Credit cards are an important part of your business and personal finances. Understanding how they work is vital to long-term financial success, particularly if you use credit cards for everyday purchases. You can use credit cards as a tool to unlock cash back and travel rewards, or a credit card can be an expensive dead weight holding you back from financial success. This guide will teach you the fundamentals of credit cards so you know how to avoid costly mistakes.
How Credit Card Interest Works
Credit card interest is the most important part of credit cards to understand. Knowing how it works can be the difference between paying $0 for using your card and paying hundreds or thousands of dollars in interest.
Credit card companies compile all of your purchase and other activity into a monthly statement. The total balance of that monthly statement is used to calculate your interest payment. Each card has a different interest rate, and if you miss a payment you’ll typically see an increased penalty interest rate go into effect. 1/12 of your annual interest rate becomes the interest rate you’re charged. For example, if you have an interest rate of 15%, you’ll pay 1.25% interest each month.
If you pay your statement balance in full before the due date, you do not have to pay any interest. However, if you carry over a balance from month to month, you are charged interest based on the balance that carries over into the next month.
Credit card interest is typically among the highest consumer interest rates. It is not uncommon to see interest rates over 20% and penalty interest rates over 30%. Interest rates are listed on your credit card paperwork as an “annual percentage rate,” or APR. The terms APR and interest rate can be used interchangeably.
Summary:
- You don’t have to pay interest if you pay your balance in full every month
- Credit card interest is commonly over 20%
How Credit Score Reporting Works
Every person with a social security number and at least one credit or loan account has a credit report. Using your credit report, the three major credit reporting bureaus calculate your credit score. Your credit report and credit score are used to decide if you qualify for new credit cards and loans. Think of your credit report like your high school transcript and your credit score like your GPA.
Every month when you make an on-time payment, that is added to your credit report. If you are late or miss a payment, that shows up on your credit report as well. Having a perfect on-time payment history and managing your credit well leads to a high credit score. Missing payments and making late payments lowers your score.
Credit scores can be the difference between being approved and denied for a mortgage, auto loan, or new credit card. Your credit history also determines your rates, and having excellent credit can easily save you tens of thousands of dollars on a mortgage.
The three major credit reporting bureaus are TransUnion, Equifax, and Experian. By law, each has to give you a completely free credit report at annualcreditreport.com. Learn more about your credit and how to get a free credit score at this guide to credit.
Summary:
- On-time and late payments are recorded on your credit report and influence your credit score
- A good credit score can save you tens of thousands of dollars on a mortgage
- You can get free credit reports from each bureau by law at annualcreditreport.com
How Credit Card Rewards Work
Now that you know the basics to keep yourself out of trouble with credit, let’s look at the good stuff: credit card rewards. The best credit cards, generally reserved for people with good to excellent credit, offer valuable rewards for your everyday purchases.
Cash bank or miles or points are common rewards. Cash back works as you would expect. You typically see 1%-2% cash back for all of your purchases. Some cards offer bonuses where you can earn limited cash back in the 5%-10% range depending on the card.
Travel rewards cards offer airline miles, hotel points, or reward program points that you can use towards free travel. You can often leverage these rewards to earn far more than the typical 1%-2% value of cash back. This takes a little more work to manage, but can lead to lucrative, free trips that take you around the world. After paying taxes and fees, you can travel around the country or overseas for pennies on the dollar of the cost of paying for travel out-of-pocket.
Summary:
- Credit cards can pay no rewards, cash back, or travel miles and points
- The best rewards come from cards exclusively for people with good to excellent credit
- Miles and points can be worth more than cash back in many situations
How Credit Card Fees Work
To wrap up this guide, let’s look at the sneaky evil part of credit cards, fees. Varieties of activities will result in fees. Annual fees are perfectly acceptable. However, you’ll earn more in cash back or rewards, virtually all other fees can be avoided through smart management of your finances.
- Annual fee – Some cards charge an annual fee. Avoid these cards unless you expect to earn more in rewards than the cost of the fee.
- Cash advance fee – If you take out cash from your credit line, card issuers usually charge a fee. Avoid this fee by shredding convenience checks and not using your card for cash advances.
- Balance transfer fee – Banks often charge around 3%-5% when you transfer a balance between cards. Avoid this by leaving your balances where they are, or just paying them off.
- Late payment fee – Banks typically charge around $25-$35 for late payments. Pay your credit card bill on-time to avoid this charge.
Summary:
- You can avoid many credit card fees
- Annual fees are okay only if you earn more in cash back or travel rewards than the cost of the fee
