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What is a credit card? It’s a question that sounds so obvious, you might be afraid to ask it. But when it comes to establishing credit, you have to begin somewhere, and a clear, simple credit card definition is a good place to start.
With that in mind, we’ve put together this primer to help you understand how credit cards work and how you can use these valuable financial tools to manage debt responsibly.
Heads up, though: When credit cards aren’t handled well, they can cause a lot of problems. That’s why it’s crucial to know about the potential benefits — and pitfalls — of credit cards, credit scores and how the two relate.
What is a credit card?
A credit card is a tool that lets you borrow money to make purchases, balance transfers and cash advances, with an understanding that you’ll pay back the amount borrowed at some point in the future.
When you apply for a credit card, the bank or issuer evaluates your credit history and other criteria. If you have a low credit score or no credit history, they may deny your application. If your application is approved, the bank or issuer will set a credit limit and interest rate.
Your credit limit is the maximum amount you can spend on the card. The Capital One® Secured Mastercard®, for example, will give you an initial credit limit of $200 after you make the minimum required security deposit of $49, $99 or $200, depending on your creditworthiness. That means you’ll be able to spend up to $200 in purchases on the card before paying off your balance.
Each month, the bank or issuer will send out a statement detailing your current balance and all transactions on your account, including purchases and interest charges. The statement also provides details on the minimum payment due and the due date.
Your interest rate is the price you pay for borrowing money, usually expressed as an annual percentage rate (APR).
If you pay the entire balance shown on your statement before the payment due date, you can avoid paying any interest (Note: This does not apply for the cash advance balance, as there’s no grace period for cash advances). This is because most credit cards come with an interest-free grace period on new purchases, typically somewhere between 21 and 25 days. If you pay less than the total balance, you’ll be charged interest at the agreed-upon rate on any remaining balance.
Right now you may be asking yourself, “Why use a credit card when I can just make purchases with cash or a debit card instead?”
One of the main reasons is security. If your debit card is stolen and the thief empties your bank account, you need to work with the bank to have your money returned. You may not be able to access your cash or pay your bills for days. If the same happens with a credit card, you’ll typically be covered. That’s because most issuers will put any suspicious or fraudulent charges on hold while they investigate further, and you’ll still have access to your own money in the interim.
Another reason to use a credit card is that it helps you establish and build your credit. Which brings us to our next point.
What is a credit score?
Your credit scores are three-digit numbers, typically ranging from 300 to 850, which lenders use to evaluate the probability you’ll repay your debts. FICO and VantageScore offer the most commonly used credit scoring models, though others exist as well.
A variety of factors may affect your credit scores, including your credit utilization rate (how much of your available credit you use on a monthly basis), collection accounts, and any tax liens or judgements against you. Different credit scores weigh these and other factors differently, so it’s important to read up on any updates to the major scoring models.
If you’ve never used credit before, Julie Pukas, head of U.S. bank card and merchant services at TD Bank, says a good way to build a credit history is opening a credit card account. “If your credit is low or nonexistent, you may need to apply for a secured card,” Pukas says.
It may be helpful to think about a secured card as a sort of credit card with training wheels. You’ll put down a deposit with the bank or issuer, and the limit on your card may be the amount of the deposit or a percentage of it. “Once you prove you’re responsible, your deposit is refunded, and you can upgrade to a regular card,” Pukas says. Major issuers such as Citi®, Capital One® and Discover all offer their own secured card, so look around before applying for the first one you see.Read more about how secured credit cards work.
How to build good credit
Your credit scores are partially based on your previous use of credit, including whether you’ve missed payments in the past and how much credit you’re currently using. For that reason, it’s important to use credit responsibly.
Mismanaging credit when you’re young can have lasting consequences down the road, making it harder to rent an apartment, buy a house and finance a car. Pukas recommends the following strategies for building good credit:
- Keep your credit utilization rate low. “Your goal should be to never let your total credit utilization rate exceed 30 percent,” Pukas says. “The lower your utilization rate, the better your credit may be.”
- Pay in full and on time each month. Prove you’re responsible by charging only what you can afford to pay off. While paying the minimum amount due each month will help you avoid late fees and avoid blemishes on your credit reports, Pukas doesn’t recommend paying just the minimum amount due. “That will only result in paying interest, and it does nothing to help your credit, so it’s best to pay your entire bill every time.”
- Use the card for needs, not wants. While you’re building credit, make smart spending choices and avoid making purchases that you can’t pay off each month. “Think of it as a loan to yourself,” Pukas says, “and pay it back as soon as possible to avoid interest charges.”
Using credit cards can help you build good credit and set you up for a strong financial future.
Those with excellent credit may enjoy easier access to the best rewards credit cards and lowest interest rates. But racking up more charges than you can handle or not making debt payments on time can damage your credit and cost you hundreds (or even thousands) in interest and penalties.
Credit cards can have an enormous impact on your financial goals, so consider them in the context of your budget, overall debt and other financial priorities. Use them wisely and save yourself from the problems that come with a rocky credit history.
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