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- How Credit Cards Work: A Beginner's Guide
How Credit Cards Work: A Beginner's Guide
Lyle is a writer specializing in credit cards, travel rewards programs, and banking. His work has also appeared on MSN Money, USA Today, and Yahoo! Finance.
If you're new to the world of credit cards, you probably have some questions about how they work. There's a lot to take on when you start using credit cards, and a lack of knowledge can end up costing you money.
This beginner's guide will cover all the credit card basics. You'll learn exactly how credit cards work, how to choose the best first credit card, and plenty of other information you'll need to know about using credit cards.
How do credit cards work?
A credit card is tied to a credit account with a bank, and when you use the card, you're borrowing money from the issuing bank. You can use a credit card to purchase goods or services with any merchant that accepts credit cards or to take out a cash advance.
Each credit card will have a credit limit, which is the maximum balance you can have on the account. Unlike loans, where you borrow a fixed amount and pay it back over time, credit cards offer a revolving line of credit. You can use the card until the balance reaches the credit limit. When you make a payment, it lowers your balance, which means you have more credit available to use again.
What is APR?
APR, which stands for annual percentage rate, is the annual cost of borrowing money with a credit card. It's the interest rate you pay on charges that you don't pay off within the grace period.
Here's a simple example -- your credit card has an APR of 20%, and you have a balance of $1,000. If you leave that balance on the card and don't incur any fees, then it would grow to $1,200 after one year. In reality, you couldn't leave that balance for a whole year as you'd need to make minimum payments to keep your account in good standing and avoid fees. But that was just an example.
Fortunately, you can avoid interest charges by paying off your card's full statement balance. If you do that, you won't need to pay any interest on purchases you make.
How to build credit
After you're approved for a credit card, it's important to use the card in a way that will improve your credit score. Here's what you need to do to build credit with a credit card:
- Pay on time: The best thing you can do for your credit is to always pay on time. Your payment history is the most significant factor in determining your credit score, and on-time payments will help you get excellent credit.
- Watch your FICO® Score: Although there are multiple types of credit scores, the FICO® Score is the one that lenders use most often. You should check yours at least once every few months to ensure you're headed in the right direction. Some credit cards include a FICO® Score tracker, but if yours doesn't, there are also free ways to check your score online.
- Keep your balances low: It's bad for your credit score if you use too much of your available credit. To avoid this, try to never use more than 20% to 30% of your available credit.
- Ask for a credit limit increase: After nine to 12 months of charging up balances and paying them off in full, consider asking the credit card company for a credit limit increase. A higher credit limit can make it easier to keep your balances below the recommended 20% to 30% ratio.
- Keep your account open: Don't let your credit card go inactive for too long. Many banks will close an account if it isn't used for six months or more. By making a small purchase with the card every few months or so, you can make sure that the card stays open and is reported to all three credit bureaus. One factor that affects your credit score is your average account age, so be sure to keep your oldest accounts around as to help boost your score.
Best first credit card
Beginner credit cards usually come with features or perks that are designed for new users. Here are a few features to look for when choosing the best first credit card:
- No annual fee: Ideally, your first credit card is one that you'll want to keep open forever, helping you extend the age of your credit history with each passing month. We think the best first credit card is one that doesn't have annual fees, so you won't have to pay every year just to keep it open.
- Free FICO® Score tracker: Some credit cards offer free access to your FICO® Score. This allows you to keep an eye on your score from your online credit card account.
- No or low security deposit: If a card is a secured card (secured cards require collateral to open an account), we believe the deposit amount should be as low as possible. Cards that offer a $200 credit limit in exchange for a deposit of $200 or less are ideal. You shouldn't have to empty your bank account to open a credit card.
- Rewards: Rewards aren't a make-or-break feature, since the primary purpose of a beginner card is to help you build a credit score and qualify for better terms on loans and cards later. That said, if you can score rewards from your first credit card, it's certainly not a bad feature to have.
Many people get their first credit card when they are at college. If you are looking for a good student card, here's our pick of the best credit cards for students.
First credit card tips
A credit card can be a useful financial tool, or it can lead you deep into credit card debt. By following these tips, you'll ensure that your card works for you and not against you:
- Only charge what you can afford: Consumers get into trouble because they use credit cards to spend money they don't have. To avoid that, only charge purchases you can afford to pay with the money that's in your bank account.
- Set up payment alerts: There's no reason to miss a payment and incur a late fee. Set up a reminder of your payment's due date or set up automatic payments.
- Pay in full: You should pay your full statement balance every month. If you do this, you'll never pay interest on your purchases.
- Review your statement: Make sure all the charges on your statement are legitimate. If you find any that aren't, notify your card issuer immediately. Even a small charge you don't recognize can be dangerous. Thieves often make small purchases to test stolen credit card numbers, and then charge much more if the test purchase is successful.
Do I need a credit card?
While you don't need a credit card, there are several reasons why getting a credit card is a good idea:
- Building credit: It's much harder to build your credit history without a credit card. A limited credit history can affect your life in many ways. The most obvious is that you'll have trouble getting approved by lenders if you ever want to borrow money. In addition, it can lead to you getting rejected when trying to rent a home, and in many states, it can even result in higher car insurance rates.
- Security: Credit cards are the best payment method from a security perspective. If a thief makes fraudulent charges with your credit card, you can contact the card issuer to get the charges removed and receive a new card. The most you can legally be liable for with credit card fraud is $50. And most card issuers even have zero-liability policies, which means you won't be liable for fraudulent charges at all.
- Rewards: Many of the best credit cards offer cash back, travel points, or some other form of rewards. This allows you to earn value back on the money you spend.
Credit cards vs. debit cards
Since credit cards and debit cards look alike, it's easy to get them confused. To help you tell them apart, we'll take a closer look at their similarities and differences.
Credit cards and debit cards are both physical cards that are tied to a financial account. You can use each type of card to pay for goods or services. The ways you use them for transactions are also the same. For physical transactions, the most common option is to insert your card or swipe it in a card reader. For online transactions, you type in your card information.
Although both types of cards are tied to financial accounts, the accounts they are tied to are different. A credit card is tied to a revolving line of credit that a bank has issued you. A debit card is tied to your bank account.
This is an important distinction. With a credit card transaction, the card issuer pays, and you pay them back later. With a debit card transaction, you pay using funds from your bank account. If you have a fraudulent charge on your credit card, you can call and have that charge removed, and you won't be out any money. If you're a victim of debit card fraud, the bank will need to investigate before it can put the money back into your account.
Because of that difference, credit cards are a more secure payment method than debit cards.
Credit cards affect your credit score, but debit cards do not. When you use your credit card and pay the bill on time, your credit will improve. Paying by debit card does not benefit your credit score in any way.
Secured credit cards
Secured credit cards are a type of credit card that require a security deposit. They're typically chosen by consumers with bad or limited credit histories who can't get approved for unsecured credit cards.
Although you need to deposit money to get a secured credit card, it's still considered a credit card and not a debit card. You're still borrowing money from the credit card company. The deposit is simply collateral. That also means a secured card can help you improve your credit just like any other credit card.
If you want to start building your credit score using a secured credit card, check out our roundup of the best secured credit cards.
Important credit card terms
Credit card: A physical card that's tied to a credit account. The card can be used to make purchases through that credit account.
Unsecured credit card: A credit card that doesn't require any security deposit from the cardholder. Most credit cards are unsecured.
Secured credit card: A credit card that requires a security deposit when the cardholder opens the account.
Cash advance: Using a credit card to get cash. Cash advances typically have higher APRs and start accruing interest immediately, so they're not recommended.
Balance transfer: Transferring a balance from one credit card to another, most often because one card has a lower APR. Not all credit cards offer this feature.
Credit limit: The maximum balance a credit card can have. Many credit cards have different limits for cash advances. For example, a card could have a credit limit of $10,000, but a cash advance limit of $3,000. That means of the $10,000 credit limit, up to $3,000 could be used for a cash advance.
Available credit: The difference between a card's credit limit and its available credit. If you have a $400 balance on a card with a $1,000 credit limit, then its current available credit is $600.
Revolving line of credit: A line of credit you can borrow from, up to the limit, as long as the account is open.
APR: The annual percentage rate, which is the annual cost of borrowing money.
Minimum payment: The minimum amount you need to pay on your credit card by the due date. If you don't pay at least this much, the card issuer can charge you a late fee.
Statement balance: The credit card's balance on your most recent statement closing date. By paying this amount in full every billing cycle, you can avoid interest charges on purchases you make.
Credit score: A number that rates your creditworthiness, or the likeliness that you'll repay what you borrow.