How Do Credit Cards Work?
If you’re a student — or you’re otherwise new to the world of credit — you may be asking yourself, “How do credit cards work?” There seem to be so many moving parts: the APR, the grace period, the minimum payment…. Starting out, there’s so much vocabulary to learn.
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Be sure you understand the basics.
If you have a checking or savings account, then you’re probably already familiar with a debit card, which allows you to access your account at the ATM or to make purchases that “debit” directly from the funds available. You’re spending money that you already have.
A credit card, stated simply, is a form of loan: The bank or credit card issuer extends you a line of credit — money that you otherwise would not have. In exchange, you pay them back, either by the monthly payment due date or over time.
Credit card debt is typically unsecured debt, because for a traditional credit card you do not have to put up any collateral or property to receive the funds. The bank or credit card issuer, in approving you for the credit card, has judged you to be creditworthy, meaning that you can be counted on to repay the money you’ll borrow.
So, how do credit cards work?
If you pay off your credit card account in full and on time every month, you will essentially be using the bank’s money for free, because you will have incurred no interest charges.
If your credit card payments extend over time, you will be charged interest, which is where that APR, or annual percentage rate, comes into play. While credit cards give you the flexibility to take your time paying back what you owe, you will pay for the privilege of doing so. Each month that you carry a balance, you will be charged interest.
And, each month, you will have the option of making the minimum payment due (as determined by your credit card issuer), a larger payment, or payment in full. Making timely payments is the first good credit card habit you’ll want to adopt, because “payment history” makes up the largest percentage of your three-digit credit score.
As you become more comfortable with using a credit card, you’ll also want to make a habit of keeping your overall utilization low. The “credit utilization rate,” which is another important factor in your credit score, is the amount you owe compared to your total credit limit.
How do I know which card to choose?
Two good options, when it comes to getting your first credit card, are the student credit card and the secured credit card. The secured credit card requires that you make a security deposit up front that will equal the amount of your available credit; otherwise, it works just like an unsecured credit card.
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Learning how to use either a student credit card or a secured credit card responsibly can help you establish the good habits that will build your credit over time. Which is an important part of learning to manage your financial life — both now and in the future.
If you are interested in learning even more about credit cards, check out this detailed whitepaper on credit card definitions, advantages and benefits, and more.