How Credit Cards Work (+ how credit card companies make money)
Aren’t credit cards bad? Don’t they trap people in a ton of debt? Not quite. Credit cards are a tool. When used the right way, they can help you build wealth. If used irresponsibly, they can trap folks in a cycle of debt that’s very difficult to break. Here’s how credit cards work.
Let’s go through them, top to bottom.
Table of Contents
Credit Card Terminology
Here’s a quick list of some of the most common terms.
Annual Fee
Some, but not all, credit cards come with an annual fee. This is exactly what it sounds like. You pay a yearly fee just for having the card. Usually, the fee is waived for the first year that you have the card. The fees range from $30 to $500 per year.
Annual Percentage Rage
You’ll usually see this abbreviated as APR. This is the interest rate you pay on the purchases you make. You can avoid paying interest if you pay off your full credit card balance each month.
Card Member Agreement
Your card member agreement lists all the card’s terms and conditions. It’s very important to read the fine print on the card member agreement before you apply, as some cards contain “hidden” fees that aren’t always immediately apparent on the card issuer’s website.
Credit Limit
Sometimes called a credit line, this is how much you can charge on the card. For example, if your card has a $5,000 limit, you can only make up to $5,000 worth of purchases.
Grace Period
This is the time period between when the credit card company issues your statement until your payment due date. Grace periods vary, but they’re usually somewhere between 20 and 25 days. If you pay your card off in full during the grace period, you’ll pay no interest. This essentially turns your credit card into a free short-term loan.
Variable Interest Rate
Credit cards can come with a fixed interest rate, which typically doesn’t change, or a variable interest rate. If your card has a variable interest rate, the rate can go up or down based on the index rate, which fluctuates based on how the U.S. economy is performing.
It’s quite common for credit cards to come with a variable interest rate. You can check any card issuer’s variable interest rate on the Consumer Financial Protection Bureau (CFPB) website.
How Credit Card Companies Make Money
Credit card companies make money by charging you interest on the purchases you make. They want you to carry a balance. The higher your balance, the more money they make as long as you don’t default.
If you pay off your total credit card bill every month before the payment due date, you won’t pay any interest at all. Used this way, credit cards work almost like debit cards. You make purchases with your credit card all month. Then you pay down the balance and the money comes out of your checking account. By paying it off in full every month, you won’t pay any interest or fees.
The reality is that most people don’t pay off their entire credit card bill each month, the average American has $6,354 in credit card debt.
Credit card companies know that the majority of cardholders can’t pay off their bill each month. In fact, card issuers count on this being the case.
Every credit card has a minimum payment you must make to keep your account in good standing. The minimum payment varies based on your total balance, as well as any fluctuations in your card’s interest rate.
While making the minimum payment will keep your account in good standing, it’s usually a bad idea to only male a minimum payment. Your balance continues to accrue interest from month to month. This is great for the credit card company, but not so great for you.
Let’s say you have a credit card with a $5,000 balance and an APR of 18%. If you only make a minimum payment of $100 each month, it’ll take almost 8 years and $4,311 in interest to pay it off. You’d be paying almost in interest as your original balance. That’s like walking around and insisting that every store charges you double just for the fun of it.
Remember this rule: paying the minimum balance means you pay double for everything.
Always pay your cards off in full every month. And if you can’t, pay as much as you can.
Different Types of Credit Cards
There are several different types of credit cards available. Some are marketed toward people with excellent credit, while others are designed for those who want to repair a bad credit score.
You can also find cards that offer lucrative rewards, as well as those made specifically for transferring a balance from a high-interest card. Here are a few of the most popular types of cards available.
1. Standard Credit Cards
Standard credit cards are basic cards that lack frills or rewards. These are the everyday run of the mill credit cards used to charge purchases and then pay them off.
Many consumers like standard credit cards because they’re straightforward and uncomplicated. If you don’t want to keep track of rewards points, and you’re not interested in spending a certain amount to trigger cash back bonuses or other perks, a standard credit card might be a good fit for you.
2. Rewards Credit Cards
This is where stuff gets fun. Once your credit is good enough, you can get a rewards card. There’s a lot of different types but in general, you get 2% back on anything you spend. Sometimes it’s straight cash back, sometimes it’s miles or points that can be redeemed for travel. Some of them also come with perks like free hotel room upgrades, airport lounge access, and free airline companion tickets.
At the very least, get a good cash back card. And if you like to travel, get a good travel rewards card. You’ll travel like a VIP for free.
3. Secured Credit Cards
Secured credit cards are typically marketed toward people who need to rebuild their credit. With a secured card, you must pay a security deposit up front. This acts as collateral for the lender, who can keep your deposit if you end up defaulting on the card.
In most cases, your security deposit is also your credit limit. For example, if your card requires a $200 security deposit, you can only charge up to $200 on your card.
You might be wondering why anyone would want a card with these kinds of requirements and restrictions.
One of the biggest draws of secured cards is that the card issuer reports account history to the three major credit bureaus: Experian, Equifax, and TransUnion. If your credit score is poor, making regular, on-time payments on a secured credit card can help reestablish you as a responsible credit user.
They’re also available to folks that can’t get any other credit card because of a credit history that’s too low.
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4. Prepaid Cards
As the name indicates, prepaid credit cards require users to load money onto their card before using it. Technically, these aren’t credit cards. Instead, they function more like a debit card.
In some cases, people use prepaid cards because their credit score is too low for them to qualify for a regular credit card. They might also use a prepaid card if they don’t have a bank account.
5. Balance Transfer Credit Cards
Balance transfer credit cards offer consumers a way to shift their credit card debt from one credit card to another. In most cases, people do this to save money on interest. For example, if they have a significant balance on a high-interest credit card, they might want to transfer that debt to a card that offers more favorable terms.
In many cases, balance transfer cards offer attractive introductory terms as a way of getting people to sign up. It’s common for them to give cardholders 12 months of 0% APR.
It’s important to be careful with balance transfer cards, however, because interest rates often skyrocket once the promotional or introductory period ends.
Applying For Credit Cards
These days, applying for a credit card is usually an easy and straightforward process. Because most applications are available online, you can check out the requirements before submitting your information.
Be wary about submitting too many applications at once. In many cases, applying for a credit card causes the credit card company to pull your credit, resulting in a hard inquiry on your credit report.
While one or two hard inquiries won’t affect your credit score much, accumulating too many of them can drop your score for several months. When you apply for too much credit all at once, potential creditors can view this as a red flag that you’re in desperate need of extra cash.
This is why you should do your research and only apply for cards you really want. Make sure you review the qualification requirements so you don’t submit an application for a card you most likely won’t get. For example, if a card requires a 750 credit score and your score is just above 600, it’s probably best to focus on cards with less stringent requirements.
It’s also a good idea to never apply for new credit cards right before you apply for another major loan like a mortgage or a car loan. You want your credit score as high as possible for those applications.
Credit Scores and Other Factors for Getting a Credit Card
Your credit score is by far the most important factor in determining whether you qualify for a credit card. Credit card companies want a snapshot of how you use credit. And your credit score is a three-digit number that gives them a quick assessment of how well you’ve handled credit in the past.
However, other factors play a role, too. This is why someone with an excellent credit score might still get turned down for a credit card, whereas another person with a mediocre score could qualify. Generally, someone with an excellent credit score probably won’t have much trouble getting approved for a credit card.
In addition to your credit score, credit card companies also consider the following factors when deciding to approve you for a card:
- Payment History – Your payment history makes up 35 percent of your FICO credit score, making it the most important factor in your score.
- Credit Utilization – This is the ratio of how much available credit you have versus how much you’re currently using. Your credit utilization makes up 30 percent of your FICO credit score.
- Length of Credit History – Your credit history is a measure of how long you’ve used credit. This factor accounts for 15 percent of your credit score.
- Credit Mix – Potential creditors also want to know how much variety of credit you have. In other words, having just credit card debt as your only form of debt can hurt you. Your credit mix makes up 10 percent of your credit score.
- New Credit – Too much new credit, which usually comes in the form of hard inquiries, can hurt your credit score. This factor accounts for 10 percent of your score.
Should you get a credit card?
As long as you can use the credit card responsibly, I highly recommend getting one. They’ll help you build wealth and travel in style.
Follow these rules and you won’t have any trouble:
- Always pay your credit cards in full every month.
- Don’t carry more credit cards than you can comfortably manage, 1-2 cards is a good starting point.
- Once you have a high enough credit score, get one solid rewards card. Use this for all your spending.
In return, you’ll get cashback, points, or miles. Possibly perks while traveling. And extra protection for travel, purchases, and identify theft. They’re a great deal if you follow the rules above.
Frequently Asked Questions about How Credit Cards Work
How do I avoid credit card debt?
To avoid credit card debt, you can try to pay off your balance in full each month, avoid overspending, and use your credit card only for necessary purchases. You should also consider choosing a credit card with a lower interest rate and fees, and avoid taking out cash advances.
What are cash advances?
Cash advances allow you to borrow cash against your credit card balance. Cash advances typically come with higher interest rates and fees than regular purchases, so they should be used sparingly.
What is a minimum payment?
The minimum payment is the smallest amount you can pay each month on your credit card bill to avoid late fees and other penalties. However, paying only the minimum payment can result in carrying a balance and accruing interest charges.
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