A credit card may seem to you like just another tool to help you make purchases, but it is much more. If you use it responsibly, a credit card can help you build a good credit history, allowing you to get loans at favorable interest rates, cheaper insurance and even a new cellular plan. Credit cards can also help you earn rewards on your everyday purchases and protect those purchases in case of theft or damage.
Simply put, a credit card can be a lot more useful than your debit card if you use it the right way.
Here are few important things to know before you get your first credit card.
What a credit card?
A credit card is a plastic card that looks just like a debit card. But the difference is that instead of having the funds removed directly from your checking or savings account when you make a purchase, it is removed from an account that works on the premise of a short term loan. Being a loan, the amount used/debited may or may not accrue interest; in most cases depending on when you pay it off that is. Be sure to ask your bank how their interest calculations work before applying for a credit card or deciding on the type of card you want.
Why you should get a credit card?
Credit cards come with numerous benefits. First and perhaps most important, a credit card is a good tool to help you build your credit. Good credit can help you obtain future loans — like a mortgage — at the most favorable rates. It can also help you get approved for an apartment or cell phone, avoid utility deposits and get lower insurance premiums. Aside from credit-building, credit cards have many other perks. Many cards offer cash or travel rewards, generally between 1% and 2% of your purchase price. Some cards have shopping or travel benefits that will save you money, like purchase protection, price protection, extended warranty, rental car insurance and more. Some cards have 0% interest on purchases or balance transfers for 12 to 18 months. When you get a card, check your benefits statement for details.
How credit card interest is calculated?
Many people think that credit card interest is assessed on the card balance remaining after the payment due date. However, if you don’t pay your balance in full, you’ll accrue interest on your average daily balance during the month.
Say you have a card balance of $1,000. On day 11 of accruing interest, you pay off $200. Then on day 21 of accruing interest, you pay off another $350. Your average daily balance would be $750.
If the card’s annual percentage rate (APR) is 20%, the periodic interest rate is 0.0548%. Your periodic interest rate is calculated by dividing your APR by 365. Multiply your average daily balance by the periodic interest rate and the number of days in the month to get the interest accrued for the month. In our case, this is $12.33.
To avoid accruing interest, you need to pay the new balance on your credit card statement each month. The minimum payment is enough to keep you in good standing, but paying interest is unnecessary if you spend within your means.
Keep in mind, if you take a cash advance, you may have to pay a higher interest rate and you won’t have the benefit of a grace period. You may also have to pay an increased penalty interest rate if you make a late payment or spend more than your credit limit. You’ll be able to find these alternative rates on your card issuer’s website.
What’s the difference between an unsecured & secured credit card?
The cash deposit in case of secured cards, which is equal to the limit offered by the card, serves as collateral and eliminates the risk of non-payment for card issuers. Such cards are a good option for users with little or no credit history to their name. Unsecured credit cards do not have any other collateral or backing to rest on. They pose higher risks for their issuers. As the permissible credit limit is based on the user’s credit history and income level, it is likely to be low for your first credit card.
How minimum payments are determined?
A minimum payment is the smallest amount of money you can pay each month without damaging your payment history and incurring a late payment fee. There are a few different methods for calculating minimum payments, but here are the primary two:
- Percentage method: Your issuer may calculate your minimum payment based on a percentage of your balance. This is generally between 1% and 3%. So if you have a balance of $2,000 and the minimum payment is 2% of your balance, you’ll have to pay a minimum of $40 to stay in good standing.
- Percentage + interest + fees method: Your issuer may also take a percentage of what you owe plus any applicable interest and fees. Let’s say you have a $1,000 balance and an interest rate of 18%, and you pay late. Your issuer might charge you a minimum payment of the sum of 1% on your balance ($10), your interest accrued ($14.79) and a late payment fee ($35). Your minimum payment in this case would be $59.79.
If your balance is relatively low, you may be required to pay a flat minimum payment, which typically ranges from $25 to $35 a month. But we always recommend that you pay your balance in full by the due date.
How credit cards affect your credit score?
Credit cards can affect your credit score in several ways. Before we get into the specifics, take a look at the five factors that go into your FICO score, the most widely used scoring model among lenders today:
- Payment history (35%)
- Credit utilization (30%)
- Length of credit history (15%)
- Types of accounts in use (10%)
- New credit (10%)
Using a credit card can affect your credit score in several ways, either positively or negatively. You can positively affect the most important credit score factor, payment history, by making your payments on time, 100% of the time. A late credit card payment likely won’t be reported within a few days, but it can be reported to the bureaus and hurt your score.
Credit utilization, or the percentage of your credit limit that you’re using at any given time, is the second most important FICO score factor. We’ll discuss how to calculate this in the next section, but essentially, you should try to keep your debt balance below 30% of your credit limit.
The ages of your newest and oldest accounts, as well as the average length of all of your credit accounts, make up your length of credit history. The longer, the better. You can influence this factor with a credit card by keeping old accounts open and active. And, of course, be patient, because building a great credit score takes time.
Types of credit in use refers to the mix of different types of credit accounts you have, such as student or auto loans, or a mortgage. Diversity is preferable to only one type of account, but this factor has a small influence on your FICO, so you shouldn’t go out of your way to take on interest-accruing debt.
When you apply for a new credit card, your score may take a small hit. To combat this, avoid applying for several cards in a short period of time, especially if you haven’t been building your credit for very long.
Should you have more than one credit card?
The number of credit cards that you should have would be dependent on individual circumstances. For instance, a rewards credit card which gives a higher reward balance as per monthly spending, brings in good rewards if the balance is paid off in time. Alternatively, a card that offers a lower interest rate is advisable if you plan to pay off the balance for a big purchase across an extended period of time.
Which fees you may be charged?
There are a host of potential credit card fees you may need to pay, but many of them are easily avoided. Here are the most common fees:
Annual fee: Charged on most secured and certain unsecured credit cards. For unsecured cards, annual fees are often charged on high-value rewards cards. You can avoid them by getting a card without an annual fee, but if your spending is high enough, a fee card may net you higher rewards.
Balance transfer fee: Charged when you move a balance from one card to another, typically 3% to 4%. Balance transfers are usually made by people with credit card debt who have found a balance transfer offer with an introductory APR of 0%. You should only pay a transfer fee if the interest you would pay on your current card is greater than the balance transfer fee you’ll pay. And if you qualify, there are credit cards without balance transfer fees.
Foreign transaction fee: Charged whenever you make a purchase overseas, typically between 3% and 4% of your purchase. To avoid this fee, you can get a credit card without foreign transaction fees. If you ever travel overseas, you should absolutely have a card without these fees and preferably with an EMV chip.
Late payment fee: Charged if you don’t pay at least the minimum payment by the due date on your credit card statement, typically around $35. Avoid this by always making your payments on time.
Over-the-limit fee: Charged if your balance exceeds your credit limit. You have to opt in to this fee, per the Credit CARD Act of 2009. Keep in mind that if you choose not to opt into this fee, your purchases may be
Where rewards come from?
Many credit cards offer cash or travel rewards on your purchases. These rewards come from interchange fees, or the fee paid by a merchant’s bank to a customer’s bank when you use your credit card to make a purchase. Interchange fees vary, but are usually 2% or more, which is enough to cover the rewards rates on competitive rewards credit cards.
Some credit cards have rewards of 5% or 6% on certain types of purchases. However, these tend to be capped at a certain monthly, quarterly or annual dollar amount. If your rewards seem a bit too good to be true compared to typical interchange fees, check your benefits statement for details on spending limits.