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Bottom Line Up Front

  • There are many advantages to using credit cards if you manage your spending and payments wisely.
  • Responsible credit card use can help you establish your credit history, allowing you to make larger purchases in the future.
  • Using a credit card is different from using your debit card. Using a credit card involves borrowed money, whereas using a debit card involves using money that is linked to your bank account and is yours.
     

Time to Read

10 minutes

May 23, 2022

Your life doesn’t always match up with your pay schedule. That is why it’s nice to know you can borrow money. One way to do this is by applying for a credit card. Once approved, a credit card will allow you to make small and large purchases alike and then pay the money back over time.

Responsible use of a credit card can also help you build credit, and good credit is what you’ll need if you want to take out future loans.

Revolving Credit

With a credit card, you’re given a maximum amount of money you can spend—referred to as your credit limit or credit line. Once you've reached that limit, you won't be able to borrow any more money until you've paid the credit card balance back down below the limit. Some credit cards will approve purchases above your credit limit, then some may charge an over-the-limit transaction fee. Here are two examples to illustrate how credit cards work and what using credit means:

Overspender

  • Credit limit: $500
  • Billing period: 12/1-12/31
  • Monthly spending
    • 12/2 - Restaurant charge: $100
    • 12/6 - Clothes shopping: $200
    • 12/13 - New TV: $350
  • Total spent: $650
  • Remaining credit line: -$150
  • Over-the-limit fee: $100
  • Interest hike due to spending over the card limit: From 13% to 20%

Savvy Spender

  • Credit limit: $500
  • Billing period: 12/1-12/31
  • Monthly spending
    • 12/2 - Restaurant charge: $100
    • 12/6 - Clothes shopping: $200
    • 12/13 - Netflix Subscription: $10
  • Total spent: $310
  • Remaining credit line: $190
  • Over-the-limit fee: $0
  • Interest rate hike: None

Some credit cards will approve purchases above your credit limit, then some may charge an over-the-limit transaction fee. Here are two examples to illustrate how credit cards work and what using credit means:

Credit vs. Debit

Credit and debit cards may swipe the same way, but you should know the differences between them. Credit cards are a form of borrowing from a lender, like a short-term loan or line of credit, while debit cards are essentially an electronic check linking directly to your bank account, namely a checking account.

To understand how credit and debit cards compare and to learn about different credit card terms, take a closer look at the chart below.

Key differences between credit and debit cards
Difference Credit Card Debit Card
Source of Funds Revolving credit line Tied to your checking account; not a loan
Spending limit Card issuer sets a credit limit based on your credit history; over-limit penalties may apply or your card may be declined if you spend more than the credit limit Limited to the funds in the account; overdraft and insufficient funds fees may apply if you spend more than the balance in your account. There are also daily spending limits
Payments Monthly minimum payment based on current balance of credit card bill Funds are debited from your account almost immediately; no additional payments are needed
Interest rate Depending on each credit card issuer’s rate, based mostly on creditworthiness; the cardholder won’t have to pay interest if the balance is paid in full each month or within the grace period. The interest is known as the annual percentage rate (APR) No interest charged
Fees Could include annual fee, over-the-limit fee, late payment fee or returned check fee Overdraft fees may apply if you have opted into a service and make a purchase that is more than your available checking account balance
Effect on credit history – A record of how a consumer has paid credit accounts in the past, used as a guide to determine whether the consumer is likely to pay future accounts on time. Responsible use and timely payments can help to improve credit score; poor or no credit history may affect your ability to qualify for a credit card Your credit history might only be affected if overdraft fees on your account are not paid and the financial institution sends the debt to a collection agency

Effect on Credit

How you manage a credit card affects your credit history, one aspect of your credit report. Your credit history can affect your ability to receive a loan, employment or a place to live, so it’s important to create a credit history that reflects responsible and intelligent financial habits.

Here’s what you can do to begin building a positive credit history:

  • Use your card regularly.
  • Make your payments to the financial institution on time by the due date.
  • Keep your balance below your limit and monitor your credit utilization rate.
  • Regularly read your credit report provided by credit bureaus, Equifax® Experian® or TransUnion®, to make sure it’s error-free and to keep track of your credit score.1

Using a credit card requires completing a credit card application subject to certain checks, such as income. Once approved, credit card users can take advantage of services such as cash advances. A cash advance, or cash back, is typically charged at a higher interest rate than a regular credit card purchase.

There are also rewards credit cards that provide various perks and cash back offers. When shopping around for a credit card, always look for the best credit card to suit you if you enjoy a rewards program, extended warranty on purchases and the ability to transfer balances onto a lower interest rate card.

Interest Rates and APR

Credit card companies, or issuers, charge a yearly rate of interest on the money you borrow from them. That rate is the annual percentage rate and it varies according to several factors, including credit history and card types.

  • Variable: These APRs start at one rate and then may increase or decrease depending on market conditions.
  • Fixed: These APRs remain the same unless the card issuer notifies you in advance about a change.
  • Introductory: These APRs are usually low and offered as an incentive to apply for and use a card. They may also be called promotional or teaser rates. As the name implies, they increase automatically after the introductory period expires. 
  • Cash advance: This APR applies to any cash you borrow against your credit card and is often significantly higher than the APR you pay for purchases made on the card. 
  • Penalty: This APR applies when a card issuer has not received the required minimum periodic payment within 60 days after the due date for that payment. A penalty APR is typically significantly higher than the APR the consumer was assigned at account opening. 

All of these APRs must be clearly displayed on your credit card agreement, as well as on the card issuer’s website.

Fees and Penalties

Most credit cards come with fees, many of which are avoidable if you use your card wisely. Some fees, like late payment fees, encourage you to follow the rules the card issuer has set.

Other fees, like annual fees, help cover the cost of the card’s special features, like travel rewards. Your card issuer may also charge fees to help pay for transactions, like a balance. Here is a bit more about some of the fees you may encounter:

  • Annual: Some credit card issuers charge users an annual or yearly fee for the privilege of using their card. This fee is most common with cards that offer rewards, such as airline miles, hotel stays or cash back on purchases. Sometimes, a creditor waives this fee for the first year as a way to encourage you to sign up for the card and use it for purchases. If you do choose to close the account, ask about getting a refund for the unused portion of the fee.
  • Penalty rate: If you pay your monthly bill late by 61 days or more, your credit card issuer can increase the interest rate that you pay. It’s called a penalty rate or default interest rate. They may also charge a fee for the missed or late payment.
  • Over-limit fee: Credit card companies set a limit to how much you can charge to a card. Exceeding this limit can result in a fee. Over-limit fees typically range from $25 to $35. Credit card companies can’t charge a higher fee than the amount you exceeded the credit by. For instance, if you went $20 over your credit limit, the over-limit fee can’t be more than $20. Credit card issuers may only charge these fees if you expressly opt in to allow over-limit transactions.
  • Overdraft fee: Your financial institution can charge an overdraft fee a debit card is used to pay for something without sufficient funds in your bank account. They also can implement a higher penalty interest rate if the bounced check results in your account being 61 days or more delinquent. The company can also implement a higher penalty interest rate if the returned check results in your account being 61 days or more delinquent.
  • Missed payment fee: A credit card company can charge a missed payment fee if a check you use to make your monthly payment is returned.

Balance

Your balance reflects the amount of charges and interest you owe to the credit card issuer. Because your balance may vary from day to day, depending on how often you use the card, credit card companies use different methods to determine the balance that is subject to interest charges.

  • Average daily balance: The issuer tallies each month’s daily balance, divides that number by the number of days in the billing and charges interest on that total.
  • Adjusted balance: The issuer deducts payments and credits made during the billing cycle from the outstanding balance at the beginning of the billing cycle. Interest is charged on the remaining balance.
  • Previous balance: The issuer uses the outstanding balance at the beginning of the billing cycle.
  • Daily balance: The issuer figures the balance each day by taking the beginning balance on each day of the billing cycle, adding any new purchases and subtracting any payments and credits.

When you make a purchase with your credit card, it may take a few days for the transaction to show up on your account. “Pending” is the difference in time between the actual transaction and when the transaction appears on your statement.

Available and Credit Limit

Available credit refers to the difference between your credit limit and the outstanding charges on your account. For instance, if your credit limit is $5,000 and you’ve charged $1,500, then the maximum amount you can still charge to the card (your available credit) is $3,500.

Your credit limit is the maximum amount you can charge to your credit card. Issuers largely rely on your credit history and current debt burden to determine this amount. Typically, the better your credit score, the higher your limit. Some issuers also take into account the limits on your other credit cards. This information is found on your credit reports. Some cards have predetermined credit limits, meaning everyone who qualifies for the card gets the same limit.

Repayment

In order to avoid a high-penalty APR, you need to pay at least the minimum payment toward your credit card debt by the due date each month. The minimum payment amount is a percentage (usually two to three percent) of your balance. This balance may include compounded interest, meaning you pay interest on the balance, or, as well as additional interest on the interest that accrues on the balance.

The dollar amount of your minimum payment drops as you pay off your balance, but card issuers usually have a certain dollar amount that limits how low minimum payments can go. If you continue to only make minimum payments while interest charges continue to accrue, it will take you longer and cost you more to pay off the debt.
 

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Disclosures

This content is intended to provide general information and shouldn't be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.