Credit Card Basics

People can have very strong opinions about credit cards. Financial guru Dave Ramsey is beloved by many people but his strict advice about credit cards is to cut them up, pay them off, and close them. However, credit cards are a financial tool just like anything else. They can be a pitfall if you don’t have the self-control to use them well, but they can also benefit you with financial flexibility and rewards like cashback.

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Credit Card Basics

What is a Credit Card?

A credit card allows you to access a line of credit offered to you by your bank. This line of credit can range in size from approximately $500-$15,000 (it is possible to get over or under these numbers, but that is unusual for the average person.) When you use the card to make a purchase, the bank lends you money from this line of credit to pay for the purchase. Every purchase made with a credit card is a loan. At the end of the month, the bank bills you for the amount you borrowed. There is usually the option of making a minimum payment instead of paying your full balance, but the unpaid balance will accrue interest so that you owe more in the future.

Dangers of Credit Cards

Spending More

Paying for something with cash mentally hurts more than paying with a card, according to a study published in the Journal of Experimental Psychology. When you pay with cash, there is physically less cash left in your wallet after the payment. When you pay with a card, you don’t see that outflow of money in a physical way. This causes consumers to spend more money on average when using a card instead of cash.

Accumulating Debt

Since credit card purchases are loans, you may spend more money per month than you make. As long as there is room on your line of credit to make more purchases, you may not even notice it. However, eventually you would hit your borrowing limit and realize that you have dug yourself into debt. You can avoid this by treating credit card purchases as though they are coming directly out of your checking account like debit card purchases and paying off your bill in full every month.

Interest Charges

Credit card purchases come with a grace period of approximately a month. If you pay off your bill in full at the end of that time, you don’t owe any interest. However, when you carry a balance from month to month, it accrues interest. This is one of the ways banks make money off of credit cards. If your balance is $1000 and your interest rate is 15% APY, interest will cost you an extra $12.50 that month. That means a $60 credit card payment only lowers the balance by $47.50!

Damaging Credit

Credit scores are complicated things and how you use your credit card can impact your score positively or negatively. Negative hits to your credit could be caused by making late payments on your card or keeping the balance too close to your credit limit (lenders like to know that you have a cushion available if something unexpected happens.) Bad marks on your credit report from things like late payments can even affect how many job offers you receive! You can check the information on your credit report from each of the three major credit reporting agencies for free once a year. Visit annualcreditreport.com to get yours.




Benefits of Credit Cards

Creating a Barrier

Credit cards add one more layer between the merchant where you make a purchase and the money in your bank account. This can be handy in certain situations such as when there is fraud on your account.

Bank to Merchant or Bank to Credit Card to MerchantA little closer to home, this can affect you when you pay for gas at the pump. Most gas pumps put a $100 hold on your card when you swipe it because they don’t know how much gas you are going to pump. The hold can last for a couple days until the actual purchase amount clears. That means if you are on a road trip and fill your tank four times in one day, there could be $400 less available in your account temporarily even though you really only spent $90 on gas. If $400 is all you have in your bank account at that point, you might be in trouble! However, if that $400 hold is on your credit card instead of your checking account, you would still have the money in your checking account available to spend.

Earn Rewards

It’s great to be rewarded for buying things you were going to buy anyway! Many cards offer rewards in the form of cash back, points, or air miles. Remember these are only meaningful if they are worth more than any interest or fees you pay for the card. For example, I keep the Blue Cash Preferred® Card from American Express specifically for gas and groceries even though it currently has a $95 annual fee because the benefit of 3% back on gas and 6% on groceries means I net more than I would using my Citi® Double Cash Card at 2%.

Building Credit

This is the other side of the credit score coin. You can be perfectly responsible with your money, but if you don’t have a credit score to show it, banks have a harder time judging that. Using credit wisely by paying bills on time every month and keeping the balance well below your credit limit can help to increase your credit score. Having a high credit score makes it easier to get loans at a lower interest rate or a credit card with better rewards.

Things to be Aware Of

  • It’s important to read the terms and conditions of your credit card even though that legal jargon can be hard to get through. Each card has its own unique terms and knowing what those are will help you avoid potential pitfalls.
  • Cards often come with secondary benefits such as extended warranties on purchases and discounts on things like hotels. One of our cards comes with car rental insurance, which we have used occasionally when we fly south.
  • Do you have poor or no credit, making it hard to get a credit card? Many banks offer secured credit cards, which work by holding a deposit from you as collateral against the loan. The tough part about these is that you have to save up the deposit in the first place.

If you handle your money responsibly, credit cards can benefit you in several ways. If you are still learning about financial responsibility, they can be dangerous. Hopefully after learning about the pros and cons you will be able to decide if a credit card is right for you.

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