Credit Card Overview

August 24, 2018

What is a credit card?

Credit cards are everywhere—Americans have, on average, about three each. But despite their ubiquity, they can be awfully confusing. If you're having trouble understanding how it all works, you're not alone. Here's a crash course in the basics: the value and pitfalls of credit cards, credit card mechanics, and a discussion of credit card debt.

Key takeaways

If you read nothing else, make sure to adhere to the following rules for credit card use:

  • Pay your balance in full each month. You'll never get charged interest if you pay off all your transactions in full (not just the minimum payments) each month. The easiest way to ensure you never miss a payment is to enable auto-pay.

  • Get a credit card when you're young to start building credit history. Even if you don't use your card, getting one early builds credit history, which can help raise your credit score.

  • Review your transaction history monthly. Identity theft is unfortunately all too common. Review your transactions to check for fraudulent charges and notify your bank as soon as you come across any.

Why use a credit card?

What's the point of using a credit card? Well, the obvious scenario in which a credit card is helpful is when you don't have enough money to pay for items or services you want or need immediately, but you anticipate that you will have the money soon. A credit card allows you to get the items now and pay later. But, of course, deferred payment is a dangerous game—to avoid getting stuck in a cycle of debt, it's best to only spend on credit what you have in the bank or know you will very soon have in the bank.

A couple scenarios in which a credit card can be helpful:

  • You need to purchase textbooks now and you don't have enough money in your bank account, but you'll receive scholarship or financial aid funds in a few weeks.

  • You want to rent a car or U-Haul. Many car rental companies only accept credit cards (no debit cards), in order to ensure that they'll receive compensation if you damage the vehicle and you have inadequate funds in your checking account.

Even if you never anticipate being in a scenario in which you need to spend beyond your means, a credit card still has two main benefits. Firstly, owning a credit card (even if you rarely use it) builds credit history, an important factor in raising your credit score. A high credit score will help you out in many ways in life, whether it's renting an apartment or getting a loan. For instance, a high credit score can get you a lower mortgage interest rate, which can easily save you thousands of dollars over time. See the section on credit scores for more info.

Secondly, credit cards can yield rewards. If you make all your purchases on credit cards, you can accrue airline miles, cash back, store credit, and more—depending on the details of the card.

An additional benefit of credit cards over debit cards: credit cards provide more protection against fraudulent charges. If you get a fraudulent charge on your credit card, the credit card company is out that money until the issue is resolved, motivating them to resolve the issue quickly. Conversely, if you receive a fraudulent charge on a debit card, you are personally out that money until the issue is resolved, and your bank is not as motivated to resolve the issue.

How do credit cards work?

Here's how a credit card transaction works: you swipe your card to make a purchase—let's say a mattress. The credit network (which in the US is generally Visa, Mastercard, Discover, or American Express) connects the bank that issued your credit card (AKA the issuing bank) to the mattress store's bank, much like a phone company connects two callers. The issuing bank pays the mattress store's bank. In doing so they essentially lend you, the cardholder, the cost of the mattress.

Before the end of your monthly billing cycle, you can continue to make purchases on credit, up to your credit limit. At the end of your monthly billing cycle, you have to settle with the bank, so you transfer money from your personal checking account to pay back the mattress and all other credit card purchases from the preceding month. Or, if you can't afford to pay off your full balance, you make a minimum payment. In the second case, the remainder of your balance becomes debt that carries over from one month to the next, accruing interest. This is the situation you want to avoid—but the one that the bank loves, since all that accrued interest equals profit for them—and we'll discuss it more below.

The above scenario is a bit oversimplified, of course. Beneath the hood, there's a complex ecosystem of parties involved in the transaction, but you as the cardholder don't really need to know or worry about most of them, with one exception: In many cases there is a partner company involved. For instance, Amazon offers several credit cards. Amazon is not a bank, so they've partnered with Chase to serve as their issuing bank. Amazon's role as partner is to provide Amazon-specific incentives and rewards for purchases on their site. The same goes for airline-partnered credit cards, which offer miles for their respective airlines as rewards for spending. You will interact with the partner by going to their website and redeeming your reward, whether it's miles, store credit, or something else.

Credit card debt

There's a popular notion that using a credit card means taking on automatic debt. Is it true? To answer, we first need to determine what we mean by "debt." Technically, any money owed is debt. Under this strict definition, using a credit card means taking on debt, since it involves spending money that isn't yours, with the expectation that you'll pay it back at the end of a monthly billing cycle. However, when people talk about "credit card debt", they mean something more serious than this "technical" debt incurred between payments: they mean continued debt spanning multiple payment cycles, debt that can grow and grow with compounding interest. Carrying debt from one month to the next is known as "carrying a balance," since it results from not paying off your balance in full at the end of each billing cycle.

This form of debt is unfortunately all too common—over half of credit card users carry a balance— but it is totally avoidable if you are able to spend within your means by paying the entirety of your credit card balance each month, reaping all the benefits (rewards, convenience, credit history, etc.) without any of the debt-driven drawback.

While paying off your balance each month is ideal, it’s not feasible for many in tough financial situations. Sometimes that’s okay—after all, there will be emergencies and other instances in which you need to make a big purchase but don’t have enough in the bank to cover the cost. If you can charge a purchase to your card with a low interest rate and pay it off within a few months, the finance fees won’t necessarily be debilitating. However, compound interest on credit cards can quickly lead to burdensome debt and lock you in a vicious cycle.

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