Credit Cards 101: What They Are and How They Work

Credit cards are a staple of modern finance, particularly for young professionals entering the workforce. In fact, two-thirds of Americans under the age of 25 already have at least one credit card (NerdWallet).

This is cool and all, but what exactly is a credit card, and how should you use it? By simplifying how credit cards work, I’m here to help you understand them and use them smartly without falling into debt.

Understanding Credit Cards

A credit card is really a short-term loan in your pocket. It's typically a plastic or metal card issued by a bank or financial institution that allows you to borrow money to purchase goods and services (Investopedia). This is in contrast to a debit card, which pulls from your bank account. With credit cards, you're borrowing money from the issuer (and you may owe interest if you don't pay it by a specific date).

Credit cards offer perks that cash or debit can't. Many cards offer rewards, returning a portion of your spending as cash back, points, or airline miles. The most significant benefit of using a credit card is that it allows you to establish a credit history. This history shows how reliably you repay borrowed money. A strong credit history can help you qualify for a car loan or mortgage at lower interest rates.

Credit cards also provide a layer of security that cash or debit cards can't match. Most major card issuers offer zero-liability policies, meaning that you likely pay nothing if someone fraudulently uses your card. This added protection can give you peace of mind when making purchases.

Components of a Credit Card

• Credit Limit: This is the maximum amount you are allowed to spend on the card. The issuer sets this limit based on your credit score and income. You can charge purchases up to this limit, but once you reach it, you must pay the balance before you can spend more. Stay well below your credit limit, as it can boost your credit score and prevent over-limit fees.

• Interest Rate (APR): Credit cards charge interest on balances you carry past the due date. It is typically expressed as an annual percentage rate (APR). A credit card might have a 20% APR, meaning that if you don't pay your full balance, interest will accrue at that rate. The key here is that if you pay your balance in full each month, you won't owe any interest on purchases.

• Grace Period: This is a window where you can pay off your new charges without incurring interest. By U.S. law, credit card statements must be sent at least 21 days before the payment due date. If you pay the full balance within this period, you are not charged interest on those new purchases.

• Minimum Payment: This is the minimum amount you must pay by the due date to maintain a good-standing account. It is usually 2%-3% or a fixed $25, whichever is greater. Paying the minimum amount avoids late fees and credit score damage; however, if you only pay the minimum, the remaining balance will continue to accrue interest. It may take significantly longer, or even be impossible, to pay off your debt by making only the minimum payment. Your statement typically warns of the number of years it will take to pay off the loan if you only make the minimum payment. Always try to pay more than the minimum, ideally the full balance.

How They Actually Work

Credit cards operate on a monthly billing cycle. Throughout the month, you make purchases, and your available credit decreases by that amount. At the end of that cycle (typically 30 days), you will receive a statement that shows all your purchases and payments for the period. The statement also lists the minimum payment, your outstanding balance, and the due date by which you must make the payment. It is advisable to review the charges on your statement carefully, as you can dispute any fraudulent or incorrect charges.

Once you receive your statement, you have two choices. The first is to pay the entire balance by the due date (this is always advisable), and you won't be charged any interest. The other option is to carry a balance, meaning that amount will start to accrue interest. Interest is typically calculated daily. The issuer will take your APR and divide it by 365 to get a daily rate. Each day, they apply this rate to your outstanding balance and add the interest to what you owe.

If you have a 16% APR credit card, the daily interest rate will be around 0.044%, meaning on a $500 balance, you are being charged $0.22 in interest per day. This adds up to approximately $6.60 per month if the balance isn't paid. This is how credit card debt can quickly accumulate and snowball out of control. The concept of 'compound interest' means that you're not just paying interest on the original balance but also on the interest that has been added to your balance. This can make your debt grow much faster than you might expect.

Benefits of Responsible Credit Card Use

• Builds Credit History: As mentioned, using a credit card responsibly can help you establish a positive credit history, which will make you more attractive to lenders when you need an auto loan, mortgage, or any other type of credit.

• Rewards and Perks: Many credit cards offer rewards programs that give you cash back, points, or miles. For instance, the Discover It Cash Back card offers 5% cash back on up to $1,500 in purchases in rotating categories each quarter. The Chase Freedom Unlimited card also offers unlimited 1.5% cash back on all purchases, as well as 5% cash back on travel booked through Chase and 3% cash back on dining and drugstore purchases. These rewards can give you free money or discounts for using these cards. Certain cards also offer travel insurance, purchase protection, or extended product warranties. Some cards also come with no annual fees, so these perks are essentially free benefits.

• Fraud Protection: As I've mentioned, some cards offer zero-liability protection. This means that if someone steals your card and racks up charges, you can report it, and the issuer will investigate while you won't have to pay for that unauthorized purchase. By contrast, with a debit card, fraudulent charges deduct money directly from your bank account, making it more challenging to recover the funds.

Common Pitfalls & How to Avoid Them

• Debt Accumulation and Overspending: Credit cards can feel like free money, but with great power comes great responsibility. It's easy to swipe now and worry about payment later, which can lead to overspending beyond your means. Remember, if you charge $500 to your card in a month, you would want to have $500 available to pay that bill when it is due. If you feel tempted to overspend, try using cash or a debit card for discretionary purchases so you feel the money leaving your account.

• Paying Late or Missing Payments: Late payments and missed payments can result in hefty fees and even a penalty APR, in addition to the impact on your credit score. The simple way to avoid this is to always pay at least the minimum by the due date. Setting up automatic payments for the minimum due date can be a safety net. I also recommend adding your credit card due dates to your calendar or setting reminders to stay on top of them. Consistency is key: paying on time every month will boost your credit and help you avoid late fees.

• General Tips to Stay On Track: Responsible credit card use comes down to discipline and awareness. Keep your utilization ideally under 30% of your limit to help your credit score. Also, avoid using your card as a long-term loan, as most cards come with a high APR. Review your statements monthly to catch unfamiliar charges. If you find yourself with a balance you can't clear, stop using the card for new purchases until you've paid it down. By staying within a budget, paying in full whenever possible, and utilizing the card's features (such as alerts or spending trackers), you can enjoy the advantages of credit cards while avoiding the debt trap (Chase).

Bringing it Together

Credit cards can be a double-edged sword. They offer convenience, rewards, and a chance to build your credit, which can make life easier and even save you money. However, with great power comes great responsibility. Irresponsible credit card use can lead to costly debt and headaches. The good news is that by understanding how credit cards work and by following best practices (like budgeting and on-time payments), you can reap the benefits and avoid the pitfalls.

Think of credit cards as a helpful tool and not a source of free money. Use it wisely, pay off what you borrow, and it will serve you well in achieving your financial goals while you enjoy some rewards along the way. Happy spending, and even happier paying off!

Disclaimer: The information provided in this article is for educational purposes only and does not constitute financial, investment, tax, or legal advice. Always consult a qualified financial professional before making investment decisions. Investing involves risk, and past performance does not guarantee future results. Please carefully consider your individual financial situation and risk tolerance before making any investment decisions. Additionally, some links included in this article may be referral (affiliate) links.