how do credit cards really work?
It’s understandable why many people are hesitant to open a credit card. They're often associated with long-lasting debt, high fees, and a negative impact on credit scores. However, if used properly, credit cards can be very beneficial to a person’s financial wellness!
The first step to maximizing the use of a credit card is gaining a better understanding of how they really work. Continue reading for answers to some of the most common questions regarding credit cards. Such as:
how are they different than debit cards?
Credit cards are used to make purchases and pay bills – just like a debit card. The difference between the two is where the funds are coming from. When you make a purchase with your debit card, your money is automatically pulled from your checking account. Credit Cards, however, charge your approved line of credit for the purchase. This allows you to make the actual payment for the purchase later – once you receive your credit card bill.
Credit cards are often associated with debt because the money is borrowed and paid back later, which is why many people are hesitant to open a line of credit. However, one significant advantage that a credit card has over a debit card is the capability to improve a person’s credit.
how can they improve my credit?
Your credit score is one of the most important factors regarding your financial wellness. Those with good credit scores typically get better rates on mortgages/loans, pay lower fees, and are offered more perks. According to FICO, the most widely used source by lenders, your credit score is determined by five distinct factors:
- Payment History (35%)
- Credit Usage (30%)
- Age of Credit Accounts (15%)
- Credit Mix (10%)
- New Credit Inquiries (10%)
Using a credit card can positively impact each one of these factors! However, if not used properly, a credit card can also be destructive. Luckily, there are easy guidelines you can follow that will help you maximize your credit card use. These include:
paying on time
The most essential factor in determining your credit score is your payment history. Because of this, you must make your credit card or other loan payments by the due date. There are many negative consequences associated with poor payment history. These include a lower credit score, higher interest rates, and late fees. You'll also be considered a “risky” person to lend money to when you apply for mortgages or loans. Lenders will likely offer you higher rates to make up for this risk.
It’s always the goal to pay more than what is due or even your entire bill each month. However, your payment history will be just fine if you're at least making your minimum payments. Ensure you're spending within your means and paying attention to your due dates!
pro tip: Setting up auto-pay on your accounts is a great way to avoid missing payments! You’ll have peace of mind knowing that your bill is being paid every month and your payment history is not affected.
keeping your balances low
A good rule of thumb with credit card balances is that you should always have at least 70% or higher of your approved credit available. For example, if you have $100 in available credit, make sure you have at least $70 available. This is because a low credit utilization rate dramatically impacts your credit score. Essentially, this information tells lenders that you can save and won't spend every penny you have.
keeping your accounts open
Let’s say you’re evaluating your finances and determine one of your credit cards is a little outdated. The logical next step would be to cancel it, right? It makes sense! Why would you keep a card open that you don’t intend on using? However, financial experts advise against this practice. In fact, regardless of what type of credit card it is, it’s typically more beneficial to keep your accounts open.
There are a couple of reasons for this. First, lenders look at your average credit age more favorably the longer it is. The other reason is the effect it'll have on your credit utilization. Suppose suddenly you take away a portion of your available credit. The percentage you’re now using will increase.
Keep in mind that there are times when closing an account would be a better option. If you find that you are constantly maxing out your cards or making late payments, you’ll probably want to get the card paid off and close the account. Always make sure that your use of a credit card improves your financial wellness and doesn’t hurt it!
pro tip: Wait at least six months between credit card applications. Applying for a new line of credit is considered a “hard inquiry," which means it'll appear on your credit report. A hard inquiry every once in a while will not affect your credit score much, but multiple in a short period can be damaging!
For more information regarding establishing good credit, check out our blog: Five Ways to Establish Good Credit.
how do interest rates work?
Interest rates are the amount a lender will charge a borrower for using their money. They'll typically be identified on your statement as the Annual Percentage Rate (APR).
Many factors determine what your interest rate is going to be. Some credit cards have a flat interest rate for everyone. Others have a range, for example, between 10%-20%, and where you fall will depend on your credit score. In general, the higher the interest rate, the more you'll end up paying. However, it's possible not to pay any interest when using a credit card!
The grace period is the time between the end of a billing cycle and the date your payment is due. You'll not be charged interest if your balance is made in full by the due date. It's not required for credit card companies to give their customers grace periods, but it's common practice.
Another way you can avoid paying high-interest rates is to take advantage of credit cards that offer 0% APR for a period of time. For example, BlueOx Credit Union offers 0% APR on balance transfers for the first six months with our Visa® Platinum Rewards Credit Card. This is an excellent option for consolidating multiple credit cards into one monthly payment to pay off your debt faster!
Now that you have a better understanding of credit cards and how they work, what now? If opening a line of credit seems like a good option for you, consider BlueOx Credit Union’s Visa® Platinum Rewards Credit Card! Take advantage of low monthly payments, Mobile Wallet, Payment Protection plans, and so much more! Click the following links to learn more:
« Return to "BlueOx Blog"