What is a Credit Card?

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It may look like a debit card, but it definitely is not. A credit card has plenty more uses with a lot more perks. But with these perks, comes responsibility.

Before you get credit card, let’s explore what a credit card is.

Credit card definition

A credit card allows you to borrow money temporarily to make purchases. You can either:

  1. Pay the total amount you spend by the end of the grace period at no additional cost.
  2. Not pay it all off by the end of the grace period and get charged interest.

Difference between debit and credit cards

There is a major difference between a debit card and a credit card.

When you use a debit card, money is taken directly from your bank account and given to a merchant in exchange of a product or service.

When you use a credit card for a purchase, you aren’t using your own funds. You are taking a short term loan from your credit card provider to make a purchase. That loan is to be paid back by at a later date.

There is a responsibility for payment when you use a credit card. If you don’t make minimum payments, your credit score will decrease and will be on your credit report for up to seven years. Also, maxing out your credit card can affect your credit score. Credit scores are also based on your debt to credit ratio or credit utilization ratio which is the amount of credit available compared to your debt. The higher the ratio, the worse for your credit score.

Using a credit card can also be very beneficial for your credit. If you are great with payments and even pay off your entire balance every billing, you will establish a solid credit history that will give you the opportunity to get the best interest rates, credit cards and loans in your present and future.

Learn more…Top 3 Reasons Why You Need a Credit Card

Understanding credit card terms

When choosing a credit card, know what your credit card terms are before you apply. These are disclosed you when you apply for a credit card.

APR

Your APR, annual percentage rate, is the amount of interest a credit card company will charge for letting you hold a balance. No, you cannot hold a balance for free. If you pay the entire balance each month by the payment due date, you will not have to pay any interest.

Your APR could be either a variable or fixed interest rate depending on the credit card.

A fixed rate remains the same. It can be increased by the credit card company if you miss 2 payments in a row (more than 60 days overdue from the payment due date). Otherwise, credit card issuers cannot increase rates for a minimum of one year.

A variable APR is based typically on the prime rate. For example, the APR could be prime + 14.0%. If the prime rate is 3.7% then the total APR, at that time, would be 17.7%. This type of interest rate will change if the prime rate changes.

Grace period

Your grace period is an interest free time period after your monthly billing period. You will not be charged interest. This is typically 21 days.

Billing cycle

Your billing cycle is the period of time between billings. It usually lasts a month or 30 days. It typically starts on the 1st, 15th or 30th day of the month.

Minimum monthly payment

Your minimum monthly payment is the amount of money you must pay each billing cycle in order to prevent any penalties. Even if you make your minimum monthly payment but are carrying a balance on the credit card, you will be charged interest.

Your minimum monthly payment is different for each bill. It is calculated as a percentage of your balance and fees. If you carry a higher balance, your minimum monthly payment will be higher as well.

If you miss your minimum monthly payment, you will be charged a late penalty. This late penalty varies from $15 to $35 depending on your late fee policy.

If your minimum monthly payment is 30 days past due, your credit card issuer will send a late payment notice to the credit bureau. This will affect your credit score and can stay on your report for 7 years. Late payments account for the highest weight of credit scores at 35%. If you miss another payment, then another notice will be issued to the credit bureau.

If you miss two minimum monthly payments in a row, your interest rate will go up. Often, they will increase it to a penalty rate. If you make 6 payments on time, the credit card issuer will decrease your interest rate to the original rate. However, any purchases made after the penalty rate was enforced will be charged at the penalty interest rate.

Late payments do happen. If you are late, make sure to make your payment within 30 days of the late payment. That way you will only be charged a late fee and interest, but it will not affect your credit score or interest rate.

Example Scenario: Your billing period is April 1st to the 30th. Your grace period is between May 1st to the 20th. Your payment due date is May 21st. You are carrying a balance of $1200. Your fixed APR is 18.9%. If your minimum monthly payment is 4% of your balance, you owe $48 minimum on your payment due date.

If you do not make any more purchases on that card and you only paid your minimum monthly payment, it would take you 79 months or 6.5 years to pay off and you would end up paying a total of $1841.26 or $641.26 in interest.

You can see that paying only your minimum monthly payment is not a good strategy if you are looking to save money or pay off your debts fast.