Intro to credit card basics
Introduction to Credit Card Basics
It’s a constant shock to find out how many people don’t understand the fundamentals of credit cards basics, despite having several cards. Most Americans have and use credit cards, but I am constantly shocked at how many people either misuse or misunderstand cards. In fact, Americans now owe more than $1 TRILLION dollars in credit card debt!
This article will review some credit card basics, what they are, and how you should use them. This is a foundational article in a series of articles about credit cards. If you’re a more advanced reader – feel free to skip ahead to those!
What is a credit card fundamentally?
A credit card is really just one type of unsecured revolving credit, which is a form of debt. What this means is that a financial institution extends you a line of credit of some amount which can be repaid by you at any time. Unlike in a traditional, simple loan, there’s no set repayment schedule, although there are likely minimum monthly payments depending on how much of the line of credit you have utilized.
This has the advantage that you can pay back on your own schedule, rather than per a fixed repayment schedule. This feature can also be what tends to get people into trouble, though, as they let debt on the card continue to accrue interest. This gets doubly bad when you factor in the high-interest rates cards typically carry. Credit card companies charge these high rates for 3 main reasons:
- Unsecured debt – they have no collateral to immediately seize if you don’t pay your bill
- The debt is almost always used to purchase a good or service which does not increase the debtors’ ability to repay (e.g. used for clothing instead of a business expense which might make more money in turn)
- Adverse selection problem – debtors with a strong ability to repay often have better/cheaper options than using a credit card
Credit cards have evolved to become an everyday fact of like, something you probably use multiple times per day and in nearly every commercial transaction you make, but they are at their core, simply unsecured revolving debt
The credit card companies perspective
Credit cards are an incredibly profitable business. This is why you might see cards offered from companies that you don’t really think of as credit card companies, like airlines, furniture stores, and sports teams.
Credit card companies make their money in two ways
- Interchange fees – this is the money the merchant pays to the credit card companies when you swipe your card at their store. Of course, merchants build this fee into their prices, so really it’s still you who is paying. This fee varies by company and can even be individually negotiated with large merchants, but typically ranges around 1-2% of the transaction plus $0.25
- Revolver fees – this is the money the card money makes from debt that has not been repaid on time and accrues interest.
While interchange fees are an important source of revenue, credit card companies make the vast majority of their money from the revolver fees.
This is why they hope you forget to pay your balance each money and carry it over to the next period, where they start charging you interest. This might be why you see them make their websites and bills and terminology so confusing – it’s all to hope you don’t pay that bill on time before it starts accruing interest. And they can make a lot of money doing this, since most people don’t understand these credit card basics
Reasons not to use a Credit Card
If you’re unable to use a card responsibly and pay it off each month, you should stop reading now and not use credit cards! The interest rate charged will likely be 15-25%, which is essentially punitive. Especially if you are low income and/or tight on money, increasing your monthly expenses 15-25% can cause your personal finances to spiral out of control.
Another, sneakier, reason not to use credit cards is the way credit card companies calculate how much interest you owe if you don’t pay your full balance on time. You might reasonably think that if your statement closes on the 1st of the month and the bill is not due until the 21st of the month, if you’re late by a couple of days it’s no big deal after all 15-25% annual interest multiplied by a couple of days should end up being a pretty trivial amount. Maybe just a couple of dollars, depending on how much you spent.
But this doesn’t account for the sneaky way credit card companies set up their billing cycle. How it actually works is that your bill is due when it closes on the 1st and the time they give you to pay until the 21st is the ‘grace period.’ You might not realize this since most companies’ bills/websites make it look like your bill is not due until the end of the grace period. So if you don’t pay by the 21st the companies charge you interest back when you incurred the charge. So if you incurred your charges on the 21st of the previous month, by being 1 day late after the grace period, they will charge you a full month’s interest!
Reasons you should use Credit Cards
If you are responsible, understand credit card basics, and will pay off your credit cards in full monthly except in rare circumstances there are two main reasons you should have at least one card (if not more)
As mentioned earlier credit cards companies charge their merchants an interchange fee, so merchants build this cost into their prices. These days, with the high prevalence of credit cards, most merchants simply set prices assuming most people will use their credit cards. And, with rare exceptions, they tend to set one price that everyone pays regardless of the method of payment. But if you use a credit card, you will tend to get most of that interchange fee back in the form of credit card rewards (which take many forms and will be a separate article). Depending on how you use your card, which card you have, you may even recapture more than what the interchange fee was
The more popular and well-known reason to have a credit card(s) is to build credit. By having a revolving credit line open and paid in full each month, you will help to build your credit score, which could help you get more favorable terms on other types of debt like a mortgage. Obviously, there is a lot that goes into this, so it too will be a whole separate article
How to use Credit Cards
There are really two main things to remember to responsibly use credit cards:
- Pay them off in full every month. This will help you avoid a personal finance spiral where you’re paying punitive rates like 15-25% annually. Of course, there could be certain rare cases or emergencies where it makes sense to carry a balance and suck it up and pay the interest rate, but these should be exceedingly few and far between
- Don’t wait until the end of the grace period (many will list that as your due date, instead set a reminder to pay as soon as the bill hits). As described above, missing the bill payment due date can easily and quickly lead to a month or more’s worth of interest charges. Instead of setting reminders to pay your bill at the end of the grace period, set them to pay it as soon as the statement is issued. This way if you forget or get busy and miss by a couple of days, you still will not have accrued any interest. It varies, but most cards’ grace period is about 3 weeks
My top credit cards and credit cards to avoid
My favorite cards come from USAA, Fidelity, and Chase. USAA offers a 2.5% flat cashback on all charges cards – the highest I’ve ever seen. Fidelity has 2% flat cash back that goes straight to your investment account – another great feature combo. And finally, if you’re willing to deal with a little less flexibility, Chase offers a very high redemption rate if you redeem their rewards through their travel rewards portal – worth it if you spend enough and care about travel.
I don’t recommend American Express, after too many negative customer support experiences, I no longer do business with them.
Hopefully you know understand most credit card basics and are ready to start using them responsibly for some great benefits. Credit cards can be a great tool to earn rewards like cash back or flights or hotels and to build credit. They can also be a backup to pay for unexpected expenses But like any tool, if used improperly they can be dangerous. For most responsible people I recommend having a few!
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