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Credit Cards: How Do They Work and How Should You Use Them?

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Credit Cards: How Do They Work and How Should You Use Them?

Credit cards are those little plastic cards that can open so many privileges in the consumer world. They are more common than they once were because credit rules have loosened up over the past few decades. Credit cards have become a favored way of making purchases. However, defaults have grown greatly with the availability of easy credit.

Things To Know

  • Credit cards are revolving credit: you can draw on your credit limit over and over within your credit limit.
  • Learn all the fees and how they are charged.

Click here to watch a short video discussing the use of a credit card.

How credit cards work

A credit card is a small plastic card that draws on a line of credit made available by a bank or credit union. Cardholders can use the card to purchase goods and services from merchants who accept that card. Once a purchase is made, the cardholder is bound by his or her contract with the card to pay back the money, with any interest required. In addition to purchases, a cardholder can take out cash (called a cash advance) from the card’s line of credit. Any amount spent, whether for a purchase or a cash advance, is considered a short-term loan made to the user.

Credit cards

Credit card interest rates

For the privilege of buying things on credit, you will be required to pay interest. The amount you pay depends on the size of your credit card balance.

The interest rate is a charge that you will pay on any balance that is still open on your card. This rate is called the annual percentage rate (APR). It is the rate that you would pay over the course of a year, not what you would pay each month. What you pay each month is 1/12 of the APR; thus, if your annual percentage rate is 12%, you will pay 1/12 of that each month, which is 1%.

Many credit cards carry an APR of 18% or higher. At 18%, you will pay $18 per year for every $100 you owe. This significantly increases the cost of any items you purchase on credit.

Understanding the minimum monthly payment

Sometimes it’s hard to know the number of payments due as well as the interest rate. Credit cards are an example. Sure, you know how much you borrowed when you bought something with your credit card, but you may not have been aware of the actual interest rate or the number of monthly payments. This works in the lender’s favor and against you. When a lender tells you what your minimum monthly payment is, you may be unaware that it barely pays the monthly interest and allocates only a small amount against principal. Using the lender’s minimum monthly payment could result in taking years to repay even a small debt. The result is that you pay much more for the loan than if you took a conventional loan with a fixed rate and fixed number of payments.

If you buy a TV, computer or furniture and make only the minimum payment, you will pay a great deal of interest and it will take a long time to pay off the item. Look at these examples:

Minimum payments

Paying the minimum may seem like a good way to get something you want, but you may end up making payments for many years, drowning in debt, and digging a hole that you never get out of. As a rule, credit cards should not be used to purchase items that cannot be paid off within a few months. The table illustrates how you could be paying for a computer you purchased for eight years. The computer would be outdated at that point and you might no longer even have it.

So how could you make large purchases like these without using a credit card? Create a budget and savings plan. Saving $500 or $1,000 before making a purchase will likely take less time than making minimum credit card payments.

Credit card fees

For the privilege of buying things on credit, you may be required to pay fees. Some fees occur when you do something you shouldn’t do, like make a late payment. Others are for other actions. Here are the most common fees and some typical amounts:

Credit card fees

As you might expect, paying attention to the types of fees that a credit card may charge is an important part of choosing a credit card.