What You Need to Know About Credit Cards

Credit cards can be powerful financial tools if used responsibly. However, without a clear understanding of how they work, it's easy to fall into the credit card debt trap. Here are some credit card basics to help you use them wisely.

Start by Monitoring and Building Your Credit Score.

Your credit score is crucial in determining your financial health. Regularly check your credit score and understand its components, such as payment history, credit utilization, and length of credit history. By maintaining a good credit score, you can qualify for better credit card offers and loans in the future. For more information about credit scores, read our blog on the topic.

What is a credit card?

A credit card is an unsecured loan that allows for variable monthly payments. Unlike secured loans, which are used to buy specific assets like a house or car, credit cards do not have collateral. If you do not pay the credit card company, they have no way to get their money back. However, they report non-payment on your credit report to warn other financial institutions. As a result of offering unsecured loans, the credit card company charges higher interest rates, typically between 10-25%, to compensate for the higher risk. Credit cards are issued by various institutions, including banks, credit unions, department and grocery stores, airlines, hotels, and others. They are run by payment networks like Visa, Mastercard, American Express, and Discover, which charge a fee for stores to accept their credit cards. This may affect where the card can be used. Each cardholder has unique spending limits, interest rates, and minimum payments set by the issuer.

Deciphering Payment Terms.

Credit card payment terms can be confusing compared to fixed monthly payments for secured loans like mortgages or auto loans. For example, if you make purchases throughout a billing cycle, your statement will reflect the total amount owed. Paying this balance before the due date, usually 30 days after the statement, avoids interest charges. However, any unpaid amount carries over, accruing interest and affecting subsequent billing cycles. Understanding these terms enables you to plan your payments effectively and avoid unnecessary interest charges. Below is a visualization of a typical credit card’s billing cycles:

Grasp the Mechanics of Interest:

The credit limit on a credit card does not represent a realistic expectation of what you can afford to spend. Credit card companies often allow for higher credit limits to trap you into paying interest on your purchases. If you don't pay off your credit card balance in full each month, interest can quickly accumulate. To illustrate, let's say you make a $4,000 purchase on a credit card with a 21% interest rate and only pay the minimum amount each month. Over time, you will end up paying over $6,000 in interest on the remaining balance, and it will take approximately 257 months to fully pay off the debt. This means that the items you initially bought could end up costing you significantly more than you intended, sometimes two or three times the original amount after factoring in interest charges.

Optimize Your Spending and Payment Strategy:

Closely monitor your spending throughout the month to avoid overspending. It is helpful to ease into using your credit card by starting with small purchases. Paying only the minimum payment required by the credit card company is how the debt trap works; the less you pay now the more you must pay later. Remember, the credit card company profits from interest charges, so they like when you accumulate interest and only make small payments over time. To minimize interest charges, prioritize paying the full statement balance each month. Also, consider making multiple payments throughout the month or negotiating a payment plan with your credit card company if you encounter financial hardship.

Manage Your Statement Date and Payment Options:

Take control of your credit cards by asking the credit card company to adjust the statement date to a more convenient time in the month, if needed. This ensures that you will have sufficient funds to pay the full balance because you can time it to be after you receive your paycheck. Automating your payments through autopay is highly recommended. There are different autopay options like paying the full statement balance or a fixed amount or the total balance but avoid the minimum payment option. When selecting a payment date, account for weekends and holidays to prevent late payments.

Be Aware of Hidden Fees:

Using a credit card at an ATM is considered a "cash advance" and can trigger a service charge and instant interest at a higher rate than normal (30%+). Most credit cards also charge foreign transaction fees when the card is used for international payments, which can be a percentage (3%-5%) of each transaction. Some credit cards with attractive benefits charge an annual fee to keep the account open. Be cautious of annual fees, especially when you're just getting started and your credit limits are low, because the cost might outweigh the benefits. Other fees to be aware of include lost card, late payment, balance transfer, over-the-limit, and insufficient funds fees.

Take Measures to Protect Yourself:

Credit card fraud is common, so it's essential to protect yourself. Be cautious of anything that raises doubts about the legitimacy of transactions, both online and at registers. Avoid using your card if the payment terminal is in disrepair or looks tampered with. Use the security chip rather than swiping or tapping your card, and don't leave your card out in the open where it can be easily compromised. If you notice any unauthorized transactions, report them immediately to the credit card company. They can reverse transactions, blacklist vendors, and provide you with credit for any fraudulent activity. This is an advantage over a debit card that instantly withdraws funds from your account. Another advantage is that credit cards offer automatic protection by preventing transactions in foreign countries unless you have notified the credit card company beforehand. Therefore, if you plan to travel internationally, make sure to inform the credit card company about the countries and dates to ensure uninterrupted usage and continued security measures.

Conclusion:

By understanding the nuances of credit cards and implementing responsible financial habits, you can leverage credit cards to your advantage. Regularly monitor your credit score, pay off balances in full, and stay mindful of payment dates and options. With these strategies in place, you'll be on your way to taking advantage of points and cash back through smart credit card usage. Remember, credit cards are a tool, and it's up to you to use them wisely!

- Kyle McCune, CFP®, Worley Erhart-Graves Financial Advisors