Credit cards are a powerful tool in today's world; they have so many benefits! Unfortunately, if you haven't been able to develop proficient financial literacy, credit cards can be confounding, even scary.
Used incorrectly, credit cards have the ability to wreck your financial future. Used wisely, they can set you up for lifelong success!
- How Credit Cards Work
- Why Everyone Should Get a Credit Card
- Choosing the Right Credit Card
- How to Build Credit
Here's everything you need to know about credit cards in five minutes.
How Credit Cards Work
There is a common misconception that credit cards and debit cards are the same; this could not be further from the truth.
Debit cards are linked directly to your bank account, so when you use a debit card to pay for something, the money is subtracted from your account.
Credit cards are a different animal. When you use credit cards, you are taking out a short-term loan that you will pay back to the credit company. Your money is not actively spent until you pay off the balance at a later date.
Credit cards function on what is called a line of credit. A line of credit is the amount of money you can borrow on a credit card. If your line of credit was $1,500, then you could spend up to $1,500 in one billing cycle. Not to say that you should, but you could.
Credit card payments are organized by billing cycles. Typically, these span over one month. At the end of every billing cycle, it is time to pay off the balance accrued over the cycle's life span.
When paying off your balance, there are multiple options. You can pay the balance in full, pay a portion of the balance, or make a minimum payment. If you fail to pay in full, the remainder of the balance will carry over to the next billing cycle. At this point, the balance is subject to interest.
For this reason, it is crucial to try and pay in full every billing cycle. Interest rates on credit cards are absurd!
Why Everyone Should Get a Credit Card
Now that you know what a credit card is, here's why you need to get one.
By using a credit card with proper caution, your credit score can be vastly improved. Credit cards are essential for establishing good credit history!
When credit cards are used to build good credit, new avenues open up for its user. With an established credit history and stellar credit score, you will have a much greater chance of being accepted for loans to be used for larger purchases, such as mortgages or car loans.
Not only will users be rewarded with opportunities for large loans, but the terms of these loans will be favorable with a good credit history. The chances of receiving lower-interest rate loans are the resultant.
Less important but still awesome, credit cards have many benefits available to their users.
Many credit card companies offer cashback on specific purchases and travel points to be later utilized. For example, Chase Sapphire offers 60,000 travel points when you spend $4,000 within three months of opening the card.
Choosing the Right Credit Card
Now you're ready to get a credit card!
When choosing a credit card, you want to ensure you're selecting one that meets your specific needs.
The two biggest factors when choosing a credit card are as follows:
- APR (Annual Percentage Rate)
- Annual Fees
The average APR on credit cards is 15.13% according to data collected by the Federal Reserve in May 2022.
The lower the APR, the better. The higher the rate is, the more interest you'll be paying on any unpaid balance.
Let's say the APR on my credit card was 10%. If I carried a balance of $2,000, I would have to pay an additional $200 over the next year in interest. Realistically, the math is not that simple because minimum payments must be made and the interest would compound, but you get the gist.
The other factor when choosing a credit card is the annual fee that must be paid to keep the account open.
The annual fee you are willing to pay depends entirely on your situation. A college student is most certainly a better fit for a card with no annual fee, while a high-spending business owner may opt for a card with an annual fee in return for greater benefits and a higher credit line.
As shown above, cards with no annual fees often come with fewer benefits and a lower credit line. These would be best for a first-time credit card or someone who will be an infrequent user of their card.
Conversely, the higher the annual fee, the more benefits the card will come with. The credit line will also typically be higher.
Second to APR and annual fees are the rewards the card comes with. This is important so you can maximize your benefits, but APR and annual fees should be the main focus.
All things considered, for those in a similar situation as I (a college student), I would recommend the Discover it Student Cash Back Card. It has no annual fees and prior credit history is not necessary.
How to Build Credit
To properly build credit, it is necessary to identify how credit scores are calculated.
There are four basic criteria for evaluating credit score, each of which can be manipulated carefully to increase credit. They are as follows:
- Payment history.
- Credit usage.
- Credit age.
- Credit mix.
Payment history is the track record of whether or not the balance has been paid off every month.
As mentioned earlier, it is not mandatory to pay off the balance in full, but it is highly recommended. If the balance is only partially paid, credit is negatively impacted.
So, to properly use payment history to bolster credit, pay the balance in full every billing cycle.
Credit usage deals with how much credit is being used every month. Once the credit line is set at a certain limit, any amount up to that limit can be spent on the card. However, this is not the most diligent way to go about using a credit card.
An important aspect of credit score is what's known as the credit utilization ratio. This is how much you spend every month in relation to the credit line.
For example, if my credit line was $2,000 and I spent $500 in one billing cycle, my credit utilization ratio would be 25%. This is because I spent 25% of my available credit.
Now, the recommended credit utilization ratio is 30% or lower. Anything above that indicates to the credit card company that you may be overextending yourself.
To build credit through usage, use 30% of your credit line or less.
Credit age is how long your history of credit is.
Companies who see twenty years of credit versus two years of credit will surely choose someone with twenty years because they have a more extensive track record. That is, they feel more comfortable loaning to a credit user who has prior experience.
As a young individual, it can be tough to establish your credit age. The general recommendation stands that you should never close your first credit card; as you leave it open, the credit age will increase even if it's not actively used.
If possible, it is also beneficial to have your name added to a parent's credit card to lengthen your credit age. This comes with its risks though; whoever the cardholder is must be responsible and pay in full, otherwise, your credit score will be negatively impacted.
Credit mix is how diversified you are in the realm of credit.
Compared to the first three credit indicators, this should be a secondhand thought. It is only a small sliver of your credit score.
Having diversified credit, like credit cards, vehicle loans, mortgages, etc. shows that you can manage your credit across different areas and successfully keep pace with payments.
Of course, if you don't need a mortgage or a vehicle, don't take a loan out for the sole purpose of increasing your credit mix. It is more prudent to simply tackle the credit opportunities you already have.
If you have a diversified credit mix, great! If not, do not worry about it; just focus heavily on being a responsible credit user.
That's all there is to know! For those interested in furthering their knowledge of credit cards, the video embedded below is an excellent resource. Go get 'em!