How Credit Cards Really Work

How Do Credit Cards Really Work?
A Guide For Anyone With A Credit Card.

 

A lot of readers of personal finance blogs are already advanced in their knowledge of how money works; how to make it, how to spend it and how to save it. It’s almost an elite club where we push each other to find new ways to stretch a dollar, make a buck or aim for early retirement. This time, I am writing for those who are not masters of their finance; people like you and me: they may be on either end of the income scale, they drive on the same side of the street and yet know nothing about credit cards.

 

These days, I am working with people and helping them understand their credit card debts.  It’s no wonder that we can get ourselves into financial messes and not really understand how it happened because no one has taken the time to explain how credit cards work.

 

CREDIT

 

Credit. It’s like a four letter word with gatekeepers on either side. Credit seems to be a confusing animal. Here is the simplified version of the way credit cards work. I wish everyone would take a moment and read or share.

 

The Credit Card

 

Credit is money that is lent to people who may have demonstrated the ability to manage money through other means as reported by the credit bureaus. Credit cards are a device to access funds that a bank or institution has given you access to. It is not your money, it is the bank’s money. If you use that money, it is still the bank’s money. You have borrowed it.

 

Let me repeat that. You are borrowing someone else’s money and the credit card belongs to the bank, not to you.

 

In order to assist you, and to be accountable to you, banks issue statements on a regular basis. Generally, they send you a statement monthly that outlines each charge or payment or adjustment that occurred during the last month, if any.

 

The statements have a due date scheduled on them, generally 21-26 days after the date of the statement, and the statement shows you a balance due. This balance is the amount YOU have spent or accrued over the last month. Pay that amount by the due date, and you’ve received a free loan. Seriously.

 

There’s a second amount on the statement called minimum due. This is a good faith payment that the bank expects from you to show that you intend to pay off that balance in time, if you cannot pay it in full. The minimum payment will keep your account in good standing but will not deflect interest from accumulating on the balance that remains.

 

Let’s simplify that: Pay full balance by due date, no interest to pay. Do not pay full balance by due date, then your balance is subject to interest from the date you spent it.

 

I want to mention here that banks are businesses. I am not advocating for the amount of money they make, as I think it’s truly excessive (my opinion). However, judging by the amount of people who do not understand how to use a credit card, it’s no wonder that they are making oodles of money and you are losing your hard-earned money in return.

 

Example: If you borrow a library book and don’t return it on time, the library fines you. This is no different. If you choose to pay in instalments on a credit card, that’s your choice to do so – that’s why the credit cards set out minimum payments.  It’s enough to keep your account current, but if you do not return the funds in a timely manner, there are fines to pay.

 

Interest on the Credit Card

 

Interest is how banks make lending money affordable. It’s how they make their money. And, if you are reading personal finance blogs, it’s all about how to make the money, right?

 

Interest rates on credit cards can range anywhere from 12 – 30%. Banks generally have lower interest rates available to those with good credit, but there’s a catch:

No rewards, good credit = lower interest rate 

Rewards, good credit = middle interest rate 

No rewards, bad credit = higher interest rate

Rewards, bad credit = highest interest rate 

*there are exceptions to every rule, but this is a general perspective.

 

Before deciding on a credit card that earns you miles, or points or freebies, you need to consider how you use your credit. If you pay your balance in full each and every month, a higher interest rate and higher rewards would benefit you because you wouldn’t pay interest. However, if you carry a balance, then you would be paying interest on these funds, and would have to consider if the cost of carrying the balance at that interest rate is worth the rewards you are receiving. It doesn’t make sense to pay a high interest rate to earn air miles, for example, if you could turn that interest into a flight by the time you are done!

 

Before deciding on a rewards card, make the decision to pay off the balance every month; otherwise, you are paying for the rewards. Why not just pay for what you want? Click To Tweet

 

Interest rates are set by market standards: cost to borrow money (if the bank borrows), cost to run the business, cost of risk from customers, etc. The standard credit card will have a range of interest rates from 18 – 22%, and more if you are higher risk. This is why the cost of borrowing money is so expensive.

 

Remember, when you don’t pay your borrowed funds back by the due date, you will owe interest!

 

Cash advances on the Credit Card

 

A lot of people have no idea what or how a cash advance works! A cash advance is when you use an ATM machine to withdraw cash from your credit card. Alternatively, it can also be when you use your credit card for gambling or lottery. These transactions are often processed as a cash advance.

 

Your credit provider likely has a fee for cash advances, as cash advances are a service provided in conjunction with the Mastercard and other networks. Like a scenario where you withdraw funds from another bank’s ATM, the other bank will likely have a service fee attached as well.

 

That’s not all that happens with cash advances. Interest begins the day that you take the cash out, and will continue until your full balance, purchases and cash advances together, are paid off.

 

Cash can be used for nearly anything and is not traceable as easily as a purchase, which makes it a higher risk transaction.

 

Cash advances are usually charged at a higher interest rate because they are a higher risk to the bank. There are usually fees associated with obtaining a cash advance, and interest starts on the first day that you take one out.

Let me repeat that: cash advances accrue interest the first day you take it out.

CREDIT CARDS Before you assume you understand the credit card, read this. I was shocked at the questions that I heard over and over. Here are your answers. #credit #creditcard #debt #wealth #money #budget

Credit cards have complicated repayment methods, and are individual to each company. There’s a good chance that your payment is spread between regular purchases and cash advances, after paying fees and interest. If you carry a balance on your credit card, you will likely not be able to directly pay back the advance. Interest on that cash advance will continue, at a higher rate, while you pay down the remainder of the balance. That couple hundred bucks you borrowed will be eating at your payments for a long time.

 

Credit cards are fantastic tools for managing your money, building credit and earning rewards, but only if you pay them in full every month. If you carry a balance, you are borrowing money, and that means the lender can charge you to do this, so don’t be surprised at the result!

Using your Credit Card Correctly

Many people get credit cards and think they know how they work, but be sure you do. Understand how interest is calculated. Be aware of annual fees, late fees, interest charges, and interest rates. I am sure to get feedback from some people that this is common knowledge, but I assure you, it’s not. If you have any questions about how credit works, please send me a message or comment below, because credit is not an easy concept for everyone, and there’s no reason to be lining someone else’s pocket when it could easily be your own.

 

This post may contain affiliate links, meaning, at no additional cost to you, I may earn a small commission if you choose to purchase through these links. Please see my disclosure for more information. Amazon Affiliate Disclosure: I am a participant in the Amazon Associates Program, an affiliate advertising program designed to provide a means for me to earn fees by providing links to Amazon.ca and affiliated sites.

Credit Score Anatomy: What’s It All About?

What’s in a Credit Score?

 

I will be offering up a credit series that gives you information on what a credit score is, how to maintain it, how to maximize your credit, and how to repair it. We will go step by step, so that beginners have an opportunity to get their feet wet. If you are not a beginner, please check back or offer up your suggestions below. We’d love to feature some tried-and-true examples and some questions from those of you who are looking to build up your credit, so please contact me here.

 

credit score

 

A credit score is a numerical value that is assigned to everyone with a Social Insurance Number, or for my friends in the south, a Social Security Number.

 

This numerical value, or credit score, is calculated by one of two credit bureaus in Canada. TransUnion and Equifax obtain information from creditors, or lenders, and input all of the information into a database. Each piece of information is weighted with a significance factor to establish a credit score.

 

The Anatomy of a Credit Score

 

Credit Scores range from 300 – 900. The closer to 900 you are, the better your score. The average credit score in Canada is 749, which is considered pretty good. If you are below that number, chances are you’ve had some issues with your credit in the past.

 

There are 5 main categories that can affect your overall score:

  • How much credit you have (30%)
  • Your payment history of that credit (35%)
  • The length of time you’ve held that credit (15%)
  • How many inquiries for credit you make (10%)
  • The type of credit you have (10%)

 

How Much Credit You Have:

 

Credit is considered the borrowing power you have, or how much “trouble” you could get into.

Meet Joe. Joe is our example man today. Joe has three credit cards. He has one with his main bank, one with a retailer, and one with another institution.

Card One: Visa with Royal Bank of Canada, limit of $5,000.00.

Card Two: Mastercard with Canadian Tire, limit of $1,000.00.

Card Three: Mastercard with Scotiabank, limit of $3,000.00.

 

In this example, Joe has a borrowing power of $9,000.00 in revolving credit.

 

 

Your Payment History of that Credit

 

Every month, or every payment cycle, your creditor or lender tells the credit bureau three things: how much your balance was, how much your payment was, and if you paid it that month.

 

If you do not pay your credit account on time, the credit bureau gets notice of this, and makes a mark on your file. This affects your credit score and brings it down. If you pay your account on time, then no mark is made.

 

 

Length of Time You’ve Held Credit

 

The credit bureau likes to see that you can manage your credit, and the longer that you hold credit indicates that you can manage credit to the satisfaction or approval of the creditor.

 

It’s not set in stone how long you need to hold credit for in order for it to positively affect your credit score, but it’s always recommended to keep one or two credit cards and use them periodically to keep them active. It goes without saying that the longer you can hold credit, you must be doing something right, as the lender continues to reward you with the ability to borrow.

 

 

How Many Inquiries You Make

 

An inquiry is just that: you inquire about obtaining credit. Credit bureaus are not big fans of people who ask for credit all the time, as it makes you appear too risky. Imagine if you had two children, and one is always asking for money. Your second child does not. She uses what money she has for the things that she wants. If the second child came to you and asked for money, you’d be more inclined to give it to her than the first, simply because she doesn’t ask often.

 

Your credit works a lot like this. Credit inquiries will hurt your score, albeit temporarily, but the more you ask for, the more you will have your score drop. The more your score drops, the more likely you will not be approved for credit. It’s certainly a lose-lose situation.

 

 

The Type of Credit You Have

 

How many types of credit can you have? Here’s a list of the most common ones, and they are each weighted differently:

  • Revolving Credit, like credit cards
  • Revolving Monthly Accounts, like cell phones
  • Installment Loans, like cars or student loans
  • Installment Mortgages
  • Revolving Mortgages, like lines of credit

 

 

Take Action

 

The first step in safekeeping your credit is to do regular credit checks. You want to ensure that someone else is not using your credit, your credit is not being checked without your approval, and that your lenders are reporting your accounts accurately.

 

 

Checking Your Credit

 

Borrowell

Borrowell is a Canadian company designed to help Canadians build and improve credit. Even if you do not think you need to change your credit habits, Borrowell allows you to obtain a free credit report and score without dinging your credit score. You can track your progress over time, and get reports on how you are doing, plus they have offers for loans, credit cards and more, based on your credit profile.

 

Why I Love Borrowell

 

I started using Borrowell a couple of years ago so that I could ensure my credit was reporting correctly.

I have found inaccuracies and had them fixed. Imagine if I’d never looked!

Borrowell also sends me periodic emails to tell me that my credit score has been updated, and to confirm that any new additions to my credit are valid. They tell me if a bank has a better deal geared to my credit score, so that I could obtain a low-interest credit card, a mortgage, or qualify for a loan.

 

Plus, did I mention it was free?

 

 

Now You Know

 

Now that you understand the basics of a credit score, I recommend that you go immediately to check yours. Make sure that each account is reporting correctly, and that there are no collection amounts.

 

The next installment of this series will talk more about how to improve credit and get you to that top score.

 

Other Sites to Get a Free Score and Report:

www.creditkarma.ca

www.Mogo.ca

www.Equifax.ca

www.transunion.ca

 

This post may contain affiliate links, meaning, at no additional cost to you, I may earn a small commission if you choose to purchase through these links. Please see my disclosure for more information. Amazon Affiliate Disclosure: I am a participant in the Amazon Associates Program, an affiliate advertising program designed to provide a means for me to earn fees by providing links to Amazon.ca and affiliated sites.