Credit cards, when used correctly, are an easy way to save money and earn rewards. Unfortunately, when used incorrectly and recklessly, they’re a great way to pay unnecessary fees and get into long-term debt. For this reason, many people are hesistant to use them, and some avoid them altogether. Personally, I’ve earned a couple thousand dollars in the past couple of years through getting credit cards and using them reasonably, and with relatively little effort and no negative consequences.
While this article does not constitute financial advice, I hope it serves as a useful introduction into how credit cards work and how to use them properly. In this first post, we’ll define the various terms and concepts associated with credit cards. In the next one, we’ll discuss how to use credit cards effectively, along with a few concrete examples.
Note: The information in this article only applies to those in the United States.
What is a Debit Card?
To understand what a credit card is, let’s first understand what a debit card is. A debit card is just a card that is directly linked to a bank account. It looks just like a credit card, but works in a simpler fashion: whenever you use a debit card, it takes money directly from your bank account and uses that to pay for whatever you’re buying.
Let’s say I have a bank account with ABC Bank with $1000 in it. ABC Bank also gave me a debit card linked to my account. If I use my debit card to pay for a t-shirt worth $20, then my debit card will take out $20 from my bank account to pay for it, and my bank account will then have $980. Using a debit card is like using a physical wallet, but digitally. With a physical wallet, you have some cash inside and you take it out to pay for stuff. With a debit card, you have some money in your bank account and withdraw it to pay for stuff. If you don’t have enough money in your bank account, you can’t pay for your purchase, just like with cash.
What is a Credit Card?
Credit cards work a bit differently: instead of paying with your money, you pay for stuff with someone else’s money (well, at least at first.) When you pay with a credit card, nothing happens to your bank accounts; the credit card company temporarily loans you the money, which you are supposed to pay back later. The credit card company keeps track of how much they loan you, and eventually, they ask you to pay it back.
Let’s say I get a credit card with ABC Bank. If I use my credit card to pay for the same $20 shirt, my bank account will still have $1000, but ABC Bank now says I owe them $20. I don’t have to pay it back yet, but I’ll have to eventually.
Of course, now that you’re not directly spending your money, things get a bit more complicated; for example, if you don’t pay your credit card issuer back on time, you will probably have to pay interest. Let’s cover some of the more common aspects of credit cards before going into how to optimize credit card usage. While this may seem like a lot, in practice, you don’t need to know all that much to use credit cards effectively.
A credit card has a credit limit, which is the maximum amount the bank is willing to loan you for a given credit card. If you have a credit card with a credit limit of $1000, you won’t be able to spend more than $1000 on it at a time.
Cycles, Statements, and Payments
Credit cards operate on cycles, generally a month long each. For example, one cycle might start on January 1st and end on January 31st, with the next beginning on February 1st (by the way, cycles don’t have to start on the 1st of the month.) After each cycle, the credit card company adds up your expenses for that cycle, and sends you a statement, which is just a summary and total (or balance) of your purchases for that month.
Once you receive that statement, you have a set period of time (often 3 weeks or so) to pay off your balance to avoid any consequences. If you don’t pay your balance in full, you will have to start paying interest (described below) on your outstanding balance. Not paying can also negatively affect your credit score (described later) if you don’t pay at least the minimum payment.
As a quick example, let’s say your cycle started on January 1, and you spent $150 in January. Your next cycle will begin February 1st, but you’ll receive a statement showing a $150 balance for the January cycle. You will have a few weeks (until mid-late February) to pay off this $150. Your minimum payment might be $25 or so, but to avoid all negative consequences, you should pay the full $150. If for some reason you can’t, try to pay at least the minimum payment.
Interest is essentially a fee charged to whoever is receiving a loan; as opposed to typical fees, interest is a percentage of your balance. Since the credit card company is paying for things on your behalf, they are effectively giving you a loan, meaning they get to charge you interest if you don’t pay them back in time. The interest rate is commonly stated as the APR, or annual percentage rate for your credit card. A common APR is around 20%. This means that if you don’t pay off your balance for a year, you’ll have an extra 20% tacked on to your balance. 20% is a very high interest rate (although typical of credit cards), so continually paying interest is a common way people spiral into debt.
One thing to note is that I never pay interest, since I always pay off my balance in full. This means that the APR of a credit card is completely irrelevant to me, since I’ll never have to deal with it. Ideally, you won’t have to either, since you should do everything in your power to avoid paying interest.
A credit score is a score that, in theory, evaluates how credit-worthy someone is; in other words, how likely someone is to pay back their debts. Credit scores are used in a number of situations involving loans; for example, when applying for an apartment, getting a car loan, signing up for a mortgage, or even applying for a credit card, companies will check your credit score. The scale ranges from 300 (worst) to 850 (best). To get a high credit score, you have to consistently show you’re responsible with credit (i.e. loans); for example, consistently paying off a credit card will improve your score, while missing payments will quickly bring it down. There are a number of factors involved in the formula, but some of the more important ones are the number of open accounts you have, what percent of your available credit you are using (credit utilization), and how consistently you pay off your debts on time.
There are 3 companies that calculate credit scores: TransUnion, Equifax, and Experian. They typically calculate slightly different scores for various reasons. You can check your credit score, or at least get an estimation of it, through services like Credit Karma, or check it directly, e.g. through Equifax.
One thing to note is that the formulas behind credit score calculations are not public, so sometimes scores seem to change in mysterious ways. As long as you pay things off on time and don’t do anything extreme, your credit score should generally trend upwards. Also, scores above 750 or so generally don’t bring much concrete benefit; there is little practical difference between a 780 and an 840.
Credit Card Processing Networks
A credit card processing network processes credit card transactions. You don’t need to know much about them, so we’ll just mention the biggest 4 for now: Visa, Mastercard, American Express, and Discover. Each processing network has various cards associated with them; the smaller two, American Express (Amex) and Discover issue their own cards, while Visa and Mastercard typically have cards issues through other companies, like banks (e.g. Chase or Barclays).
How Do Credit Card Companies Make Money?
This question has numerous answers, but I’ll just cover a few of the reasons here. Obviously, credit card companies don’t issue credit cards out of the goodness of their hearts, but to make money; issuing credit cards is clearly a lucrative business.
One way is through processing fees. Every time you pay for something with a credit card, the payment processor (i.e. Visa, Mastercard, Discover, or Amex) collects a fee, something in the range of 1-3%, to facilitate the transaction. This means that every time you pay with a credit card, the payment processor (e.g. Visa) collects a small fee based on what you purchase. They get to charge this fee for providing this service of facilitating credit card transactions. (Side note: this is why some businesses, especially smaller ones, prefer you pay in cash: they get to avoid these fees, which can eat into their margins.)
Credit card issuers make money from interest and other fees. Credit card companies know that some people will inevitably not pay their credit cards on time, and get to charge high rates of interest to those people, making them money. Often, LOTS of money, for a long time. They also charge fees like annual fees, foreign transaction fees, and balance transfer fees.
One thing to note is that credit card companies also lose out when people don’t ever pay their debts; for example, following a bankruptcy. They do their best to avoid customers who will declare bankruptcy, as then they will never get their loans paid off. That’s why they screen people using credit scores and set credit limits to ensure they don’t risk too much money on any particular person.
With all this in mind, credit card companies are happy to offer credit cards to people they think are profitable, in the sense that they will earn the companies enough money in interest and fees over time to outweigh the potential risk that comes with lending them money. More subtly, they also factor in the possibility of making money from you in other ways: for example, a bank may happily issue a credit card to you if it means you end up getting using more of their services later on. With this in mind, credit card companies offer incentives to people to encourage them to get credit cards, even if it loses them money sometimes, as long as they think they can attract other people who will earn them even more money.
It follows that for us to use credit cards effectively, we need to minimize how much money we pay to the credit card companies; that means avoiding all interest and not paying any unnecessary fees. We also want to maximize the incentives we receive from credit card companies. We’re not necessarily trying to minimize their profit, but instead trying to maximize our gain.
So, Why Get a Credit Card?
As long as you manage to avoid the downsides of credit cards, using credit cards comes with a variety of benefits over using cash or debit cards. The next post, Making Money With Credit Cards, will go into many of these benefits, from a financial perspective.
One other nice thing about credit cards is that they’re more robust against fraud. If you get fraudulent charges on your debit card, it’s generally harder and more inconvenient to dispute them than it is with a credit card. In this way, you’re a bit safer, from the perspective of dealing with fraud, when you pay with a credit card. Other benefits, like purchase protection or emergency assistance, may also be included with credit cards, leaving you better equipped to deal with a variety of sticky situations.
Read Making Money With Credit Cards next