A credit card allows you to borrow money to buy almost anything you want. However, they come with added costs such as interest and fees – and sometimes they give you benefits, like rewards and credit-building.
Keep reading to learn exactly how credit cards work.
What is a credit card?
A credit card enables you to borrow money from a financial institution to buy goods or services (where applicable) — whether it’s groceries, bills, or a full-fledged vacation.
- Note: It’s unlikely you’ll be able to use your credit card to pay for some bills, like car finance payments or student loans payments, since those lines of credit are already borrowed money.
The card itself is merely a thin piece of plastic, but it can hold a lot of spending power. It can be tempting to spend money you can’t pay back immediately.
With a credit card, there’s an agreement between you and the financial institution lending you the money, that you will pay back the money you spent with any applicable interest, as well as any other established charges.
You can either pay your bill back all at once, or just a portion, or even carry over the balance to the next month. If you choose the latter, you’ll have to pay interest (a percentage of the money you owe) in addition to what you’ve borrowed.
Secured vs. Unsecured credit cards
Most major credit card companies offer both secured and unsecured credit card options. Here’s what you need to know to understand the difference – and make the right choice for you:
- Secured Credit Cards: These are available to people with poor credit or short credit histories. The credit card is backed by a cash deposit that determines your limit. For example, if you make a $500 deposit, you’ll have a $500 spending limit.
- Unsecured Credit Cards: These don’t require a deposit and are available to people with average to excellent credit scores.
What They Both Have in Common:
Both types of credit cards will often have an annual fee (but there are many that do not). You can use either type of credit card wherever they’re accepted.
How responsible you are with the card (i.e. paying it back on time) will help you build or rebuild your credit over time, or go into debt.
Understanding Annual Percentage Rates (APR)
An annual percentage rate (APR) is the amount of interest you pay on a loan, credit card, or any other line of credit in a year.
The percentage amount is determined by the total balance you owe. For example, if you’re borrowing $1,000 for 1 year and your credit card has an APR of 10%, you’ll pay around $100 in interest by the time that loan is paid off.
What is a good APR for a credit card?
Your APR is assigned when you open a new credit card and it’s determined by your credit score as well as what’s called the U.S. prime rate – an index used by major banks that sets the rate on consumer loans (i.e. credit cards).
Lenders consider the prime rate and factor in their own additional margins to make sure they turn a profit with interest rates and decrease the chances of someone “defaulting” on the loan — or not being able to pay it back.
But let’s define “good” APR.
APRs are entirely variable because they depend on so many factors, so there really isn’t a short definition of “good.” That said, typically the lower your APR, the better it is. And the higher your credit score, the more likely you are to have a lower interest rate.
Understanding how credit cards affect your credit score
There are a few ways a credit card can affect your credit score. Let’s review everything you need to know:
- It adds hard inquiries to your credit file. This is one of the two types of inquiries that exists in your credit file. When you apply for a credit card, the lender will use a hard inquiry to determine whether or not you are a good candidate.
Hard inquiries could lower your score by a few points — more if you have too many, too often. Soft inquiries on the other hand, do not affect your credit score.
- It varies your credit mix. A credit mix is all the different types of credit a person can have – car loans, personal loans, etc.
So adding in a credit card shows potential lenders you’re able to manage different types of credit, and if you’re responsible with paying them all on time, it will increase your credit score.
- It helps your credit utilization rate. This is the percentage of total credit you’re using in relation to your credit limit.
When you first open a new credit card, this will bring down your average of all your credit accounts. But the longer you have the credit card, the more it will help your score (again, if you’re responsible).
How to apply for a credit card
Applying for a credit card is as easy as filling out most online applications.
But there are some key things to know to make sure you’re actually approved for one:
- Your credit score. This is the most important factor an issuer will use in deciding the fate of your application. You can find this information at MyFICO.com.
- Decide what kind of credit card you need. If it’s your first credit card, you might want to aim for a credit card company that has no annual fee and a lower interest rate.
Retail credit cards are often a good place to start, so check to see if your favorite store offers one.
- Understand the key terminology on the application. We’ve already covered APR, but here are some other terms you’ll see (and need to understand):
- Annual Fee – The yearly fee that lets you use the card charged by the card issuer.
- Balance Transfer Fee – The amount charged to transfer a balance onto your credit card. This usually ranges from 3-5%.
- Minimum Interest Charge – This is the least amount of interest you can be charged if you carry a balance over from one billing period to the next.
- Transaction Fee – This is the amount charged on different types of transactions you could make. For example, if you use your card outside of the U.S., you’ll most likely be charged a foreign transaction fee.
- Penalty Fee – This the amount an issuer will charge if you make a late payment or go over your credit limit.
- Choose where to apply. If you already have a checking or savings account with a bank or credit union, they may offer a credit card option as well.
How to get a credit card with no credit
If you don’t have any established credit, you might consider a secured credit card.
Like we’ve mentioned, this option requires you to put down a deposit that will determine your credit limit. If you don’t want to do that, there are also student credit cards that are available to those who qualify.
Alternative credit cards also exist and are issued by smaller companies that evaluate an applicant’s creditworthiness based on considerations other than just a FICO credit score.
How to pay off credit card debt
Once you have a credit card, it can sometimes be trickier than you originally planned to keep up with the monthly payments. Here are four suggestions for tackling debt quickly and efficiently.
- Pay at least the minimum. Especially if you have multiple credit cards. Then, shift your focus to paying off the total balance on each card one at a time. Start with the card that has the smallest balance first and also check to see which credit card has the highest interest rate.
- Even better, pay more than the minimum. If you can afford it, pay a little extra each month so that your overall balance will be smaller, and therefore so will your interest rate.
- Consolidate your debt. This will allow you to combine several of your debts into one that has a lower interest rate. Then, you’ll be able to pay your debt off faster without increasing the payment amounts.
- Make a budget. And stick to it! Most credit card companies offer a “spend analyzer” that can show you exactly what you’re buying each month. See if there’s any spending category you can cut back on and lower your monthly bill so it’s easier to pay.
FAQs
What credit card should I get?
Finding the right credit card for you is a very personal decision! Afterall, you’ll most likely use it on a daily basis.
First things first, check your credit score. Once you know this you’ll be able to choose from the three types of credit cards available: cards that earn rewards, cards that save you money on interest, and cards that help you improve your credit score.
Think about your needs realistically from there. For example, travel credit cards may sound fun, but if you don’t actually travel, they probably won’t do you much good.
How many credit cards should I have?
There isn’t an exact science to the exact number of credit cards someone should have, but it is a fact that having too many credit cards can hurt your credit score.
How do I cancel a credit card?
Because cancelling a credit card account can actually hurt your credit score, it’s best to just leave them open even if you aren’t actively using them.
However, if that isn’t an option for you, there are ways to safely close an account.
Be sure to pay off your credit card balance in full every month so you can save money on interest and protect your credit score. If your credit card balance shows $0, it’s possible to close the card without damaging your credit score, but be sure to contact your lender before closing to make sure you have paid off your debt.
What happens to credit card debt when you die?
While a scary thought, everyone is going to die, meaning if you have debt – someone is going to be responsible for it when you’re gone.
Typically this responsibility falls on your estate. They’ll be in charge of paying everything you owe to bank accounts and other assets. Your personal representative or executor should notify your creditors in a timely fashion of your passing so your debts can be settled.