How do credit cards work?
Paying with a credit card is basically using borrowed money to pay for things. You are in debt to the credit card company because you are promising to pay the credit card company back. Notice how I say BORROWED, and not FREE. Those that dig themselves into enormous credit card debt usually buy on the notion that the money is free without fully understanding that they will have to pay it back at some point.
The credit limit is the maximum you can spend on that credit card. They can range anywhere from as low as a few hundred dollars to, if you’re credit history is really awesome, unlimited. I’ve got three credit cards, not including department store credit cards, with credit limits of $3300, $7200, and $10,000.
The interest rate is the cost of borrowing the credit card company’s money. It can range anywhere from usually 5% to 26%, maybe even higher. When you hear about how credit card debt is one of the most expensive kinds of debt, it’s because the interest rates on credit card debt tend to be higher than most other kinds of debt. In simple terms, borrowing $100 will cost you $26. That means when you pay back the $100, you actually have to pay $126.
The calculations for interest is actually much more complex than that, but if you pay off your monthly statement balance every month, you won’t incur any interest expenses.
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Which brings us to the minimum payment.
The minimum payment is exactly what it sounds like, the minimum payment needed to keep the credit card company happy. I assume it’s calculated using some asinine formula.
For example, on a balance of $591.82, the minimum payment on my credit card for that corresponding month was $25.00.
As you’ve probably heard, paying only the minimum payment is one of the best ways to keep yourself in debt. If you pay only the minimum payment, it will take years to get out of debt.
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My credit card statement even tells me it will take 2 years to pay off the $591.82 balance making the minimum $25.00 payments.
You pay late, your charged a late fee. Plain and simple. For example, my hubby once ordered a $15 Little Caesars pizza and paid for it using a credit card. Unfortunately, he put it on a credit card that he didn’t use often and completely forgot about it. The next credit card statement came, and he assumed it was $0 and never opened it. The credit card statement after that came, and he decided to open it. Low and behold, the $15 pizza grew to a $100 pizza due to interest and late charges.
Cash Withdrawal Fees and Interest
It’s possible to withdraw cash at an ATM using a credit card, but it’s not usually advisable. Besides the cash withdrawal fee, you’ll pay higher interest on that cash if you don’t pay off the statement balance in full. I once withdrew $80 from an ATM using my credit card to pay for a tattoo because the bank was closed, the tattoo artist didn’t accept credit card payments, I didn’t have my ATM card, and he had already finished the tattoo, so I had to pay him. While I paid the statement balance off in full to avoid the interest charges on it, the cash withdrawal fee was $20, so the $80 tattoo turned into a $100 tattoo. That was my own fault for not checking if he accepted credit card payments before he began.
Balance Transfer Fee
Some people will pay off one credit card using another, which is called a balance transfer. It’s a way to pay less interest on the credit card balance. The correct way to transfer the balance is to move it from the card with the higher interest rate to a card with a lower interest rate, or zero interest rate. There’s usually a transfer fee, either a flat fee or a percentage, or sometimes both.
Some credit cards charge an annual fee, usually anywhere between $25 to $500. The general rule is the higher the annual fee, the more perks you get. Perks like extra credit card point, frequent flyer miles, etc. The $500 annual fee is only worth it if the card holder uses the credit card (and pays it off) so much that the extra perks are worth more than $500. I don’t have any annual fees on my credit cards because I don’t use my credit card enough to accumulate enough of the perks to justify any of the annual fees.
There’s usually an international fee if you charge anything on the credit card in another country. It could be a flat fee or a percentage of the amount, or both.
Credit Card Perks
Most credit cards have credit card perks, usually frequent flyer miles or credit card points.
Frequent Flyer Miles
Frequent flyer miles are extra air travel miles that you can earn for every dollar you spend on the credit card. I don’t know much about them because I rarely fly, but I do know that there is a complicated web of rules and restrictions to redeeming them. Frequent flyer miles are only worth it if you fly frequently have control over booking the flights.
Credit Card Points
Credit card points can be used to pay for items and lower your out of pocket costs. For example, on my Citibank credit card, I earn a point for every dollar I spend. I can either buy items from a long list that Citibank provides me, which includes giftcards to different stores, or I can use the points to pay for stuff when I order from Amazon.com. I’ve used point to pay for my usual consumable items like diapers and toilet paper, and to buy gifts for myself, like books, shoes, and jewelry. It’s more fun when I use the points to pay for shoes and jewelry.
Store Credit Cards
Department store credit cards work the same way as regular credit cards but tend to have much higher interest rates and much lower credit limits than regular credit cards. However, you can only use them at that store (or family of stores). Department stores will also periodically offer enticing sales and deals to get you to sign up for a credit card, like an extra 10% on top of whatever sale is happening if you sign up for a credit card. In my opinion, they are really just the bottom of the barrel credit cards, a starter credit card, if you will.
One of my first credit cards was a department store credit card when I had very little credit history. Once I had some credit history, I got a real credit card and stopped using my department store credit card. I think the store even cancelled my card due to inactivity. The last time I got a store credit card was when I purchased a hot water heater at Home Depot in 2015. I applied for the credit card specifically to get 10% off a large purchase of $500, free installation of the hot water heater, and the interest free introductory period to make interest free payments. I haven’t used it since.
Credit cards are a great way to both improve and mess up your credit score.
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Use them correctly, and you can buy yourself shoes and jewelry for free. Use them incorrectly, and a $15 pizza can become a $100 pizza.