The Ultimate Guide to How Credit Cards Work

How credit cards works is quite possibly one of the most misunderstood things in this day and age. The scary stories of people drowning in an ocean of debt and ending up in financial ruin are so common, we practically tell them to our children as we sit by the campfire.

Well gather ‘round kids, because we’re about to dispel those nasty rumors and be your guiding light towards a glowing credit score, no debt, and personal responsibility. <- That’s the important one.

That doesn’t mean credit cards can’t be dangerous in the wrong hands. Ignorance and irresponsibility can lead you down some painful pitfalls (like me trying to cook).

But fear not! That’s where we come in. With a little bit of guidance, you’ll be winning the battle of good credit and snagging some cushy rewards, all while staying debt free.

What is a credit card?

That plastic little thing in your wallet is good for more than just scraping ice off of your windshield!

But before we get into that, what exactly is a credit card? Basically, it’s a loan that can be reused every time you pay it off. This is often why credit cards are called a revolving line of credit. Much like a revolving door at a fancy hotel, this “rotating” credit can be very useful, just be careful not to get trapped in the endless spiral of debt.

When you purchase something with a credit card, you haven’t actually paid for it yet. The bank has “allowed” you to buy that pumpkin spice latte, under the assumption that you’ll pay it back.

Example

Let’s say you have a $20.00 credit limit. After purchasing your $5 coffee, you’ll now have a $15.00 limit, and a $5.00 balance. That balance must be paid within roughly one month. If you don’t pay it off in time, you’ll owe a fee on top of it. So be sure to only buy what you can afford, and pay your card off every week!

By using your credit card responsibly, you’ll not only be buying a tasty coffee, you’ll be building your credit score as well. On top of that, you could be getting a small bit of cash back on every purchase, if you’re using a cash back card.

Debit vs Credit

They sound similar, look similar and work similar (for us), so what’s the dif? Quite a bit!

Debit cards are tied directly to your bank’s checking account – they’re basically a plastic piece of money, sort of like a bad Hollywood actor. This makes them safer for frivolous spenders, as you can’t spend more than you actually have.

The downside is that they offer less security, no rewards, don’t build your credit, and don’t give you any leeway in an emergency.

Unlike debit cards, credit cards work more like a loan – meaning you don’t actually “need” the money before buying something. On top of that, credit cards have the added benefit of slowly building your credit score. Having a good credit score means better rates for future loans, like when buying a new home or car. Lastly, credit cards also offer a much higher level of security against fraud and theft, which is why we recommend them for any online purchases.

To put it simply:

  • Credit Cards: I want this cookie now, I’ll pay for it later – with the threat of paying more if I don’t do it soon.
  • Debit Cards: I want this cookie now, and I’ll pay for it now or I can’t have it.

Should you have a credit card?

Absolutely! Credit Cards come with many benefits, such as:

  • Better Security
  • Emergency Safety Net
  • Improving Your Credit Score
  • Rewards and Cash Back Programs

Responsible use of your credit cards can be one of the most powerful financial tools available to you. Entry level cards typically have no annual fee, can come with rewards benefits, and help quickly build your credit score.

Because credit history has such a large impact on your credit score, I always recommend people get a credit card sooner rather than later. Paying off your balance and avoiding interest fees builds your credit score, and trust with your bank.

Think of your credit card like a fine french cheese, the more it ages, the better it gets.

Never carry a balance

You do not, nor should you, ever carry a balance. I highly recommend people pay off their credit cards every week, in full.

Carrying a balance does not build your credit faster nor help you in any way. That’s simply not how credit cards work.

This is a common mistake many people assume with credit cards. The only results you’re going to get from carrying a balance, is paying more money for stuff.

Period.

If your barber asked you “Would you like to pay $10 for your haircut, or $12 in a week?” Which would you choose?

Be responsible, save your money, never carry a balance on your credit card.

Credit cards have extraordinarily high interest rates and you should never use these for large purchases you can’t immediately pay for. This is the single biggest mistake people make when owning a credit card and why people succumb to the soul crushing weight of credit card debt.

What APR means for a credit card

APR or Annual Percentage Rate, means the added fees you will pay if you don’t pay your balance off in full. That last part is important, if you pay your credit card off in full, you will never pay interest fees.

Now don’t be mislead by the name, when it comes to credit cards, APR and Interest are two words meaning the same thing. Here’s where people often get confused. They see the term “annually” and think “hey, that’s not so bad!” But don’t be fooled! This is the interest you will pay every month if you carry a balance and don’t pay it off.

Example

Let’s say Robyn gives me a dozen cookies for a party, with the agreement that I will bake her a dozen cookies in return, at the end of the month.

If don’t bake her cookies in time, I’ll have to make a few extra on top of it. If I miss my deadline a few times, I could end up baking two or three dozen cookies!

Lesson learned? Never carry a balance, and pay your debts off in time.

Or choose to pay significantly more for something when you don’t have to, it’s up to you!

Why APR changes

APR can mean many different things, depending on the loan or credit.

Thanks to the Truth in Lending Act, banks are required by law to show the full cost of a loan. This means lenders can’t sneak in any hidden fees after you sign an agreement. The most common “extras” include interest, document processing fees, closing costs, and many other ridiculous fees. Make sure you read the fine print to know exactly what your APR is made of!

As for credit cards, there aren’t any added fees besides the interest itself. This means you can consider your APR and Interest Rate as the same thing.

Just don’t take that to mean credit card debt isn’t something to fear. On the contrary, credit card debt is one of the most difficult holes to climb out of after falling in.

Credit cards are more secure

This one is a little tricky, though mostly true.

Whether it’s debit or credit, banks are very understanding when it comes to fraud. You will almost always get your money back if someone steals your card, but there is a difference. Since the bank is acting as a middle man, no money is immediately taken when purchasing with a credit card. Whereas with debit cards, money is instantly taken from your account upon purchase.

This limbo period with credit cards gives the bank an extra leg up when it comes to canceling transactions and fighting fraud. It also protects you from hefty late fees on missed payments, because you’re still waiting for your funds to be returned to you.

Think of your credit card like wearing a bio hazard suit for online purchases. It gives you an extra layer of protection against the toxic world of the internet.

Debt-inator, The Destroyer

illustration of the Debtinator. A one eyed dragon holding two sacks of money

Debt is the mighty dragon most Americans face today.

The average credit card debt is over $2,000, almost all of this on frivolous spending. If you’re making the minimum payments on your card, with typical interest rates, you’re looking at a 30 year long battle to defeat your Debtinator.

We want to change this line of thinking and help prevent people from falling into the all-consuming maw of the Debtinator. By following these three simple rules, you can live a debt free life with your credit card and gain total control of your spending habits.

Did you know? America’s average credit card debt is $6,358, soaring our national revolving credit to over $1,000,000,000,000 (trillion)!

1. Use your card the same as cash

Be responsible, don’t buy what you can’t afford. Your credit card is not meant to be an “increase” in your income or spending power.

If you have $500 dollars in your checking account, you have $500. Not $500 + $500 in credit, not $500 “plus a little extra I can swing”, just $500. Want to buy that $1500 dollar diamond ring and only have $500 in your checking? Unfortunately, you need to find a cheaper ring.

Personal responsibility is the single most important part to your financial prosperity. Understanding your limits and only buying what you can afford is the first step to being debt free. That’s why it’s important to understand how credit cards work.

2. Pay your balance every week

Most helpful tips and tricks recommend you pay off your credit card balance once a month. I disagree, once a month is not nearly enough.

Be vigilant about keeping track of your balance, and most importantly, pay your cards off Every. Single. Week. Only paying off your balance once a month will lead to credit-shock seeing that large number. Especially for those with their first credit card.

As you grab your Friday paycheck and skip merrily down the street with your hard-earned dough, use this opportunity to pay your balance off, in full. This will give you a set routine, show you how much you’re truly spending, and give you an idea of just how (depressingly little) money you actually have for the week!

All that may sound a little gloomy, but it’s important to maintain responsible use of your cards! Credit cards are practically the definition of the term “slippery slope”.

Already stuck in the pit of debt? Here’s how we beat the battle of debt, and how you can too!

3. Credit cards are not a magic wand

Much as they make you feel like a magical wizard that can conjure things for free, you are not. I want to impress this upon you again, credit cards do not give you more money.

Some cards can give you the flexibility to pay for something over time, without eating away your emergency funds; such as the amazon card, which has 0% APR for 6 months on larger purchases. This does not mean you can, or should, buy things you do not currently have the money for.

Treat your credit card the same as if you’re buying everything with cash, or debit. With a few added bonuses thrown in, like cash back rewards and growing your credit score.

Different types of cards

It’s easy to get lost and confused when searching for a new card. With the multitude of rewards, travel, secured and prepaid cards out there, where do we even begin? Fear not! We’ve got a handy guide to some of the more popular types of cards and what they’re good for.

If you’re just jumping into the fray of how credit cards work, use this as a reference to best gauge what fits your needs.

Check out our in-depth guide on which credit cards are the best and which ones to avoid!

Cash back cards

The most popular cards out there, because hey, who doesn’t like a little kick-back? Cash back cards give you more incentive to use your card and offer you a nice bonus for doing so. They typically range anywhere from 1.5% all the way up to 5% cash back on all purchases or select categories.

We recommend looking for a lower end rewards card if it’s your first ever credit card as they tend to not have annual fees for owning one. Furthermore, they have lower credit score and income requirements.

Our Top Picks

Illustration of Cashback card

Citi Double Cash Card – Our personal favorite. This card nets you 2% back on all purchases made with the card, has a decent APR, and no annual fee! We recommend this to pretty much everyone as a go-to card.

Chase Freedom Unlimited Card – Much like the Citi card, this one is a great all-rounder rewards card. We highly recommend it for both beginners and avid credit card users.

U.S. Bank Cash+ Card – Though the standards for approval are a little higher, this can be an excellent choice if you frequently shop at stores that meet the 5% cash back categories. This one is good for people who shop at larger retail chains.

Travel Cards

Travel cards are all the rage nowadays, but they can be a bit more tricky to know if it’s worth it or not. We recommend travel cards for those who are comfortable with their finances and credit score, as these cards have much higher minimum requirements. On top of higher requirements, they usually come with a hefty annual fee, ranging from $90 up to $500!

These cards are a hot ticket for people who manipulate new card rewards programs. These new card bonus rewards can reach upwards of $650, if you can hit the spending requirements.

TL;DR

We hope this in-depth guide helped you better understand how credit cards work and the risks that come with them. They can be a powerful financial tool if handled responsibly. Remember these simple guidelines and you’ll be living a debt free life and building a strong credit score!

  • A credit card is not a magic wand, don’t buy what you can’t afford
  • Avoid using your credit card for large purchases
  • Pay your balance in full, every week
  • Your ultimate goal with a credit card is to always have that balance show $0

Now that you know how credit cards work, learn how to start building your credit score!

Credit card terms made easy

Balance: What you currently owe on your card.

Difference between Credit vs Debit: Using a credit card is like taking a small loan that you promise to pay off. When using a debit card, the money is directly, and instantly, taken from your account.

Difference Between Interest and APR: With credit cards, there is no difference.

Interest / APR: What you’re charged if you don’t pay off your card, in full, at the end of the month.


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