Credit Card Debt

How Do Credit Cards Work?

Pin to Pinterest Share on LinkedIn

Credit cards can be a valuable tool for purchases of any sort, from daily expenses to large purchases and more. But even with their universal popularity, credit cards have managed to retain a stigma of negativity. That could be because credit card debt is one of the most common types of high-interest debt that many of us find ourselves dealing with.

Part of the reason it’s so easy to end up in credit card debt is because most people were never taught how credit cards actually work and they don’t know how to use them responsibly. That’s why it’s important to understand some basic facts about credit cards, as well as common credit card mistakes that may be keeping you in debt.

Credit Card Basics

In order to have a healthy relationship with your credit cards, you first need a thorough understanding of how the cards work. Knowing the fundamental terms and concepts that govern how you use and pay for your credit card could help you understand what you’re getting into before signing up for a new card.

Credit Card Terms and Conditions

It’s impossible to discuss credit cards without mentioning their terms and conditions. Unsurprisingly, credit card terms and conditions refers to the list of rules, guidelines, and other information that governs the use of a card. Terms and conditions are typically available on the issuer’s website, though you can also contact your issuer’s support department by phone or online to discuss anything you’re not sure about.

Your card’s terms should include information including, but not limited to:

  • Your interest rate and how interest is compounded
  • How your card’s rewards program works (if applicable)
  • Information about minimum payments
  • Any fees associated with using the credit card

It’s in your best interest to consult a card’s terms and conditions before applying for approval, as a card’s marketing materials may not be totally up front about everything being a cardholder entails.

Credit Card Interest

Most credit card balances will incur interest on a regular basis. Your card’s interest rate is generally known as its APR — annual percentage rate — but that doesn’t mean interest is applied once per year. To the contrary, interest is usually calculated and applied to your account daily, or, occasionally, monthly.

As you accumulate interest fees, those fees will be considered part of your balance, and will therefore be factored into future interest calculations. These fees can build up very quickly if you’re not careful, which is why most financial experts recommend paying off your balance in full during each billing cycle in order to avoid interest altogether.

How Is Interest Calculated?

There are a few different methods with which issuers calculate interest fees. We’ll cover the two most common.

  • Daily balance method: With this method, your interest is calculated on each individual day of the billing period. These interest fees may be added to your account daily, or they may be added together and applied to your balance monthly.
  • Average daily balance method: This method involves your issuer averaging your balance for every day of the month, and then applying your card’s interest rate to that number.

You’ll seldom see another method of interest calculation used, but make sure to explore your card’s terms and conditions to confirm which approach you’ll be dealing with.

Paying Your Credit Card

Once you’ve built a credit card balance, you’ll have to start paying it off. Paying down your balance in full is a common expert recommendation, but because that’s not always feasible, it’s important to understand the importance of making your minimum payment at the very least.

How are minimum payments calculated?

Your credit card’s terms and conditions should outline how its minimum monthly payment is calculated. Much like APR, this may vary based on the card, but you can generally expect a minimum payment that’s somewhere between 2% and 5% of your overall account balance. This number will usually be rounded to the nearest dollar or $5 for the sake of simplicity.

Your terms should outline a minimum amount due for balances that are above a certain threshold, too. If your balance is at least $15, for example, you may have to pay a minimum of $15, since 2% to 5% of your overall balance would be miniscule.

Is paying the minimum payment enough?

Paying the minimum payment will help you avoid late fees, but you’ll still accumulate interest, which may can cause your debts to snowball. Only paying the minimum payment may also leave you with a high utilization ratio — your amounts owed compared to your total credit limit — which can damage your credit over time. Paying off your balance in full is the best possible way to maintain both your financial wellbeing and the health of your credit scores.

Other Credit Card Fees

Interest isn’t the only type of fee you may encounter during your time as a cardholder. Delve into your card’s terms and conditions, and you’ll likely see that there are all sorts of fees you might have to pay if you don’t use your credit card carefully.

  • Annual Fee: Many credit cards require cardholders to pay an annual fee. Higher-fee cards generally come with a better selection of benefits that make such fees easy to offset.
  • Balance Transfer Fee: Transferring a balance from one credit card to another will typically require a fee that’s a percentage of the balance being transferred.
  • Cash Advance Fee: Most experts strongly recommend against credit card cash advances, as they generally include hefty fees and exceedingly high interest rates. Consult your card’s terms and conditions for more information.
  • Foreign Transaction Fee: Some cards charge an additional fee for foreign transactions. That said, there are plenty of cards — travel credit cards in particular — that do not.
  • Late Fee: Late fees are charged if you don’t pay the minimum amount owed by its due date. Depending on your issuer’s policy, missed payments may also be reported to the nation’s credit-scoring bureaus, in turn causing your scores to drop.

Common Credit Pitfalls

By now, you should have a handle on the basics of wise credit card use. But it’s important to remember that these useful tools come with a host of dangers that could pose a threat to your long-term financial health. Keep these in mind while you’re sifting through your card options, and tailor your spending practices accordingly.

Late Payments

Even one late payment can do a number on your credit. In fact, payment history is the most significant factor in determining your credit scores — it accounts for a whopping 35% of your personal FICO scores — which highlights the importance of staying ahead of your payment schedule. Avoid late payments by setting up your card’s autopay feature.

High Utilization

After payment history, the next-highest component of your credit scores is amount owed. This includes your utilization ratio. It may be tempting to carry a large balance from month to month, but this will detract from your credit scores in the long run. Always try to keep a low balance relative to your total available credit limit.

Settling for the Minimum Payment

Paying only the minimum amount due can help you avoid a missed credit card payment, but that doesn’t mean it’s a wise move. To the contrary, maintaining a large balance at your credit card’s due date means you’ll garner interest fees, which may cause your debts to accumulate too quickly for you to handle. Interest also offsets the value of the rewards you earn in the process of accumulating debt. That’s why your best bet is to avoid taking on more debt than you’re able to pay off in a month.

Not Checking Your Statements

Credit cards come with excellent fraud protections. But there’s a catch — they won’t be much help if you don’t regularly check your statements in order to identify fraudulent charges as soon as possible. In some cases, paying your card acknowledges the charges as valid, and you may not be able to recoup the money spent.

Ignoring the Terms of the Card

The importance of a card’s terms can’t be understated. Case in point: many credit cards feature excellent rewards at the associated store, but they often come with high enough interest rates that you’ll only truly benefit if you spend a great deal of money at the store and pay off your balance prior to every due date. Dig deep into the terms of the cards you’re considering before you apply, so you know exactly what you’re getting yourself into.

Using a Credit Card for a Cash Advance

When you’re in a pickle, you might be tempted to use your credit card for a cash advance. But should you? Most experts agree that it’s not a great choice. Credit card cash advances come with strict terms and exceptionally high interest rates that could be disastrous for your credit if you’re not ready to pay it off in full as soon as possible.

Spend Wisely

If you find yourself relying on credit cards to make purchases that you wouldn’t be able to afford otherwise, it may be time to step back and reexamine your financial situation. Doing something as simple as creating a budget could help you avoid additional debt. Sometimes, however, you may need to work with a financial professional to tackle your current debts while still keeping up with life’s essential expenses.

Regardless of your situation, always make sure you do your research and evaluate all of your options before taking out a new card, and be sure to stick to good debt management practices to keep your finances under control while taking advantage of all the good that credit cards have to offer.

A credit industry analyst at Credit Card Insider, Sean Messier strives to empower individuals with the knowledge required to use credit cards to their advantage. His writing- and research-based background has granted him experience in an array of topics, from finance to business and beyond.