credit card balance if you pay your balance in full every month. To do this, you’ll need to make sure you know when your credit card’s billing cycle ends and make your payment before that date.
You can also take advantage of any grace period your credit card company offers. This is usually a period of 21 to 25 days after the close of your billing cycle during which you won’t be charged interest on your balance if you pay it in full.
Use the credit card interest calculator below to see what your monthly payments could be and the amount of time it would take to pay it off.
How Do Credit Cards Work To Improve Credit Score?
One of the great advantages of credit cards are that they can be a great way to improve your credit score. Using a credit card responsibly – by making payments on time and keeping your balance low – can help you build a good credit history. This, in turn, can lead to a higher credit score. And a higher credit score can mean access to better financial opportunities, such as lower interest rates on loans.
So if you’re looking to improve your financial situation, consider using a credit card wisely. FICO scores are the industry standard for assessing creditworthiness and are used by 90% of the top US lenders. Check your FICO score.
What Are Some Alternatives To Credit Cards?
There are many alternatives to credit cards, including personal loans, payday loans, cash, and debit cards. Each has its own pros and cons, and it is important to understand how each works before deciding which is right for you.
Personal loans may be good alternatives to credit cards for those who need to borrow a large amount of money. They typically have lower interest rates than credit cards, and you can choose a repayment plan that fits your budget. However, personal loans can be difficult to qualify for and may require a good credit score.
Payday loans are a quick and easy way to get cash, but they come with high fees and interest rates. If you cannot repay the loan on time, you may be charged additional fees. This can make payday loans very expensive and difficult to repay. They are not good alternatives to credit cards and are a type of debt that should be avoided.
Cash is always an option, but it can be risky to carry around large amounts of money, you also cannot spend more than you already have like you can with credit. Debit cards are a good alternative to cash, as they allow you to access your funds without carrying cash. However, debit cards debit the money straight out of your bank account, so you need to ensure you have enough money in your account to avoid going overdrawn.
Credit Cards 101: FAQs
Although we’ve discussed how credit cards work along with the different types of credit cards and their advantages and disadvantages, there are still some common credit card questions we get asked which are answered below.
How Old Do You Have To Be To Get A Credit Card?
There is no one answer to this question as it can vary between countries, plus each credit card issuer has their own requirements, but there are some general guidelines. In order to get a credit card in the US, you must be at least 18 years old. However, some issuers may require you to be 21. If you are under 21, you may still be able to get a credit card if you can show proof of income or have a co-signer.
How To Get A Credit Card For The First Time?
There is no one-size-fits-all answer to this question, as the best way to get a credit card for the first time will vary depending on your individual circumstances. Before applying, you should ensure you understand how credit cards work and consider if you really need one. However, some tips on how to get a credit card for the first time include:
1. Check your credit score: Before applying for a credit card, it’s a good idea to check your credit score to see where you stand. If you have a good credit score, you’ll be more likely to be approved for a credit card with favorable terms.
2. Shop around: There are a lot of different types of credit cards out there, so it’s important to shop around and compare offers before you decide which one is right for you.
Compare the top credit cards at BestCreditCard
3. Consider a secured credit card: If you have a limited credit history or a low credit score, you may want to consider a secured credit card. This type of credit card requires you to put down a cash deposit as collateral, which can help you get approved even if you have bad credit.
4. Use your credit responsibly: Once you get your credit card, it’s important to use it responsibly. That means paying your bills on time and keeping your balances low. If you do this, you’ll help improve your credit score over time, which will make it easier to get approved for credit in the future.
Can I Have More Than One Credit Card?
Most people can have more than one credit card, but there are a few things to consider before opening additional accounts. For example, you’ll need to make sure you can handle the additional responsibility of paying multiple bills each month.
You’ll also want to consider whether having multiple cards makes sense for your financial goals. If you’re trying to improve your credit score, for example, you might want to keep fewer cards open so you’re not tempted to spend more than you can afford.
Ultimately, the best way to decide if having multiple credit cards is right for you is to carefully consider your own financial situation and goals.
Do I Have To Pay The Interest?
No, you don’t have to pay the interest on your credit card, providing you use it responsibly. There are a couple of ways to avoid paying interest. One way is to simply ensure you pay your balance in full every month. This way, you’ll never be charged interest. Another way is to take advantage of 0% APR credit cards. These cards offer a period of time (usually around 12 months) where you won’t be charged any interest on your balance.
Can I Withdraw Cash With A Credit Card?
You can use a credit card to get cash advances from an ATM. Cash advances come with fees and high interest rates, so it’s best to avoid them if possible. If you need cash, your best bet is to use alternatives to credit cards such as a debit card or withdraw cash from your bank account.
What Is A Credit limit On A Credit Card?
A credit limit on a credit card is the maximum amount of money you’re allowed to spend in a day, month, or year. Credit limits are set by the card issuer and can be either fixed or variable. A fixed credit limit is a set dollar amount that you can’t exceed, while a variable credit limit fluctuates based on your creditworthiness. Different types of credit cards may have different limits. For example, a credit builder card may have stricter limits as they are aimed at those with a poor or no credit history.
Are Credit Cards Bad For Your Finances?
Credit cards can be both good and bad for your finances, depending on how you use them. If you are disciplined with your spending and always pay off your balance in full each month, then credit cards can be a great way to earn rewards and build your credit history.
However, if you tend to overspend or carry a balance from month to month, then credit cards can quickly become a financial burden. In general, it is best to use credit cards wisely and only charge what you can afford to pay back in full each month. You could consider using alternatives to credit cards if you struggle to manage them.
How Credit Cards Work Conclusion
In conclusion, we have explained how credit cards work and the reasons for using them. There are many advantages of credit cards – they are a great way to build your credit, make purchases and potentially earn rewards.
However, it’s important to understand the different types of credit cards and how they work before you sign up for one. Be sure to do your research and read the fine print before signing up for a credit card.
We hope you have found our guide to credit cards useful. If you need more help, be sure to sign up for our newsletter and get more help with your personal finances on our blog.