Whether you’re new to the credit card world or a seasoned participant, it’s crucial to have a good understanding of what credit cards are and how they work. Credit cards may seem like just another form of payment for everyday purchases. In reality, there’s more than meets the eye when it comes to credit cards.
Credit cards can be used in many positive ways to improve your credit and allow you to make large life purchases. If misused, they can put you in a tough position that will require some time and patience to resolve.
A Brief History of Credit Cards
When you think about how currency has changed over the centuries, it’s quite astounding to think how far it’s come. Looking back in time as far back as 9000 B.C., currency took many forms from bronze and copper cowrie shells to Native American stringed wampum beads.
Fast-forward a few thousand years and historians explain that merchants in the 1800s often used items called credit coins and charge plates to offer local farmers and ranchers as a form of credit. These coins and charge plates acted as a placeholder until they collected profits from harvests.
Credit cards as we know them came about in the 1950s and 1960s when banks found value in providing credit to everyday consumers. During these years, the major players in the credit card industry like Visa and MasterCard were founded.
Credit cards rapidly gained popularity and to this day, continue to have major advantages over all other forms of money. They’re small and easily portable, rather secure, and have no intrinsic value. It’s just a piece of plastic, right? But above all – credit cards allow you the leniency to spend now and pay back later.
Credit Card Basics
Today, credit cards open up a new world of buying power. In order to realize how they can help you, it’s vital to understand that credit cards are not a form of income or wealth.
Credit Cards Can Be a Form of Debt
Let’s say that you get a letter in the mail saying you are pre-approved for a credit card. You go onto the website listed in the letter, apply for a credit card, and are approved. You receive your new credit card in the mail and are told that your credit limit is $5,000.
Unfortunately, you are not $5,000 richer and that money is not technically yours. It is quite the opposite; credit cards can be a form of debt. When you apply for a credit card, lenders review your credit report to determine your creditworthiness and use the information therein to decide to offer you funds in exchange for repayment plus interest.
What Happens When You Get a Credit Card
When you get a credit card and make a purchase, your account details are forwarded to the merchant’s bank. The bank then gets approval from your credit card company or network to proceed with the transaction. Once the card issuer verifies your information, the transaction is either approved or declined.
Once the transaction is approved, the purchase amount is deducted from your available credit. The balance on your credit card statement will reflect whatever you spend during the billing cycle. Each billing cycle is typically one month long.
There is a grace period from the time you make a purchase on your credit card to the due date that is listed on your statement. This due date usually falls on the same day each month.
If your due date comes around and you pay off your entire balance, you will not be charged any fees. If you do not pay the entire balance, you will be subject to an interest charge; meaning you now owe the rest of your balance plus an additional fee.
Many people argue that any form of debt, including credit cards, should be avoided. However, a credit card can be a useful financial tool when you know how to use it correctly.
Benefits of Having a Credit Card
You may be wondering what the benefits of having a credit card are. While credit cards can be a form of debt, responsible use can help you improve your credit, help in emergencies, and offer you rewards that may prove to be worthwhile.
1. You Can Improve Your Credit Score
When you apply for a loan, buy a home, or rent a house or apartment, your credit score plays a huge factor. In order to be able to make large financial decisions, it’s important that your credit score is in good shape.
There are five factors that make up your credit score:
- Payment History
- Length of Credit History
- Credit Mix
- Credit Utilization
- New Credit
When it comes to credit cards, they can play a huge role in several of these factors that make up your total score. Here are a few examples of how having a credit card can boost your score.
Good Payment History Can Increase Your Credit Score
Your payment history accounts for 35% of your overall credit score. When you have a credit card and pay on time each month, this can be an enormous help to your credit score. Even if you only pay the minimum balance due, your payment will still be on time.
Many people take advantage of the auto-pay feature that comes with credit cards to make sure they never miss a payment. Once you establish a history of making payments on time, your score will go up and lenders will see that you’re consistent and responsible with your money.
The Longer You Have a Credit Card, the Better Your Score Will Be
Another aspect that makes up about 15% of your credit score is the length of your credit history. This refers to the record of your debts, payment history, and other public records.
The length of your credit history begins when you get your first credit card or take out your first loan. Having a credit card and keeping the account open is an easy way to keep your credit score healthy.
All in all, credit cards can be a huge help in every aspect of your credit score. As long as you use a credit card responsibly, lenders will see that you’re able to manage your money well. As a benefit, you will be able to qualify for better loans, get lower interest rates, and be able to have more options for housing.
2. Credit Cards Help In Emergency Situations
In the case of an emergency, having access to quick funds can be a life-saver… literally! Whether that be for an expensive medical bill that isn’t covered by insurance, unexpected car troubles, or anything else that life might throw your way.
There are even credit cards like CareCredit that are specifically intended for medical purposes and offer deferred interest payment options. When you make a large medical purchase with the card, many businesses offer promotions to where you don’t have to pay any interest for 3,6, 12, or even 18 months.
You can never predict an emergency, so having credit available to you for when you need it can be incredibly valuable. Expecting the unexpected can also help you decide on what credit cards best suit your needs and lifestyle.
3. You Gain Access to Rewards
Some credit cards offer rewards that can be worthwhile. For example, many credit cards offer redeemable airline miles that accrue when you use the card. Rewards also include discounts on shopping purchases, hotel rooms, and much more.
It all depends on what you value and what you would get the most out of. Oftentimes the rewards that come with your credit card can save you money that you wouldn’t be able to save if you were using a debit card.
Downsides to Having a Credit Card
It’s important to keep a level head when exploring the world of credit cards. Yes, they are helpful in many ways when used correctly, but they can also harm you financially if mismanaged.
1. There May Be Costly Interest Fees
It’s important to understand that credit card companies are for-profit. They make money from the fees they charge merchants when you use your credit card to buy something. They also make money from the interest fees they charge you.
What is Interest?
In simple terms, interest is what the credit card companies charge you for allowing you to borrow money from them. This is commonly referred to as the annual percentage rate (APR).
For most credit cards, the only time you will have to pay interest is if you don’t pay your bill in full each month. So if you have a balance going into the new billing cycle, you will have to pay interest on your balance.
Understanding Varying Interest Rates
There are varying interest rates that come with credit cards. That’s why it’s so important to keep interest rates in mind when shopping for a new credit card. Choosing a credit card with a reasonable APR can save you hundreds if not thousands in the long run.
According to the Federal Reserve, the average interest rate on a credit card in the U.S. during the first quarter of 2021 was 15.91%. So before you apply for a credit card with an interest rate of 26.99%, you may want to shop around for a better rate.
It can be somewhat confusing seeing a percentage rate and figuring out how much you will be charged if you don’t pay your balance in full each month. We have an article here with more information on how the rates are calculated.
How Interest Fees Can Become Troublesome
Letting interest accrue on your credit card is a dangerous game. Interest can build on top of interest, and the next thing you know you’ve reached your credit limit and have to deal with more interest on top of that.
When you’re repaying credit card debt, interest fees can throw a wrench into the works and stifle your progress. Oftentimes if you’ve maxed out your credit card and only pay the minimum payment each month, the interest charges on top of that can make it seem like you’re not getting any closer to paying it off.
2. Credit Cards Can Make It Easy to Overspend
Another drawback to having a credit card is the potential to overspend. If you’re unable to pay off your balance each month, interest fees will accrue and you will owe even more money. Remember that a credit card should never be considered as income.
According to a study done by Experian in 2020, the average American has a credit card balance of $5,897. That is a huge amount! Before you dive into getting a credit card, be cognizant of how you spend your money.
If you know where your money is going and how you’re spending it, you can set yourself up for success and avoid overspending.
3. Poor Management Can Cause a Negative Impact on Your Credit Score
Just as much as credit cards can help you improve your credit score, they can also harm your credit score. Each month, your credit card issuer reports information concerning your card use to the three major credit bureaus:
If you carry a high balance on your credit card, this will reflect negatively on your credit report. It tells lenders that you do not manage your money responsibly since you carry a high percentage of debt. Also, if you make credit card payments late or miss them altogether, lenders will see that as inconsistent and your score will drop.
Now that you have a good base of knowledge when it comes to how credit cards work, it’s time to explore the many options out there for you.
Unsecured Vs. Secured Credit Cards
There are two types of credit cards commonly referred to as unsecured and secured. They are both lines of credit, but they are different from each other in several ways. If you’re wondering which type you would benefit from more, here’s a breakdown.
What Are Unsecured Credit Cards?
Unsecured credit cards are the most common type of credit card you’ll find out there. When you’re approved for an unsecured credit card, the debt on the card is not secured by collateral. Instead, you provide your signature promising to pay back any debt that you owe to the lender.
Lenders are more likely to approve people that have a decent credit history for an unsecured credit card. If you’re just starting out or have a credit history that needs some repair, a secured credit card may be a better option.
What Are Secured Credit Cards?
Secured credit cards, as you may have already guessed, are lines of credit that are backed by collateral. When you open an account, you will make a cash deposit that is equal to the credit limit. So if you deposit $600, your line of credit will be $600.
Secured credit cards are great because their approval rate is much higher. If you don’t qualify for an unsecured credit card, this may be a great option for you. Secured credit cards are proven to help build (or rebuild) credit.
Although you need to make a cash deposit when you open the account, a lot of lenders will refund that money to you after a period of responsible use. They will convert your account to an unsecured credit card and your credit score will receive another boost.
How Many Credit Cards Should You Have?
Once you select a credit card that works for you and are comfortable with managing it, you may see an appealing offer in the mail for a credit card with airline mile rewards. Or maybe you’re shopping at your favorite department store and a sales associate pitches their store credit card to you.
So how many credit cards should you have? Unfortunately, there is not a one-size-fits-all answer to this question. The average American has 3.84 credit cards. With that being said, you might be better off with six credit cards while someone else might be better off with only two.
Here are a few factors you should consider before getting another credit card
- Your ability to use the card(s) responsibly
- The rewards programs offered
- The annual percentage rate (APR)
- Annual fees
After you’ve considered what comes with a credit card, it’s important to understand the pros and cons of having multiple cards.
Pro: You Can Improve Your Credit Utilization Ratio
One benefit to having multiple credit cards is that it can decrease your credit utilization ratio. As mentioned earlier, your credit utilization is one of the five factors of your overall credit score. It’s a good rule of thumb to only use up to 30% of the credit available to you.
For example, if you have a balance of $500 on your credit card that allows for spending up to $1000, your credit utilization ratio is at 50%. Let’s say you were to open up a second credit card that also has a spending limit of $1000. Now that your total credit limit is $2,000, your credit utilization ratio drops down to only 25%.
This ratio gives lenders an insight into how you manage your money. If you have a low credit utilization ratio, it demonstrates restraint and responsibility. If you have a high credit utilization ratio, it can harm your credit score and lenders could see you as more of a risk.
Pro: You Can Stack Credit Card Rewards
Another benefit that comes with having multiple credit cards are the rewards programs. This is where it’s important to put some thought into what you value and what you want to spend your money on.
By dividing your purchases up between cards, you can access different rewards programs that allow you to save money in other areas of your life. To some people, the rewards may not be a big deal. To others, it may be the deciding factor between which credit card they apply for.
Con: You Can Easily Overspend
There’s always going to be a negative flipside when it comes to having multiple credit cards. The most obvious drawback to having multiple cards is the chance that you may overspend.
Having to manage two different credit card accounts can be harder to keep track of. Instead of checking your balance on one account, you will need to check two, three, four, or even more. If you fall behind, it can quickly turn into a stressful situation.
At the end of the day, you need to decide how many credit cards are right for you and your lifestyle. Be sure to compare offers, track your spending habits, and be honest with yourself before taking on more credit cards.
Takeaway
Credit has been around for centuries. Although it looked different hundreds of years ago than it does today, the idea is still the same. Credit unlocks buying power that allows you to make huge life purchases.
Credit cards are small, seemingly insignificant plastic cards that actually hold a lot of power. When used correctly, they can help better your financial standing. When misused, they can do the opposite.
When considering getting a credit card, it’s crucial that you keep a level head and consider everything that goes into credit cards. It can be daunting at times, but learning more about how they work and how to use them to your advantage will prove to be worth its weight in gold.
