Credit Cards 101

By HonestFinance | Updated September 23, 2018

Credit Cards 101

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The Most Important Rule For Credit Cards

Before we review how credit cards work and the benefits of using one, we must first cover the one important rule that supersedes all other rules when it comes to using credit cards - PAY OFF YOUR CREDIT CARD BALANCE EVERY MONTH NO MATTER WHAT!

Are you thinking of swiping your credit card to purchase those shiny Christian Louboutin heels you saw at the mall knowing damn well you don't have enough cash to cover the credit card balance when its due? Too bad, don't make that purchase until you have enough saved to cover the cost. As harsh as it sounds, you must be responsible and deter this type of spending habit to avoid joining the millions of Americans who are already trapped in massive credit card debts.

Credit cards are fantastic financial tools when used responsibly. But once you start racking up debt, the credit card and (bank) owns you instead. Having the discipline to avoid irresponsible purchases and paying off the balance every month is critical. Credit card companies' (banks') ultimate goal is to entice you to rack up credit card debts and put you in a situation where you are only able to the "minimum" payment due each month. In many cases, this means you will be paying the credit card company until you die; not joking (we will discuss how this can happen in the interest section below). This is why it's so important to use your credit card responsibly by purchasing only what you can afford and paying off the balance every month.

So what is a credit card?

A credit card is literally a "card" that you use to buy things (and services). It's basically a line of credit (debt/loan) issued by a bank which you are using to make those purchases. But after you make those purchases, the bank obviously expects you to pay them back. Most credit cards (banks) require you to pay back at least a partial percentage (around 3%) of the balance each month. This partial percentage is the "minimum" payment required by the credit card company each month.

Interest

If you pay back the full balance each month, there is no interest accrued on the balance. But if you pay only a partial amount of balance instead of the full amount, the bank will charge you "interest" on the remaining balance. This is how the credit cards (banks) make money. Based on your credit score, the interest rate (APR - Annual Percentage Rate) offered by the credit card company can be extremely high. As you can imagine, if you are paying only 3% of the balance ("minimum" payment due) each month on a credit card with a high-interest rate (APR), you will be paying the credit card company forever.

For example: Let's assume you have $10,000 balance/debt on a credit card that charges 37% APR, and you're paying only the minimum payment (3% of the balance) due each month. At 3% of the balance, the minimum payment due is around $300 ($10,000 x 3%). After paying the minimum amount, the balance now sits at $9,700 ($10,000 - $300). But the remaining balance will continue accruing interest at 37% APR because you didn't fully pay off the balance. So for the next month, the remaining balance will accrue an interest of around $300 ([new balance of $9,700] x [37% APR] divided by [12 months because APR is "Annual Rate", not monthly]). Adding this monthly interest to the remaining balance, the total balance next month is back up to $10,000 (Remaining Balance:$9,700 + New Interest Cost:$300). As you can see, if you only pay the minimum amount due (3% of the new balance) each month, the balance will basically stay at $10,000 forever and you will be making the minimum payments until death. This is the ultimate trap that many consumers fall into. To avoid this trip, you must adhere to the most important rule (it was the first thing mentioned in this article) - PAY OFF YOUR CREDIT CARD BALANCE EVERY MONTH NO MATTER WHAT!

Line of Credit

The maximum line of credit (debt) you are allowed to use is based on your credit history, credit score, and income. For example, a credit card company may issue a card with $5,000 maximum credit line to a person who has good credit (meaning they consistently make payments on time) and has an annual income of $100,000 (the ability to pay off the debt). But for someone who might not have a good credit score and has low annual income, the credit card company might only offer a card with a maximum of $1,000 credit line (debt), because the credit card company (bank) thinks this person probably doesn't have the tendency and the ability to pay back $5,000 based on their credit and income.

Credit Score and Utilization

Your credit card payment history and credit utilization will affect your credit score. Late payments are reported to credit rating agencies who will downgrade your credit score for delinquency. Even if you could only pay the minimum balance, make sure to pay it by the due date.

Credit utilization is the percentage of the total credit card balance (debt) divided by the total maximum credit line across all of your credit cards. Lower credit utilization percentage equates to healthier credit scores. For example, if you have $100 in credit card balance with $200 total credit card limit, your credit utilization is equal to 50%. Meanwhile, someone with else could have a much larger credit line of $10,000, but they could have an abysmal credit utilization % because they have $9,000 in total credit card debt ($9,000 divided by $10,000 = 90%).

Should I cancel my card?

You should not cancel the credit card in most cases. First, canceling a credit card without opening another card will decrease the amount of total credit available which also increases your credit utilization (smaller denominator). Combined with increasing credit utilization and putting an end to one of your credit histories, it will most likely hurt your credit score.

So what are the benefits of using a credit card?

Based on what we've covered so far, it may sound like a credit card is just an evil tool that should never be used. So why would anyone use a credit card in the first place? Again, when used with care, credit cards can provide a variety of benefits which you can leverage to improve your overall finances. Some of the benefits include:

 

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