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How Credit Cards Work (and How to Use Them Responsibly)

Credit cards are an interesting tool. If you use them responsibly, they’re a great way to build your credit, protect yourself from fraud, and even earn some cool rewards along the way.

But they also have a dark side. Because they make it so easy to buy now and pay later, credit cards can land you in massive debt if you aren’t careful. Not to mention that your credit score (and general quality of life) can suffer if you can’t afford to pay off your card(s).

Most of the trouble people get into with credit cards, however, is the result of misunderstanding (or not understanding) how credit cards work.

To clear up any misconceptions, we’ve put together this guide. Not only will you learn how credit cards work and how to get a credit card, but you’ll also learn how to use them responsibly. This way, you can use credit cards as a powerful financial tool instead of a path to financial ruin.

Credit Cards: Instant Revolving Loans

We don’t often think about it, but making a purchase with a credit card is nothing more than an instant loan.

How is that even possible? Doesn’t taking out a loan require lots of paperwork and meetings with people at a bank?

Well, that depends on the type of loan you’re talking about. In general, there are two types of loans: installment loans and revolving loans. Let’s look at how each of them works:

Installment Loans

Installment loans are for a fixed amount of time (or “term,” in financial speak), have a set repayment schedule, and are for a lump sum of money. You may already have an installment loan if you have an auto or student loan.

Because everything is agreed to upfront, interest rates on installment loans tend to be low (less than 10%). However, the requirements for getting installment loans often tend to be stricter than revolving loans.

Revolving Loans

In contrast, revolving loans don’t have fixed terms or repayment schedules. They don’t give you a fixed lump sum, either, just a maximum amount you can borrow. And they tend to be easier to get than installment loans.

However, this greater flexibility also comes with higher interest rates, as revolving loans are a bigger risk for the lender.

If you’re looking into credit cards, that almost certainly means you’re getting a revolving loan. This can be very powerful (borrow as little or as much money as you need), but also dangerous. You can easily rack up huge debts that continue to compound, taking decades to pay off.

But how is this possible? How can a few purchases here and there snowball into mountains of debt? To understand this, we need to look at how credit card interest works.

How Credit Card Interest Works

Credit card companies don’t want you to think about interest; it’s all “buy now, pay later.” But interest is the main way credit card companies make money, and you better understand how it works before you sign up for a card.

What Is APR?

The Annual Percentage Rate (APR) is the number credit card companies use to determine how much interest you’ll pay.

You’ll see this number prominently displayed when you’re applying for a credit card or when you get your monthly statement. The APR will vary depending on your credit score and the card you get, but it will always be quite high (especially compared to installment loans).

On its own, however, the APR is misleading. Because while a card might have an APR of 20%, that doesn’t mean you get charged 20% interest on all of your purchases each year. Instead, most credit card interest is calculated and charged on a daily basis. This is called the daily rate.

How to Calculate Credit Card Interest

To calculate the daily rate, divide your APR by 365 (some companies use 360, but the difference is so minute we won’t worry about it here). So if your APR is 20%, your daily interest rate is 20% / 365 = 0.055%.

Great, but how does that help you figure out how much you’ll pay in interest each month?

To do that, we need to do a bit more math. Credit card issuers apply your daily interest rate to what’s called your average daily balance.

To calculate this, add up your daily balance (the amount you owe) for each day in your card’s billing period and then divide that by the number of days in the billing period.

For the sake of simplicity, let’s say we did the math and your average daily balance worked out to be $1,000. Now you can finally calculate the interest you’ll pay.

Multiply your average daily balance by your daily rate and the number of days in the billing period. Assuming your billing period is 30 days, your interest owed will be $1,000 x 0.055% x 30 = $16.50.

Whew! That was a heck of a lot of math. But why should you care about the minutiae of how credit card companies calculate your interest charges?

You should care because you can actually lower your interest payments if you pay early or spread your credit card payments throughout the month.

To see why, just do the math.

Paying Early and Frequently Can Help You Pay Less Interest

Let’s assume you have $500 to put towards your $1,000 credit card balance. If you pay that amount on the day your payment is due, then your average daily balance is:

($1,000 x 29 days) + ($500 x 1 day) = $29,500

$29,500 / 30 days = $983.33

But if you make that payment on the 15th day of your billing cycle, then your average daily balance will drop:

($1,000 x 14 days) + ($500 x 16 days) = $22,000

$22,000 / 30 days = $733.33

And finally, if you make multiple payments throughout the billing cycle, your average daily balance will be even lower. Let’s assume you make a payment of $175 on the 7th, $175 on the 15th, and then $150 on the 21st:

($1,000 x 6 days) + ($825 x 8 days) + ($650 x 6 days) + ($500 x 10 days) = $21,500

$21,500 / 30 days = $716.67

While this is pretty cool, you shouldn’t be too concerned about this math in practice.

Why? Because you’re never going to pay a cent of interest. You’re going to pay your card’s balance off in full each month.

Otherwise, you risk falling into the black hole of compound interest:

Compound Interest: Your Worst Nightmare

So far, we’ve been talking about credit card interest over the course of a month. While this is helpful for understanding how credit card interest works in general, it doesn’t give you the full picture.

Credit card interest isn’t simple interest. That is, it isn’t just charged on the amount you borrow (the “principal”, in finance terms).

Rather, credit card interest is compound interest. This means that interest accrues on top of the interest you owe. This doesn’t matter much in one month, but this interest can really start to stack up if you let it accumulate over the course of months or years.

Here’s an example of how bad it can get:

Let’s say your credit card has a minimum payment of $10, an APR of 20%, and a $1,500 balance. “Cool,” you think. “I only have to pay $10 each month. What a steal!”

But if you do the math, the reality is sobering. If you only make the minimum payment, it will take you 36.5 years to pay off that debt. And you’ll end up paying $5,584.01 just in interest. What’s insane in this case is that your monthly interest charges work out to $12.75, $2.75 more than your minimum payment.

Unlike when you’re investing your money, this is the wrong side of compound interest to be on. And it’s a case for why you should always pay more than the minimum.

Even paying just a little more per month can vastly reduce the amount of interest you’ll pay and the amount of time you’ll be in debt. If you want to play with the numbers yourself, check out this free credit card interest calculator.

Now, it’s almost time to talk about the mechanics of getting a credit card. But before we do that, there’s one more aspect of credit cards you need to understand: fees.

Struggling to repay your credit card debt? This guide can help.

The 3 Credit Card Fees You Should Know

In addition to interest charges, most credit cards have fees. Some fees are part of having the card (such as annual fees), while other fees serve as penalties for messing up (late fees). Here are the three main credit card fees you should know:

Annual Fee

Many credit cards charge an annual fee. Essentially, you’re paying for the “privilege” of having the card, plus any perks that come with it.

In general, we advise against paying annual fees. You’re paying for the ability to borrow money, which doesn’t make a lot of sense.

There are some situations when paying the annual fee can make sense, such as travel credit cards that offer valuable enough perks to offset the fee.

But this is a more advanced topic than this article has space to cover. If you want to learn more, check out my friend Trav’s site Extra Pack of Peanuts.

Late Fee

If you don’t make the minimum payment on time, your card issuer can charge you a late fee. There are laws in place to limit these, but obviously no amount of late fee is good.

You can find the late fees in your credit card agreement. To avoid paying late fees, set up autopay for your card. Not only will this help you avoid fees, but it will also save the time you’d spend manually paying your card each month.

Cash Advance Fee

A cash advance is when you use a credit card to withdraw cash from an ATM or bank. It’s essentially an instant cash loan.

While there might be some truly desperate circumstance in which you need to do this, just don’t. You’ll pay insane fees, you’ll pay higher interest than for purchases, and interest will start accruing on cash advances immediately (unlike purchases, which typically have a grace period).

Still interested in getting a credit card now that you know the dirty details? While all of this can (and should) scare you, it’s simple to use credit cards responsibly. You just have to play the game instead of letting the game play you.

And the first part of “playing the game” is understanding the most important factor in getting a credit card: your credit score.

Your Credit Score: The Key to Getting a Credit Card

Odds are, you’ve seen ads talking about how to raise or check your credit score. But what is a credit score, and why does it matter?

A credit score is an easy way for lenders to determine how risky it is to let you borrow money. Instead of reviewing every minute detail of your financial history, lenders can request this number from a credit reporting agency and quickly determine if they should lend to you.

There are three main credit reporting agencies: TransUnion, Equifax, and Experian. Different lenders will use scores from different agencies, but they’re all basically the same for our purposes.

So what information do these companies use to calculate your credit score? It all comes down to five factors:

1. Payment History

First and most important, there’s your payment history. A credit reporting agency looks at all the loans you’ve ever taken (student loans, auto loans, credit cards, mortgage, etc.) and sees how consistent you were in making payments.

If you’ve ever missed a payment or declared bankruptcy, that will seriously hurt this part of your score. Which is especially bad news since payment history accounts for 35% of your score — more than any other factor.

This is why it’s so important to always make at least the minimum payment on time. Missing a payment can set your credit score back for years.

2. The Amounts You Owe

The next factor that credit reporting agencies look at is the amount you owe.

This includes your total debt across all types of accounts, including mortgage, student loans, personal loans, and credit cards. And it also includes what’s called your “credit utilization,” the percentage of your available revolving credit that you’re currently using.

In general, you should try to keep your credit utilization below 30%. So if you have $2,000 in total credit available to you across all your credit cards, try to keep your balance below $600.

The amounts you owe account for 30% of your score, meaning that paying down debt (particularly credit card debt) can greatly improve your score overall.

3. Length of Credit History

In theory, the longer a person has responsibly used credit, the less of a risk they are to a lender. Because of this, the length of your credit history accounts for 15% of your credit score.

All things considered, a longer credit history is better. But assuming you’re keeping the other aspects of your credit score in good standing, you shouldn’t worry too much about your length of credit history. Only time can improve this part of your score.

4. New Credit

From research and experience, lenders have figured out that someone who opens a bunch of new lines of credit at once is probably a bigger credit risk. Therefore, your amount of new credit accounts for 10% of your credit score.

While this is less of an important factor than some of the others, it’s still wise to avoid opening a bunch of new credit cards at once. Otherwise, a lender might perceive you as too risky.

5. Credit Mix

This final factor looks at the different types of accounts you have, including credit cards, student loans, auto loans, and mortgages.

More variety is theoretically better, as it signals that you know how to manage different types of credit responsibly.

But since this only accounts for 10% of your score, don’t worry too much about it. You’re better off focusing your efforts on maintaining a consistent payment history and keeping your credit utilization under 30%.

Now that you understand how your credit score works (and how to improve it), we can look at the process of getting a credit card.

How to Get a Credit Card in 3 Steps

So you’re itching to get your hands on a credit card. How do you actually do that? The whole process boils down to three simple steps:

1. Check Your Credit Score

Before you go out and apply for a credit card, it’s best to see if you’ll be able to qualify in the first place. To do this, you should check your credit score. These days, there are many ways to check it for free and online. Your bank may even have a tool you can use.

If you’re not sure where to start, however, our top recommendation is Credit Karma. Just download their app or visit their website, answer a few questions, and see your score for free.

But what are you supposed to make of this score? What’s a “good” score, and what’s a “bad” one?

Exact evaluations of your credit score will vary based on the lender. But in general, here’s what different credit score ranges mean, according to Experian:

  • 300-579: Poor
  • 580-669: Fair
  • 670-739: Good
  • 740-799: Very good
  • 800-850: Excellent

If you’re new to credit, your score probably won’t be super high. It’s unlikely to be “Poor” unless you’ve made some financial mistakes, but it’s also unlikely to be “Good” or “Very good.”

This is a good case for having at least one credit card that you regularly use and fully pay off. The moment you get a credit card, you have a chance to start increasing your credit score.

Each on-time payment and each month you have the card will boost your score. And a higher score will make it easier to do things down the road such as buy a house.

But we’re getting ahead of ourselves. You need to get a card first. And the next step is to comparison shop.

2. Compare Credit Cards

If you’re over 21, then you probably get credit card offers in the mail all the time. But you shouldn’t apply for any old credit card. You need to do your research to find a card that’s right for you.

When you’re starting out, this typically means finding a card that:

  • You can qualify for with a low(er) credit score
  • Doesn’t charge annual fees

If the card also offers some perks such as cash back or no foreign transaction fees, great. But when you’re starting out, the goal is more to start building a good credit history. You can worry about fancier cards down the line.

Also, if you’re under 21, then it can be a bit trickier to get a credit card. It’s still possible, but you may need to provide additional income verification info or proof of permission from a parent/guardian.

To compare credit cards, we recommend CreditCards.com. It lets you easily sort cards based on credit score, fees, and benefits.

3. Apply for the Card

Once you’ve found a card that fits your needs, it’s time to apply. You’ll likely be shocked at how easy this is. All you have to do is provide some basic info:

  • Legal name
  • SSN
  • Date of birth
  • Annual income
  • Housing information (do you rent or own, and how much do you pay for housing each month?)

If you apply online, you’ll likely receive a decision in a few minutes. If the card issuer approves your application, they’ll mail you your new card within a few days.

Now that you have your card, however, you have a big responsibility. So let’s finish by looking at some common credit card mistakes (and how to avoid them).

Common Credit Card Mistakes (and How to Avoid Them)

If you don’t use a credit card responsibly, there’s no point in having one. Here are some common credit card mistakes you should avoid at all costs:

1. Paying Interest

If you pay even a cent of interest on your credit card, then it isn’t worth it. While interest is how credit card companies make money, that doesn’t mean you have to pay any.

Your goal is to be what credit card issuers call a “deadbeat” — a person who pays their balance in full each month.

As long as you pay the full balance each month, you’ll be able to take advantage of your card’s “grace period.” The grace period is the time between the end of your billing cycle and your payment due date.

During this time, you won’t accrue any interest on new purchases. And as long as you pay the full balance during the grace period or on your due date, your card company won’t charge interest.

However, if you slip up one month and pay less than the full balance, your card issuer can get rid of your grace period. So always, always, always pay the full balance each month.

2. Missing Payments

I mentioned this already, but never miss a payment on your card. If you do, it could severely harm your credit score.

If you miss a payment by just a couple of days, you shouldn’t be too worried. You’ll still have to pay a late fee, but credit card companies typically don’t report late payments to credit bureaus unless the payment is more than 30 days late.

However, there’s an easy way to be sure your payments are never late: set the card’s full balance to autopay each month.

3. Overspending

Does using a credit card cause you to spend more money than if you paid with cash or a debit card? Some research suggests that the answer is yes.

A 2000 experiment from researchers at MIT found that people were willing to pay up to twice as much for items in an auction if they used a credit card as opposed to cash. Crazy, huh?

And in your daily life, you may find that having a credit card causes you to overspend. Because you don’t get the bill until the end of the month, it can be harder to mentally account for what you’re spending.

Thankfully, there are a couple of ways to mitigate this. First, use a tool like Mint to regularly monitor your spending. Often, simply seeing how much you’re spending is enough to make you cut back.

If that’s not enough, however, then don’t use your credit card for everyday spending. Put a couple of recurring bills on it, set it to autopay, and then put it in a drawer and forget about it. This way, you still get to build your credit without the temptation to overspend.

Looking for more ways to save money? Check out these tips.

So Should You Get a Credit Card?

When all is said and done, is getting a credit card worth it? I think the answer is yes, as long as you:

  • View credit cards as a tool to build credit
  • Pay the balance in full each month
  • Don’t overspend

If you’re worried that you aren’t responsible enough to use a credit card, then you have a couple of additional options for building your credit.

Get a Secured Credit Card

First, you can get a secured credit card.

These cards require you to pay a refundable security deposit upfront. The security deposit determines the amount of your credit limit. This way, you can never actually spend money you don’t have. Your credit line is “secured” with your deposit.

Besides these unique features, a secured credit card works just like any other. This makes them a great tool for building your credit if you have a limited credit history or are worried about overspending.

Report Your Rent Payments to Credit Bureaus

Second, some rent payment systems will also report your payments to credit bureaus, helping you to build your credit.

You’ll need to ask your landlord if they use such a system (or are willing to do so). But if you can get them to do it, then it’s an easy way to build credit without taking on any debt.

Credit Cards Are a Tool

I hope this article has shown you how credit cards work and how to use them responsibly. There’s a lot of jargon that credit card companies will try to confuse you with, but now you know how to see through all of that.

Of course, building good credit is just one aspect of smart personal finance. You can also benefit from increasing your income. To learn how to do that, check out our guide to making extra money online.

Image Credits: handful of credit cards