Credit Card Basics Spelled Out: Credit 101
“Money is a terrible master but an excellent servant.”
~ P.T. Barnum, entertainer and entrepreneur
“The desire of gold is not for gold. It is for the means of freedom and benefit.”
~ Ralph Waldo Emerson, American author, speaker, and philosopher
“The handy thing about credit cards is they’re a great way to pay off your credit cards.”
~ Author Unknown
Relationship Status to our Credit Cards: It’s Complicated
Americans have a love-hate relationship with credit cards. We love the freedom they offer us, but other times hate that same freedom when we use it poorly. Credit cards make it easy to reserve hotel rooms long-distance, to purchase things online without leaving our homes, or to deal with practical needs during unexpected circumstances. They’re one of the easiest financial tools to get (often decorated with favorite logos or team colors) and one of the easiest to use in a wide variety of circumstances. Credit cards in many ways really do set us free.
And yet so many Americans end up feeling a sense of bondage towards that little rounded plastic rectangle in their purse or pocket. We choose the short-term rush over the long-term responsibility. We tell ourselves simple little lies about what we will and won’t do with this magical tool, then repeat those lies to ourselves again and again despite never quite following through.
It reminds me of trying to eat well. You know the routine. We feel overweight (and maybe we are), but it’s not like science hasn’t yet unraveled the mysteries of obesity. Then we eat too much, of all the wrong things, and we exercise too little. We know how to do better. We just… don’t. Not 24/7 at least. Because that’s the trick with being healthy, isn’t it? You can eat right and demonstrate wonderful self-control for 23 hours a day. All it takes is that super-sized fast food drive-thru lunch and some snacking after dinner, though, to ruin it all. Time to shop the Big’n’Tall aisle.
Credit cards can feel that way, too. We can be so responsible for 28 days each month. All it takes are those moments of “weakness,” though, many of which seem so reasonable at the time, to mess it up. It almost seems unfair, like we should be charged on a sliding scale factoring in all the times we didn’t splurge. It’s funny, because we think we KNOW the credit card basics, just like we think we KNOW how to live more healthily. It’s just the DOING it part that’s tricky. And we’re not entirely wrong. Still, maybe it’s time to revisit those basics and make sure.
Credit Cards Made Simple
My wife is the most responsible credit card user I know. She uses her cards sparingly, and almost always pays off her full balance before the end of the month – meaning she pays zero interest, no matter what rate the card supposedly charges. Combined with various cash back programs or other incentives, she comes out ahead most months, all because she’s the credit card user we all want to be if we grow up. I knowcredit card basics; she lives them. Effectively. Every month.
I always carry a balance. It’s not like it used to be, though – my balances are manageable, if a bit higher than I’d like. I remember too well the years of multiple cards, maxed out limits, and juggling bills each pay period to decide who’d get paid this week. I didn’t care for it. Honestly, even the spending wasn’t fun anymore, because I stunk at using credit cards appropriately. At the time, I thought the issue was simply that I didn’t make enough money. In retrospect, I was immature, and rather ignorant.
I can’t help you with maturity, dear friends, but maybe we should revisit some credit card basics – their blessings and their potential dark side as well. Some of this you’ll already know, but that’s OK – it never hurts to go over it again to help us think clearly. Besides, no one’s watching. It’s just you and me, and I’m not going to tell anyone.
What Is A Credit Card?
Like I said, credit card basics.
A credit card at its most literal is a small rectangular piece of plastic with rounded edges and a series of numbers embedded on it, along with your name. The numbers and your name identify your specific account, and the card usually indicates quite proudly from whence it is issued – Visa, Discover, MasterCard, American Express, etc. (Debit cards look the same, but draw directly from your checking account.)
There’s typically a magnetic strip (the “mag stripe”) on the back, and more and more commonly a fancy little chip you can see from the front, both of which do the same basic thing. When you swipe or insert the car, the strip or the chip tell whatever machine you’re using your name, account info, PIN number, etc. It’s not so different from how cassette tapes or VHS used to work.
If you’re making a purchase using your credit card, the machine reads this information, then communicates with your credit card company (directly or indirectly) to find out if you have enough credit to buy whatever you’re trying to buy. (If you’re using a debit card, it merely calls your bank to find out if you have enough money in your checking account.) So far it sounds pretty simple, right? Now let’s go just a tiny bit deeper…
How Do Credit Cards Work?
A credit card is a form of loan you get from a financial institution like your local bank, credit union, online lender, etc. When you get a card through a different sort of organization, like Amazon Prime or Target, they have usually partnered with an existing financial institution to create a card designed to carry specific benefits when used at their business. Otherwise, they’re basically the same – a fancy form of loan.
Your credit limit is how much you can borrow at one time in total. You don’t have to borrow up to your limit, and you only pay interest on the amount you currently owe. In other words, unlike a traditional loan, your monthly payments are based on how much you’ve actually used up to that point, not on the total amount available to you.
Paying Interest on a Credit Card
Like any loan, you pay interest as well. The interest on most cards is expressed as APR (“annual percentage rate”). On most credit cards, you can avoid paying interest altogether if you pay within the “grace period,” which is usually between time of purchase and 20-30 days later or by the due date each month. Your credit card’s APR is computed not on your credit limit but on your balance – the amount you currently owe.
Another thing making a credit card different from a traditional bank loan is that as you pay back what you’ve borrowed, that money becomes quickly available to you again to use. For example, if you borrowed $1,000 from your local bank with a traditional loan to be paid back monthly at 7% interest, your monthly payments would be around $87. Halfway through the loan, you have an unexpected medical bill and need another $200 to pay it. Even though you’ve paid off half of the original $1,000, getting more money would require going back to the bank and asking for an additional loan. Even if they’ll do it, it’s a rather inconvenient way to get what you need.
Let’s assume that you have a credit card through that same bank instead, with a credit limit of $1,000 to start with. Typically, credit card interest rates will be a bit higher than those of traditional loans, but we’re talking credit card basics so we’ll keep it at 7% for simplicity’s sake. You spend the entire $1,000 the first month (remember, it’s just an example), then make regular monthly payments of around $87 without using the card again until six months have passed.
When that same unexpected medical bill comes in, you’ve paid down the card enough that you can use it to pay that $200 without having to do anything special. You have access to your full credit limit minus your current balance, whether you use the card twice a year or twice a week. It doesn’t get much more convenient than that!
Other Credit Options Besides Credit Cards
There may be some benefit to splitting the difference between these two options and establishing a line-of-credit with your lender of choice. It can be tougher to qualify for, but offers relative flexibility without all the pitfalls of a traditional credit card. That’s getting a bit outside of credit card basics, but it’s worth comparing a line of credit option over a credit card before deciding which way to go.
There are other possibilities, of course like a personal loan. Don’t be afraid to ask different lenders what they offer or suggest. You don’t have to take their offers – that’s up to you – but you can educate yourself. Local banks and credit unions usually have pretty straightforward information available on site or on their websites. Online lenders, one of the wonders of the 21st century, may be less well-known, but sometimes offer creativity and flexibility lacking among traditional financial institutions. Keep in mind that the internet is still the Wild West in many ways. That’s why companies like Loanry exist – to connect you with online credit card providers. What you do with that connection is up to you.
Whether its credit card basics or other forms of personal or business loans, ask those questions. Seek those options. It’s time-consuming to educate yourself, but it’s so worth it. I promise.
Why Would I Want A Credit Card?
The most basic reason is that the card company grants you replenishable credit. It allows you to pay off certain purchases over an extended time. But credit cards provide flexibility in other ways as well. As a recent Forbes article about credit card basics put it…
Credit cards are like DVRs for money. Digital video recorders allow users to “time-shift.” Television channels, at least for now, have regular schedules during which they air programs. However if you’re not free at 8:00 PM to watch The Big Bang Theory, your DVR allows you to watch the program from the beginning at your convenience.
Used as tools of convenience, credit cards are at their best. Used to live beyond your means, it doesn’t take long for things to go off the rails.
Interest adds up quickly, and could make a $100 purchase cost $200 in total or more rather quickly. When this happens, it’s more than just time-shifting; it’s as if waiting to watch your 30-minute recorded show would require 60 minutes of your life.
Other Benefits Of Responsible Credit Card Use
Many credit card policies include fraud protection or other consumer assistance. It’s generally easier to dispute a charge on your card than it is to get other forms of payment corrected or reversed. If you ask your credit card company to reverse a charge for a legitimate reason, this gives you leverage. Either with the retailer or service provider with whom you’re having the dispute. While this benefit may not be the first thing you think of when selecting the right card for you or your small business, it’s a big one when you really need it.
In a world in which we use cash less and less, responsible credit card use can help keep track of exactly where all of our money is going. For some folks, this makes it easier to modify their budget. Or also to adjust their spending habits, since the patterns are there in black and white, laid out in months of spending records.
This benefit assumes, of course, that you’re paying most or all of your credit card balance each month. Especially to avoid excessive interest charges or late fees. Otherwise, the best way to adjust your monthly budget would be to use your credit card less!
You hear it in the ads all the time. “Get 5% cash back!” “Earn extra miles when you fly!” “Double your points every time you use our card at one of our partner locations!”. Many of these promos are offered with full awareness that most people aren’t going to make enough use of them to offset the interest or other fees they’ll accrue using the card. They’re promos. They’re goal is to get your attention, secure your business, and make money off of you.
That said, responsible card users can benefit significantly by paying attention to those 5% cash back offers, or earning those extra miles, or using the right cards at the right locations. If you’re buying gas anyway, why not use the card that gives you bonus points for gas, as long as you pay a reasonable portion of the balance each month? If you shop at Target religiously anyway, why not sign up for one of their specialty cards and earn those rewards, as long as you carefully manage that balance? Credit card basics includes paying attention to the pros and cons of each card, both when you’re deciding what card(s) to get and when you’re using those cards in daily life.
Building Your Credit or Rebuilding Your Bad Credit
This is one of the best reasons to use a credit card and to use it responsibly. If you have a limited credit history, good or bad, or if you have a spotty credit history with some unfortunate stories on your credit report, credit cards can help make things significantly better over time or much, much worse almost right away.
Almost anyone can qualify for some sort of card, although with a limited or poor credit history that probably means a modest credit limit and a high interest rate – at least at first. Make a few small purchases, then pay them off in a reasonable amount of time. Make a few more, and pay them off. A year later, ask your card company for a better interest rate, or find a card with a lower rate and apply for it. Stop using the higher rate card, but don’t cancel or destroy it. (Having available credit you’re not using is one way to improve your credit score.) Repeat until fabulously wealthy and successful.
Rebuilding Your Really Bad Credit
If even a modest card with high interest is out of reach, you can start with a secured credit card. A secured card is one for which you deposit a set amount of money with the backing institution up front – let’s say $500. They issue you a credit card tied to that deposit. When you go to the store and spend $40, it operates like any other credit card except that you can’t spend above the amount you have on deposit.
I know, this sounds like a debit card (a “checking card”) or like you’re paying someone else interest and fees in order to spend your own money, right? And you are. That’s how it works. The reason you might choose to do this, however, is that same convenience and protection we discussed above. Plus, AND THIS IS A BIGGIE…
Smart Money Tip!
Payments on your secured credit card are treated just like payments on any other debt for purposes of credit reporting. If you make your monthly payments and avoid maxing out your secured credit card for a year or two, you’re on your way to qualifying for an unsecured credit card with a higher limit. Keep using that one responsibly and you’ll start to qualify for lower interest rates, not only on your cards but on any other sort of credit you may use. See how that works?
Of course the foundational element of credit card basics is using the card responsibility in terms of purchases and payments. That’s not the end of the story, however. Your credit card use, both good and bad, has larger ramifications. Your credit card use is never just about credit cards.
Consolidating Your Debts with Credit Cards
This may be the best use of a good credit card ever if the interest is better, but it comes with its own risks as well as its own rewards. Interest rates on credit cards can often be higher than personal loans. That’s why often it’s reversed where people take out personal loans to consolidate credit card debt. We’ve put together this helpful video to help you understand why.
VIDEO: How to Consolidate Credit Cards Using a Personal Loan
Let’s assume you owe multiple creditors money each month. Maybe you have a few medical bills, a couple of department store cards, that personal loan from your brother-in-law he won’t shut up about, and possibly one or two other obligations as well. You’re paying an outrageous rate on the department store cards, especially since you’re behind, and interest and penalties on the rest as well. (The only debt that’s not building back up as fast as you can pay it off is the one to your brother-in-law, but you’d almost rather he charge you interest than constantly bring it up at birthday parties, family holidays, etc. You can’t punch him, though, because you owe him money.)
Paying off all of those debts with one card at a lower interest rate can make your monthly payment situation FAR more manageable. You owe the same total amount, but now you’re paying one, smaller, easier installment each month, to one place that sends you one bill to keep track of. You eliminate lots of other late fees and interest charges, and it shuts up your brother-in-law (at least about this, for now). Plus, your credit record can start to recover because it’s easier to make one monthly payment than ten, and everything else will show as paid in full.
Avoid the Debt Cycle
But listen to me on this one, Grasshopper – this part is very important. The voice of long, painful, embarrassing experience is about to speak great truth to you. And I want you to be ready for that. You should probably be sitting down and taking notes for this part. IF YOU USE A CREDIT CARD TO CONSOLIDATE YOUR DEBTS, DON’T START ADDING UP NEW DEBTS ONCE YOU HAVE THE OLD DEBTS UNDER CONTROL. In other words, after you’ve reduced your total obligations to a single easy monthly payment, don’t spend more on that department store card. Don’t ignore that medical bill. And whatever else you do, don’t borrow more money from that brother-in-law!
The trickiest thing about improving your credit and reducing your debt is that it immediately qualifies you for more credit. This way, it opens up the possibility of more debt. No matter how desperate you may feel in the moment, going down this path again and again never works in your favor. It can’t. There’s even a technical term for this: “BAD.” If you start accumulating new debt after consolidating and getting a handle on the old debt, that’s what we in the financial world call, “BAD.”. Or sometimes, “REALLY BAD.”. This isn’t just an essential element of Credit Card Basics, this is Personal Finance 101.
Remember, your goal with any credit card or other form of loan is to make your life better. You’re trying to increase your flexibility, not to reduce it. You don’t reward yourself for losing 3 pounds by hitting the buffet and topping it off with an entire cake. Then don’t celebrate your debt consolidation by going back into unmanageable debt.
Incidentally, another alternative is to use a personal loan to consolidate your credit cards and pay off debt. It offers some definite benefits, and while there are still pitfalls, it might be a great option. Just thought I’d mention it, since we’re sharing.
The Dangers of Credit Card Use
It hurts me to even cover these. Indeed I think we know many of these already. But if you are like me, sometimes we need to hear it again. And maybe again after that. Then one more time.
Credit Cards Are Designed To Keep You In Debt
This is Credit Card Basics, Day One. They don’t have to keep you in debt any more than eating pizza has to make you gain weight. But card companies need a majority of customers to keep spending and keep paying interest. They don’t actually want more customers like my wife. (meaning customers who take advantage of the perks then pay their balance in full every month). And of course you’re not doing them any favors if you go bankrupt and can’t pay them at all. That’s no good, either.
But unlike other loans, credit cards are designed to keep you perpetually using and paying. Once we recognize that, we can decide how much of that works for us. I have several credit cards and I use them and like them and appreciate them because I’ve found a balance that works for me. That’s the key.
Interest and Fees Add Up Quickly
It’s so easy to lose track of just how much you’re paying. Especially when letting the bulk of your balance ride from month to month. Credit Cards tend to carry meaty interest rates, even if they start off quite low. If you have other options for paying for things, do your best to make that happen. Credit card basics say only use your card(s) when you’ve thought it through and believe it’s the best option.
Minimum Payments Aren’t Like Other Payments
When you pay your electric bill for the month, you’re caught up. You get electricity for another 30 days. When you owe your brother-in-law $500 and pay him $100, you only owe him $400 more. But if you make the required minimum payment on your credit card, most of the time all you’ve gained is a little time. Your balance doesn’t go down very much. Plus, it might go up – even if you don’t make any new purchases.
Minimum payments are designed to keep you paying interest and fees on the card without substantially lowering your balance. With a high balance, you’ll actually fall further and further behind each month making only the minimum payment.
I’m not pointing this out to make you feel bad. Some months are just like that, and it’s FAR better to make the minimum payment than no payment. But it’s not a long-term plan. You’re going to need a way to pay that balance down more consistently. Of all the credit card basics we’ve discussed, this one should be filed in your top two or three.
Credit Cards Allow Us To Be Impulsive
And now we’re back where we started. The best thing AND the worst thing about credit cards is how much freedom they offer us to spend when, where, and how we see fit at the time.
“With great power comes great responsibility.”
~ Ben Parker, fictional character (Spider-Man comics)
If I Want A Credit Card, Which One Should I Get?
That’s not an easy question to answer. It really depends on your wants and needs, as well as what you qualify for at this point in your life. But at least you’re asking the right question, because they’re not all the same.
I know it’s easier to just sign up for that one they sent you unsolicited in the mail. Or even easier to call that 800 number the first time you see an ad on TV. However, credit cards are kind of a big deal – for better and for worse. Research several, from different sources (including online card shops), and read through the terms. Ask questions without embarrassment or fear; any company unwilling or unable to talk you through the details doesn’t deserve your business.
That’s one final thing ALL credit cards have in common. YOU’RE the customer. YOU’RE the one who should end up happy with the card and how you use it. Some of that’s on you, of course. Hopefully you’ve been paying enough attention to have picked up on that by now. But it also means you have every right (and every responsibility) to choose your card(s) carefully from your available options. The more attentive and informed you are, the better choices you’re able to make. That applies to choosing your card(s) just as much as it does using your card(s).
Blaine Koehn is a former small business manager, long-time educator, and seasoned consultant. He’s worked in both the public and private sectors while riding the ups-and-downs of self-employment and independent contracting for nearly two decades. His self-published resources have been utilized by thousands of educators as he’s shared his experiences and ideas in workshops across the Midwest. Blaine writes about money management and decision-making for those new to the world of finance or anyone simply sorting through their fiscal options in complicated times.