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. 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 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.
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