Credit cards are the most common form of debt. True, plenty of borrowers have access to mortgages, car loans, lines of credit, etc. However, almost everyone these days has at least one credit card to deal with. They can be useful tools for buying the things we need and building good credit as a result. The only problem is that many consumers do not recognize the impact that credit card usage, both responsible and irresponsible, can have on their daily expenses and their financial health as a whole.
So, if you’re just getting your first credit card, or if you’re a frequent credit card user, but you haven’t read up on the subject, it’s important for you to understand the many aspects, benefits, and disadvantages of credit cards. Remember, while credit cards can be very useful, there are plenty of things that can go wrong, if and when you’re not handling them with care.
Is cancelling a credit card bad for your credit score? Find out here.
Main Credit Card Components
What most consumers find appealing about credit cards is that, while most of them come with relatively high-interest rates, they also have a monthly grace period, allowing them to purchase various things, but not spend money on them right away. On top of that, if they manage to pay back their full balance each month, no interest will be charged to their account.
The monthly balance, however, isn’t the only thing that consumers, you included, should be aware of when using one or more credit cards. In fact, there are several other key components that every credit card user should understand before they apply for their first card, or start using their current ones irresponsibly for any reason.
Minimum Payments
The “minimum payment”, which every credit card has, refers to the minimum amount that you, as the card user, must pay toward your balance every month. The minimum amount is usually a percentage of your total balance, or a fixed amount that will be required every month. By sticking to your minimum monthly payment, you’ll be at least ensuring that your credit score doesn’t drop and that you won’t be charged any late fees. If you don’t at least manage to make your minimum payments, not only will you be racking up debt in penalties, your credit score will be damaged with every late payment. The lower your credit score drops, the harder it will be to get approved for credit products in the future.
It’s important to realize, however, that while sticking to your minimum payments will spare you from damaged credit and penalties, it’s best not to keep up this habit for too long. That’s because every dollar in your monthly balance that you don’t manage to pay off will add to the interest that you’ll be charged. Depending on how bad you let it become, high-interest debt can take months, even years to pay off in full.
Make sure not to fall into the minimum payment trap.
Interest Rate
That brings us to our next credit card component, your interest rate. An interest rate is what lenders apply to their credit products in order to make a certain profit from the services they provide. Typically, there are two different types of interest rates, known as “variable” (the rate fluctuates in accordance to the current market prime rate) and “fixed” (the rate remains the same). In the case of most credit cards, a fixed rate that will be applied.
Generally speaking, the interest on most credit cards is relatively high (sometimes 19.99%) starting off. However, the rate you’re given may also fluctuate based on your current credit score. The higher your credit score is the lower your overall interest rate will be, and the more money you’ll save, if and when you don’t manage to pay off your full credit card balance from month to month.
Interest-Free Grace Period
When it comes to credit cards, the “grace period” refers to a period during your typical monthly payment schedule when no interest will be applied to your pending balance. In Canada, your grace period is 21 days after the end date of your statement period.
For example, let’s say that you made a purchase on the 12 of June and your statement is from the 1st of June to the 31st of June. You will then have until July 21st to pay off the complete balance of your statement if you want it to be interest-free. In the event that the balance is not paid off in full, you’ll be charged interest from the date that you made the purchase.
What happens when you stop paying your credit card bills? Find out here.
Credit Limit
Your “credit limit” refers to the maximum amount that you’re allowed to borrow when using your credit card to make various purchases. When you first activate a new credit card, you’ll be approved for a basic, starting limit, the amount of which is established by your credit card company according to your financial history and your credit rating. Whenever you charge an expense to your card, that amount will be deducted from your credit limit, reducing it until you pay off that balance. If you try to go over your limit, your purchase may be declined. Furthermore, you may end up having to pay enormous fees due to “overdraft”, which is a penalty that a bank charges you to cover the cost of the excess money you’re trying to spend.
For some tips on how to avoid NSF (non-sufficient funds) and overdraft fees, look here.
While the idea of a credit limit might seem a bit nerve-racking at first, it’s set in place so that borrowers don’t end up piling on more debt than they’re able to handle. And, as time goes by and you continually make responsible credit card payments (balances are paid on time and in the fullest amounts possible), your credit card company may approve you for a higher credit limit.
This is beneficial in two ways. Firstly, you’ll be at less risk of maxing out your credit limit. Secondly (and this is very important), your credit score will be less affected the further from your credit limit your balance is. This is known as your “credit utilization ratio”. It’s recommended that you try to keep your ratio below 30% of your available credit limit (the total credit limit you have over all your credit cards). The higher your utilization ratio is, the closer you will be to your credit limit, and the more your credit score will drop. However, as you pay off your balance, your credit score will rise. So, if you feel like you’re at risk of reaching your current credit limit, you can always accept the increase that was offered or request a higher limit if you aren’t yet approved for one.
Cash Advance Transactions
By performing a “cash advance transaction”, it means that you’re withdrawing cash from an ATM, at your bank, or another source, up to your specified credit limit, similar to a cash-back transaction you can make with your debit card. While a cash advance transaction can be handy, it’s not recommended due to the fact that your credit limit will still drop, but the money you withdraw won’t be applied to your regular grace period. On top of that, you’ll be charged interest as soon as you make the transaction.
Fees
It’s also essential to know that most credit cards have multiple fees related to usage. Below, we’ve added a simple list to help you understand the fees that may potentially be charged to your monthly statement without you realizing it.
- Annual fee: a fee that is required annually (usually the date you activated the card) to keep the account active. While many basic credit cards are labeled “no annual fee”, some rewards/points cards can cost upwards of $100 per year.
- Cash advance fee: as we discussed just above, this is the fee that follows a cash advance transaction.
- Currency conversion: a fee you’ll be charged when you use your credit card to purchase items in another country, where the conversion rates are different.
- Balance transfer: a fee applied when you transfer the outstanding balance from one credit card onto another credit card.
- Dishonored payment: a fee that’s applied to your account when you default, meaning you fail to pay at least the minimum payment required.
- Over limit: this is essentially an overdraft fee. When you go over your credit limit, this amount will be charged to your account.
- Lost card: a fee charged when you request a new credit card due to losing your initial card.
- Past statement reprint: some financial institutions charge a flat fee when you request to print up a past statement.
- Rush card: a fee that’s applied to credit card orders when you want them to arrive quicker than the normal waiting time.
Watch out! Applying for new credit affects your credit score. Click here to find out how.
Reward Programs
When you’re shopping for credit cards, chances are that you’ll come across tons of different options. Credit card companies and financial institutions offer many perks for using their various cards. One credit card type that you’ll be offered frequently over the counter at your bank is the “rewards” or “points” card. These rewards programs are for incentive purposes, either to attract people for enrollment or simply to make you spend more money. Perks are given to the consumer based on their spending habits and the amount they generally charge to their card.
Here are a few examples of popular credit card rewards:
- Point rewards: based on the amount you spend, you will receive a number of points that you may redeem at a later time in exchange for various products. In some cases, you can also use these points to pay down your credit card bills.
- Cashback: a percentage of your spending that will be given back to you at the end of the year. Sometimes this requires a minimum spending amount. Other times, it’s simply a percentage of your total balance. You may receive a cash check or you can use it for purchasing.
- Specific store discounts: these cards, which you can apply for at certain retail locations or gas stations, will give you a discount on all purchases made at that specific store. While you’ll earn more discount points when you use the card at that store (or chain), you still receive a small amount when you use it elsewhere.
- Flight insurance/assistance/ discounts: these are credit cards for people who travel a lot. They offer services such as travel insurance and assistance for specific airlines. Travel-rewards cards can be used to rack up air-mile points, so you can potentially receive discounted flights, even free ones if you earn enough.
The Pros and Cons of Using Credit Cards
Just like every type of financial product out there, all credit cards come with their own set of advantages and disadvantages, so be aware of them before you start applying for the first card that catches your eye.
Advantages
- As long as you’re paying your monthly statements in full and on time, you can potentially receive short-term, interest-free financing for the purchases you make.
- This saves you from reducing your bank account balance right away.
- When used responsibly, credit cards can help build your credit score and credit history, allowing you to gain access to future loans and other credit products.
- You have emergency access to quick and easy financing.
- Many cards come with perks, cashback, rewards points, etc.
Disadvantages
- Many credit cards have fees and costs that you might not notice at first.
- Having access to high credit limits prompts some consumers to overspend and take on more debt than they can afford.
- When not used responsibly (late, short, and/or missed payments), mounting credit card debt can damage your credit score, leading to more serious financial consequences.
- Some cards charge very high-interest rates when your balances aren’t paid in full. Not only will these rates put you in more debt, the effect can ruin your credit score, making it harder for you to get approved for future credit products.
Credit cards are a great financial tool that can help you grow your credit and achieve your goals. Use them responsibly and your finances should flurish.
