Understand the benefits of credit cards, the types available, and how to use them effectively.
The Top Line
- Credit cards are issued by banks and allow you to spend up to a predetermined amount known as your “credit limit.”
- You are expected to pay what you owe at the end of each month and if you do so there is no penalty. If you don’t, then you will owe a late fee and interest.
- Banks make money through credit card annual fees and when you don’t pay your monthly balance in full and pay penalties and interest.
- Credit cards offer a variety of benefits such as sign-up bonuses, cash and travel rewards, and fraud protection.
- Depending on your objectives, there are a number of benefits that credit card companies offer as rewards. Some are aimed at specific types of customers such as business travelers or students. Others offer better rewards based on your credit score.
What Are Credit Cards?
Made of plastic or metal and embedded with a security chip, credit cards are issued by banks and allow you to make purchases or pay bills using a line of credit from the bank. After making the purchases in-person or online, you pay the bank back at the end of the billing cycle in full or over time with interest.
Using Credit Cards
When you apply for a credit card, the bank will take into account your credit history looking at what accounts you currently have open, how you’re using those accounts, and how you’ve managed credit in the past. The bank will provide you with a credit limit for the credit card. This is the maximum amount that you are allowed to spend.
Once your application is approved, you will be able to start making purchases. For in-person purchases, you will swipe or tap your card using the security chip. The merchant will get approval for your purchase from the bank. There are different types of credit cards available from Visa, Mastercard, Discover, and American Express. The merchant pays Visa, Mastercard, American Express, and Discover a small percentage whenever you use your card to buy something. While this might seem like a bad deal for the merchant, it actually results in customers spending more money with them since credit cards are so easy to use.
After making purchases, you will have a 25- to 30-day grace period in which you may pay the balance in full. If you do so, you will not have to pay any extra fees or interest. This is the best way to use credit cards because you will only pay for what you spend. If you don’t pay the balance in full, you will have to pay it over time. By doing so, you will incur interest charges.
Your credit card accounts will appear on your credit report and affect your credit score. Paying your bill on time and keeping a limit on how much of your credit you utilize will help build your credit score. Over time, this will have an impact on your financial future and how much you may borrow and how much it will cost to borrow for other items such as a car or house.
What Are the Advantages of Using Credit Cards?
While credit cards should be used with care, they offer a variety of advantages including:
Sign-up bonuses. When you are approved for a card, you may receive a one-time cash or store credit bonus or travel credit. Or banks may provide a bonus of airline miles or hotel points.
Rewards. On an ongoing basis, you may receive rewards such as a percentage of cash back or travel credit, airline miles, or hotel points.
Improving your credit score. Obtaining and using credit cards helps you build your credit score. The amount of credit that you use and payments that you make are reported to the credit bureaus and are used to determine your credit score. In turn, your credit score is used to help you obtain larger loans such as auto and home loans.
Fraud protection. By using a credit card, the bank acts as a middleman between you and the merchant. If you are charged for a good or service that you don’t receive, you can dispute the charge with the bank and get the charge reversed. Unlike with cash or with a debit card, you don’t lose access to the money in dispute.
0% APR period. Some credit cards offer a limited term in which balances have a 0% APR. This means that during this time period, you don’t pay any interest on the balance which makes the debt less expensive to pay off.
Adjustable payment period. Credit cards allow you to manage when you pay for purchases. This can be helpful if, for example, your paycheck will come in at the end of the week but you need to buy groceries today.
Retail and other benefits. Besides rewards, credit cards may offer other benefits such as extended warranties, theft protection, travel insurance, car rental insurance, and more.
What Are the Different Types of Credit Cards?
There are a variety of different credit cards, each with their own benefits.
Cash rewards: As their name suggests, these provide a percentage of cash back for every purchase. These cards are best if you pay off the balance each month.
Travel: Travel cards give rewards such as airline miles or hotel loyalty points. Some provide general travel benefits such as a percentage of what you spend that can be used for travel or credits for travel expenditures.
Rewards: There are other reward cards such as store-affiliated cards that provide free shipping, access to cardmember sales, and store credit based on your purchases.
Business: Credit cards may be designed for business owners and employees.
Balance transfer: Some cards offer the best rates for balance transfers.
0% APR: Some cards offer a limited-time 0 percent interest on balance transfers or new purchases.
Student: College and university students are eligible for student cards, which are designed for those who don’t yet have extensive credit histories. If you are younger than age 21, you will need to have income of your own or a co-signer.
Secured: For these types of cards, you will need to provide a security deposit and usually may spend up to the amount of the deposit. When you close the account, the deposit is returned to you. The bank may put the deposit into an account that earns interest such as a CD.
Average or poor credit. If you have average credit, you will want to pay attention to the annual fee and interest rate. For poor credit, typically the best solution is a secured credit card. This is a card in which you pay a security deposit and which is usually better than an unsecured credit card in which you don’t supply a security deposit.
Unsecured: These types of credit cards typically charge higher fees that are not returned to you after you close the account.
How Are Credit Cards Different Than Other Types of Cards?
Credit cards are different from other types of cards such as debit cards or prepaid debit cards. When you make purchases with debit cards, the amount is immediately deducted from your bank account. There is no grace period for paying the balance off. Credit cards offer more protections for fraud. On the other hand, debit cards do not incur interest and many of the other fees of credit cards.
Prepaid debit cards are paid for in advance and you may only spend the amount of money that you load onto a card.
What Are the Costs of Credit Cards?
If you pay off the balance on your credit card each month in full, there can be no costs for credit cards. Many have no annual fees, and the banks provide a grace period for paying off the balance in full with no interest.
However, there may be costs for credit cards which may include:
- Annual fee: Many credit cards have no annual fee or an annual fee of about $100. Some with a higher level of benefits charge up to a few hundred dollars.
- Interest: If you don’t pay the balance in the full at the end of the month, you will pay interest on the balance, just as you would with any other kind of loan.
- Late payment fees: If you pay a bill late, you will need to pay a late payment fee.
- Balance transfer fees: If you carry a balance and want to transfer it to a card that has a lower interest rate, the bank may charge a balance transfer fee.
- Foreign transaction fees: Some cards charge a fee when you use the credit card internationally.
Expert Tips for Using Credit Cards
To keep costs low and to use credit cards most effectively, here are some tips to best utilize credit cards:
- Pay bills on time. By doing so, you will avoid late payment fees.
- Don’t spend more than what you have. This will help you be able to pay your bill in full and not have to pay interest.
- Mind your credit card utilization. Aim to keep your balance below 30%. In other words, if your credit limit is $1,000, spend a maximum of $300 on your card.
- Minimize card applications. Each time you apply for a credit card, it is recorded on your credit report. Too many applications have a negative impact on your credit rating.
- Keep on top of your charges for budgeting. You want to only spend what you have so that you won’t be burdened with heavy interest payments.
- Watch for fraud. Review your credit card activity regularly to make sure there are no fraudulent charges.
- Improve your credit score by keeping old accounts with no annual fee open. One of the factors that affects your credit score is how long you’ve had your credit cards. By keeping old cards open, this will help your credit score.