Credit Card Basics

A credit card is a useful personal financial tool. It gives you purchasing flexibility. It gives you a regular report of your charges. Here's some advice for becoming an informed and responsible credit card customer.

What Are Credit Cards and How Do They Work?

A credit card essentially authorizes you to borrow money up to a certain limit. You borrow the money when you use your card to make purchases or take out cash advances. You can repay what you borrow right away or pay over a longer period of time.

Credit Card Terminology

Getting credit is one situation where reading the fine print can really pay off. Crucial information about interest rates, repayment terms, and conditions unique to the card should be included with the credit card application. You receive this information again when you receive your credit card. Plus, a summary may be printed on your monthly credit card statement.

Here's what to look for:

  • Annual percentage rate (APR). The interest rate charged on unpaid debt stated as a yearly percentage rate. A single card may have multiple APRs. For example, purchases, cash advances, and balance transfers may all have different APRs. Also, a card may have an introductory APR that converts to a regular APR after a specific length of time.
  • Balance. The total of what you owe.
  • Balance transfer. When you pay off all or part of what you owe on one credit card by transferring the amount to another credit card.
  • Credit limit. The maximum amount a credit card company will allow you to borrow on a single credit card at any one time. Sometimes called a "credit line."
  • Finance charge. The cost of using the credit card, comprised of interest costs and other fees.
  • Grace period. If you have paid off your previous balance on your card, this is the period of time you have to pay for purchases before interest charges apply. There is usually no grace period for cash advances or balance transfers.
  • Cash advance. An on-the-spot cash loan charged to your card. Banks provide printed checks you can use for this purpose or you can use your card at an ATM. Cash advances may have fees, higher interest rates, and no grace period.
  • Balance transfer fee. A charge for transferring the balance (or portion of a balance) from one credit card to another.
  • Annual fee. A fee some cards charge once a year.
  • Other fees. Charges associated with specific actions such as paying late, getting a cash advance, or exceeding your credit limit.

Who Can Get a Credit Card?

When a bank considers whether to offer you a credit card, they try to evaluate the type of customer you will be, specifically: Are you likely to pay back what you owe on time? If you already have credit cards or loans, a credit card provider can learn more about how you've managed your accounts in the past by viewing your credit report and credit score. (Your credit report shows your repayment history and your credit score is a number that is calculated based on the information in your history.) Many credit card issuers believe that a person's past credit history serves as the best indicator of the type of borrower they will be in the future.

If you are under 21, you probably don't have much of a credit history or a credit score. Before issuing you credit, the bank must determine whether you have the independent ability to make the required minimum payments. To do this, the bank will look at certain factors, such as a history of on-time payment of rent or utilities, your debt obligations, and your income or assets (savings and things you own, like a car). Also, you must be 18 or 19 years old to obtain a credit card, depending upon the state you live in.

Although you might not have a credit history or credit score yet, you will begin to build one after you obtain your first credit card. The most popular credit scoring formula is called the FICO formula, produced by the Fair Isaac Corporation. It calculates credit scores based on the following five factors: payment history (on-time vs. late payments), amounts owed, length of your credit history, new credit (number of recent requests for your credit history and accounts opened), and mix of credit types, such as credit cards and installment loans (where you pay a fixed amount per month for a fixed term).

What to Consider When Choosing a Credit Card

  • Think about how you will use the card. Will you pay the balance every month? Remember, charges can add up quickly—and so can interest and fees. Are you financing a longer-term debt? The size of the interest rate can make a big difference in how much you pay in the end.
  • Compare the terms and conditions. Shop around for the plan that fits you. Make sure you read—and keep—the fine print.
  • Find out if interest rates or other terms will change. Read through the credit card offer to see if charges, such as an introductory interest rate, are subject to change.
  • Understand the difference between fixed and variable rates. Fixed means the interest rate will not change. Variable means the rate can increase or decrease based on changes in an underlying interest rate index.
  • Consider customer service. Check whether the card provider offers customer services via telephone and Internet. These services can include access to account information, online bill payment, ability to update personal information, and problem resolution. Be sure you understand any fees charged for these services.

Understanding Your Credit Card Statement

You will receive a billing statement from the bank each month. Look it over carefully. It lists details of your activity during the account billing cycle, such as purchases and payments. (The billing cycle is typically a one-month period.) The statement should also include information about the terms and conditions of your card, including how interest is calculated and where to call with billing questions.

Your statement contains a lot of information. Here's what to look for:

  • Previous balance. The amount you owed at the end of the previous billing cycle.
  • New balance. This is the amount you need to pay to avoid further finance charges. It represents the total of your previous balance, any new purchases, cash advances, and other transactions—minus any payments and credits.
  • Account activity. List of all transactions (purchases, cash advances, payments, credits, and fees) that occurred since your last statement.
  • Minimum payment due. The smallest amount you must pay by the due date. If you make the minimum payment, you typically will be charged interest on your unpaid balance and all new charges until the entire debt is paid off. If you do not pay the minimum by the due date, you will likely be charged a late fee.
  • Credit available. The amount of credit remaining on your card after your balance and your current charges are subtracted from your total credit limit.
  • Payment due date. The date your payment must be received.
  • Finance charge. The cost of using the credit card during a billing cycle, comprised of interest costs and other fees.

Check your statement each month to make sure all the information is accurate. Also check the payment due date, interest rate, and credit limit, as these can change.

Paying Your Credit Card Bill

There are several things to consider when you make your credit card payments.

  • Your payment size. You have to pay at least the minimum payment each month. You can pay this amount or a larger amount, or even pay off the whole balance. Keep in mind that you will be charged interest on the unpaid balance, and think about what makes the most sense for you.
  • Your credit limit. It is important that you not go over this limit. If you do, you will likely be charged a fee.
  • On-time payment. Know when your payment is due. If your payment is not received by the due date, you are likely to be charged a late fee. In addition, your interest rate may increase, and your account will be considered "past due" and may be reported as delinquent to the credit reporting agencies. If you mail your payment, send it at least a week ahead of the due date, just to be safe. If you pay online, submit your payment before the due date. If you wait to pay online until the due date, check the payment cutoff time so you know the time by which your payment must be received to be credited that day.
  • Method of payment. Many credit cards allow you to pay by mail, phone, or online. A bank may charge a fee if a bank representative assists you with making a last-minute payment.

Getting Credit Smart

Opening your first credit card accounts can be exciting. Learning how to use them responsibly is essential. By taking the time to learn about how credit cards work, you are already on the right path to making smart choices about using credit.

Information in this article is of a general nature and may not apply to you or your situation. Contact a financial or legal advisor before acting on such information.

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