When people think of credit cards, many times the thought immediately goes to debt. This stigma can give credit cards a bad name, yet even when faced with this, so many people use credit cards to buy things that they can’t afford. Why is that? Given how easy it is to tell yourself you’ll pay for it with your next paycheck, just charging away can seem harmless. Doing that for a month? That’s when the interest can start piling up. People begin charging items on their cards without paying off the first purchases, which starts to create a downward spiral in the interest payments. This post will talk about an introduction to credit cards, including how to use them effectively and some common pitfalls to watch out for.
How Credit Cards Work
Credit cards can be an amazing financial tool. Many have fantastic benefits attached to them, such as extended warranties, excellent fraud protection, and 24/7 customer service for any incident or question you may have. They can also be a dangerous credit destroyer if used improperly however. Most credit cards have an interest rate in the 15 to 25 percent range. Given this, it is extremely important to understand how to effectively use a credit card.
Credit cards are typically billed on a monthly cycle. The charges that are on the monthly statement are the purchases from the previous month. Typically, when the statement is received, there are a few weeks before the payment is due. If there was an overdue balance on the card prior to the statement start date, then interest will be charged on this. I won’t be going into too many details on how the actual interest charges work – they can be very complicated and involve monthly balance averages and other unintuitive methods of calculating how much is added to the bill.
There are many different types of credit cards as well. Some have an annual fee, others don’t. Typically cards with an annual fee tend to have some exclusive features. For the purposes of building up your credit though, these aren’t worth it. Many cards now offer certain types of rewards. The Citi Forward card for instance offers points on all of your purchases. These points can be used on Citi’s website to redeem cool items, or even on Amazon directly as a replacement for cash. Others are useful for gaining airline miles or can only be used a specific store.
New credit cards typically also come with a bonus period as well. This can range from 6 months to 18 months or more, depending on the card. Usually this bonus period will include an introductory interest rate (usually zero percent interest), as well as point bonuses for spending a certain amount within the first month of owning the card. This luxury can actually cause more harm than good and begin a vicious cycle for many people. When used properly though, it can be a very beneficial thing to have.
How should I use credit cards?
Using a credit card is fairly straight forward. Rather than using cash or a debit card, you just swipe the credit card at the register instead. The many protections that come with it are automatic. The purchase will typically take a few days to post on the account. Once it has posted you should be able to see it online in the account. This will increase the balance for the card and if it falls during the appropriate statement period, you’ll be billed for it when you receive the statement.
It is important not to get in the mindset of thinking that a credit card is free money, especially if you are in an introductory period. A good way to think about credit cards is that if you wouldn’t be able to pay for it with cash or a debit card, you shouldn’t buy it. This can get you thinking about credit cards as a tool for earning rewards and increasing your fraud protection rather than a mini-loan.
When the statement period ends, the credit card company sends you a bill. This will include the purchases and total interest charges, as well as the due date. The statement balance may be different from the current balance, depending on when purchases were made. In order to avoid interest charges, it is important to pay off the statement balance by the due date. A good way to track what you are spending and ensure you don’t buy things you can’t afford is with You Need A Budget. We’ll talk more about this in the future.
Some common pitfalls
The big reason many people are paying interest on credit cards is that they are using them on big-ticket items. Many people will charge a new TV or phone without much thought as to where that money is coming from. The psychology behind it is simple: credit cards are quick, easy, and allow us to buy things when we don’t have the money for it. When the bill comes due, often times people will be unable to pay the full balance, resulting in the interest charges. The same thing the following month, so the new balance will have interest charged on top of that. Eventually, a $600 TV for instance can become an $800 payment all thanks to compounding interest.
Another mistake is paying off purchases immediately. This can be bad if you are trying to build up credit. Credit card companies only report your utilization rate once a month, typically when the statement is sent. A chunk of your credit score is based on your utilization ratio (the amount used compared to the total available credit). By paying off purchases immediately, the utilization ratio will be zero, which looks worse than a utilization of 20 or 30 percent. It sounds counterintuitive, but only pay on the due date. As long as you pay the full amount on the statement, you won’t have to worry about any interest charges.
This was just a quick introduction to credit cards. There can likely be a countless number of posts about this subject. For now, just remember these key points. Always pay the statement balance on the due date, don’t buy things you can’t afford, and try to only use around 30 percent of your available credit. We will go in more details on some of these topics in future posts. Credit cards don’t have to make your financial life difficult and instead should be able to make it much easier to deal with. Do you have any tips on how to use credit cards? Any recommendations for a credit card to apply for? Feel free to leave a comment below!