A Credit and Debt Guide: Part 2 – How Credit Cards Work

by Drew Jackson
credit cards

Credit cards can be powerful tools in the right hands by giving a family assistance in making a large purchase or allowing one to rack up travel rewards while doing everyday shopping.  Likewise, mishandling a credit card can have devastating effects not only on your current financial well-being but on your family long-term goals as well.  To navigate the world of credit cards, there are many nuances to consider.  Let’s jump right in and help to answer the common question: How do Credit Cards Work?

Credit Cards vs Debit Cards

When deciding between cards for making purchases, it helps to understand the differences between what is available to you in order to make wise financial decisions.  Both debit cards and credit cards are accepted by the same places and often carry the same card appearance, but behind each card, you will find vastly different terms, services, and fees.

What is a Credit Card?

A credit card is more than just a small piece of plastic in your wallet, but something that allows you to borrow money from a bank to make purchases.  I like to think of a credit card as my banking institution is providing me a small to medium short-term loan.  I emphasize “short-term loan” as the amount borrowed comes with what is known as a grace period of 25-30 days in which you can pay the loan back with no penalties or fees.  After this period of time, if you have an outstanding balance on your loan, you must pay back what is know as interest on top of the money you have borrowed.

Credit Cards vs Debit Cards

Credit Card Pros and Cons

When deciding whether to use a credit card or not, there are many factors that one should consider based on your current financial situation and being able to use the card responsibly.  We want to list a few of the upsides and downsides that one might face that can help to determine if it’s appropriate to use a credit card for your family:

Credit Card Pros:

  • Help build credit. For a student starting college, or an adult looking at giving their credit score a boost, credit cards can be extremely helpful tools for establishing and building credit.
  • Rewards. So many credit cards today offer different incentives such as cash back or reward points that can be spent on travel or gift cards.  Cards like the Citi Double Cash Mastercard (reviewed here by Nerd Wallet) are our family’s card of choice here at Work Parent Sleep due to 2% cash back rewards (1% received for every dollar spent, and 1%  received for every dollar paid off when paying the credit card bill).

Citi Double Cash Master Card

  •  Flexibility. While this can be listed as a pro and a con, credit cards give you the ability to buy now and pay later.  This allows families to make large purchases and spread payments out over time.  This flexibility can be extremely beneficial when you have a household appliance break or need the family car repaired and don’t have the cash on hand to pay for it.  Placing these larger purchases on a 0% APR Credit Card also gives you the best of both worlds.
  • Fraud Protection. We have all heard a horror story of someone’s identity being stolen online and used for malicious credit card purchases; believe it or not, credit cards actually have better federal protections than debit and ATM cards.  With a debit card, anyone making fraudulent charges can drain your actual cash sitting in a family checking or savings account, causing instant loss with generally long waits for receiving refunds of that cash.  In the cases of credit card fraud, although there is short term potential for your credit report to get dinged, your on hand cash funds are not affected at all and you’ll pay a maximum of $50 in the event of fraudulent transactions.

Credit Card Cons:

  • Debt. For a lot of people, overspending is a big risk when having a credit card.  Credit cards give instant access to make purchases that might otherwise not be made because either they weren’t budgeted for or there simply isn’t enough money to purchase today.
  • Interest. Carrying even small balances between statement periods will begin to rack up interest charges that might seem small but accrue over time.  With a high APR on your credit card, these fees can be drastically high.
  • Destroying Credit.  As quick as you built it up, you can also tear it all down.  Missing payments, carrying maximum balances, or opening and closing credit cards too often can all have adverse effects on your credit score.

How to select the right credit card for your family

Whether this is a shared family card for online bill pay to help raise your credit score or an emergency card for those “Honey, the hot water heater exploded and leaked into the basement” times, there are many factors to consider before choosing the right credit card for you:

If your family needs to transfer a balance from an existing credit card

If you currently have a credit card with a high-interest balance and are only making the minimum payments, you are probably cringing when looking at each of your statements and seeing the money flow out of your pocket in interest fees that being given back to the credit card company.  Fortunately, you are in luck, as there are many credit cards that come with low to no transfer fees and a stacked introductory 0% APR on top of that to transfer these balances.  Nerd Wallet has broken down the Best Balance Transfer and 0% Interest Credit Cards of 2017, showing pros and cons along with the best scenarios for using each card.

If your family wants to avoid paying additional annual fees

For some families, there will be a credit card with a rewards plan so appealing that an annual fee is outweighed by the perks of the card, but the majority of families are looking for a credit card with no annual fees.  The Points Guys, who do great work on rewards accounts of all kinds, put together a great breakdown of the 7 Best No-Annual-Fee Credit Cards for 2017.

If your family wants to earn cash back or other rewards

If you are a responsible spender there is no reason you shouldn’t be earning some additional rewards for the shopping that you are doing on a weekly basis.  We covered the Citi Double Cash Mastercard in the pros section of why to have a credit card above.

If your family is in need of making a large purchase and paying it off over time

Sometimes we are faced with large unexpected expenses such as car repairs or replacing a hot water heater.  These unplanned expenses might fall outside of your current budget, and because they can be time sensitive and often required, your credit card can become a great tool.  Finding a credit card with 0% Promotion APR for 12+ months will allow you to use the transaction on your card as an interest-free loan where the purchase can be cut down into payment chunks and paid off over time.

If your family plans on carrying a balance on the credit card from month to month

There are often times when all of our current 0% APR Promotions have run their course, and we are stuck with a credit card balance that we need to pay down over time.  In these cases, you want to pay close attention to your credit card’s current purchase APR and make sure that it is at a percentage your family feels comfortable with.  You can test different balances and interest rates here with this Loan Calculator which should give you a good idea of how much interest you are looking at paying over time.

 

Understanding Credit Card Interest

All credit card purchases are subject to a base interest rate knows as the Annual Percentage Rate or APR.  This can vary between credit cards depending on factors such as your credit score, current income level, and other factors determined by the financial institution you are applying with.  Understanding credit card interest will help you manage your payments and determine in any given situation whether using your credit card is your best option.

 

How is Interest Calculated?

When you receive your credit card you will be provided with an Annual Percentage Rate (APR) that will be applied toward all purchases made with that card.  To better understand how credit card companies charge interest we are going to break that number down.

Interest Rates

Let’s use a typical APR of 14% and a credit card balance of $1,000 for our example scenario.  First, we will take this number and divide it by the number of days in a year, 365.  This gives us what is called our “Daily APR” at 0.038356%.  At the end of each day, your credit card company takes your daily APR and multiplies it against your current balance to come up with your daily interest charge.  On our first day, this is equal to $0.38, so they add that to your current balance giving you a new balance of $1000.38, plus any additional purchases and minus any additional credits or payments.  This process then repeats every day until the end of your monthly statement cycle.  Keep in mind that, on day 2, the daily rate of 0.038356% is being multiplied by your new balance of $1000.38 and not $1000.

If you are looking for an additional breakdown of interest payments by daily, weekly, monthly, or quarterly rates see the following chart:

  • For a daily interest rate, divide your Annual Percentage Rate (APR) by 365
  • For a weekly interest rate, divide your Annual Percentage Rate (APR) by 52
  • For a monthly interest rate, divide your Annual Percentage Rate (APR) by 12
  • For a quarterly interest rate, divide your Annual Percentage Rate (APR) by four.

 

Glossary of Credit Card Terms

Here is a list of some of the most commonly used terms you might stumble across in relation to credit cards.

General:

  • Annual Percentage Rate (APR): The annual percentage rate or APR is the interest rate charged on credit card balances that you will pay over the course of a year.  This rate is provided as a percentage (ex. 14% APR).
  • Card Member Agreement: The credit card member agreement provides the customer with the terms and conditions of the credit card.  This agreement is required by federal law on all credit cards as a consumer disclosure.
  • Credit Line: A credit line is the amount of money that can be charged to your card.  This is a fixed amount that is agreed upon during signup.  This can be increased or extended during the life of your card based on account status, limited missed payments, and salary/income level provided.
  • Due Date: The due date is the date you are required to make your payment.  All credit cards bills have due dates, and failing to make a payment by this date will force you to be charged what is know as a Late Fee.
  • Grace Period: A grace period–usually 25-30 days–is the period of time in which you can pay your credit card balance in full, avoiding any interest fees.
  • Minimum Payment: The minimum payment is the lowest amount of money that is required to pay towards your credit card statement in any given month.  For more information on how the minimum payment is calculated please see your credit card’s terms and conditions.
  • Secured Credit Cards: Secured credit cards require collateral towards the account, generally in the form of a cash deposit in order to be approved.  These cards are usually tailored towards people with no credit or poor credit.
  • Unsecured Credit Cards (typical): Unsecured credit cards are the most common type of credit card.  There is no collateral necessary to open an account.  You qualify for these cards based on credit history, current financial strength, and earning potential.

Rates:

  • Fixed Rate: Fixed interest rate cards are considered the best and most secure card for all practical purposes.  Fixed rate means that the interest rate will not change unless there are special circumstances where the issuer has decided to change the rate.
  • Introductory Rate: Introductory rates allow cardholders to enjoy several months or billing cycles with low or no interest on certain balances.  This gives applicants with good or excellent credit scores the ability to take advantage of these rates on new cards.  Introductory rates must last at least six months, but may be longer by law.  For more information on this, see Part 4 of our A Credit and Debt Guide for Parents: 0% APR Credit Card Promotions to the Rescue (COMING SOON).
  • Variable Rate: Variable rate cards are tied to certain indexes (such as the prime rate, T-Bills, LIBOR, etc.) and can go up or down depending on what direction the index goes.  These are generally viewed as riskier due to the fact that your credit card rate could double overnight.

Fees:

  • Annual Fee: An annual fee is a standard fee you pay annually for using certain credit cards.  Generally, this fee is associated with credit cards providing larger rewards programs and benefits.
  • Balance Transfer Fee: A balance transfer fee is charged when you transfer debt from one credit card to another.  Balance transfers can often be very beneficial to the credit card user, based on their current credit card’s APR.  On average, you can look at paying between 3% to 5% of the total amount transferred onto the new card.  Many credit cards offer a 0% APR promotion for a limited amount of time, generally one year or more.  We discuss this in-depth in Part 4 of this series, 0% APR Credit Card Promotions to the Rescue (COMING SOON).
  • Cash Advance Fee: Certain credit cards allow you to use your credit card to take cash out of the ATM.  These withdrawals come with what is know as a cash advance fee of between 2% to 5% of the total amount borrowed.  On top of this fee, you can also expect to see a standard ATM fee also apply.  Some cards even charge higher interest rates on cash advances as opposed to standard purchases.
  • Finance Charge: Once your 0% APR promotion expires, a finance charge will be levied on the account for any balances that are carried over between statements.  The easiest way to avoid these charges is to pay your balance in full each month prior to your statement deadline.
  • Foreign Transaction Fee: When traveling overseas or abroad, most credit cards are subject to a foreign transaction fee for all purchases made outside of your home country.  This fee ranges between 1% to 3% of the purchase amount.  There are specific travel credit cards that many providers offer that will waive these fees.
  • Late Fee: A late fee is charged when a minimum payment is not made by the statement due date.  The fee can be in the neighborhood of $25 to $45 but you will still be required to pay your remaining balance as well.
  • Over-the-limit Fee: Similar to overdraft fees on a checking account, credit cards will allow you to complete charges that place you over your credit limit and assess what is known as an over-the-limit fee on your account.
  • Returned Payment Fee: A returned payment fee is charged after a check submitted for payment towards the balance of your credit card account bounces or a bank account you have established as your source for automatic payments declines for insufficient funds.  This fee varies but generally is around $35.

WPS SERIES GUIDE FOR: A Credit and Debt Guide for Parents

Part 1: Owning Your Credit and Debt
Part 2: How Credit Cards Work
Part 3: Building Your Credit (COMING SOON!)
Part 4: 0% APR Credit Card Promotions to the Rescue (COMING SOON!)
Part 5: How Do I Get Out of Debt? (COMING SOON!)
Part 6: Managing Your Money and Bills (COMING SOON!)
Part 7: Understanding Your Credit Score (COMING SOON!)
Part 8: How to Make Credit Cards Work for You (COMING SOON!)

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