How Do Credit Cards Work? – A Simple Guide With Examples
It’s no secret that I love credit cards and the benefits that they bring to my life. I have shared almost a half dozen pieces of content on them ranging from why I think everyone should have one to my recommendations on specific cards. Over the last couple of months, I have been receiving more and more messages asking questions and they all usually come back to the same topic:
How does a credit card work?
Let me try to answer that question for you.
A credit card gives you a line of credit (think of this as an allowance that you have to pay back) each month which you can use to make purchases. The amount that you’re allowed differs with every person and is typically based on your credit history. In addition, credit cards offer balance transfers and cash advances which aren’t as commonly used as the line of credit.
Credit cards are simple tools but for some reason, how to actually use one usually gets misrepresented.
In my experience, people usually think I’m crazy for my stance on credit cards. The usual responses are “you just don’t understand” or “you must be in so much debt”. Well, I can happily report that I do understand and that I have zero credit card debt. Never have and never will.
In this article, I want to take you back to step one of a credit card. I’ll be honest, I’m going to start out with the cons because that is where most people get into trouble with credit cards. From there, I’m going to explain to you how I’ve never made an interest payment ever. Then finally, I want to show you how you too can successfully use a credit card.
To wrap the article up, I want to address some common misconceptions as well as answer some related questions.
Enough small talk, let’s jump into the dangers of credit cards.
Why Credit Cards Are Dangerous
People commonly think that credit cards are simply a loan and they should use them as one. While they are technically correct a credit card should NEVER be viewed as a loan. Think student loans are bad? Wait till I show you the math of credit card interest a little later in this article.
Credit cards are dangerous because they charge an extremely high-interest rate. Luckily for you and I, we don’t have to ever pay interest if we follow this one simple rule:
Pay off your credit cards in full every single month and never carry a balance.
Please pause, go back and re-read that.
Seriously, it’s that simple. But this is the most commonly broken rule and gets you into a debt situation that could ruin you.
Credit card interest is no joke. It doesn’t matter if you have a perfect credit score, your interest rate will almost always be over 20% APR (annual percentage rate). This interest is applied monthly so that 20% rate becomes 1.6% per month.
Ouch right? Well here’s where it gets even worse. You can choose to make the minimum payment per month and pay that 20% APR. Depending on the bank that issued the card, the minimum payment can be as low as $25 or a percentage of your balance. When you’re only paying the minimum amount, all of the rest of your balance is earning interest in a bad way. And if you miss the minimum payment altogether, you will have to pay a penalty APR which is usually around 30%.
See how easy it is to get sunk in credit card debt and why you shouldn’t treat it like a loan? Let’s do some math to drive this point home.
Credit Card Interest Math
To make this super clear, I need to put numbers in front of you to show you how much of a problem credit card debt actually is.
In the example below, each person spends $2,000 a month on their credit card. The first person (which represents you and I after you are done reading this article) pays off their card in full and never carries a balance.
The second person makes a minimum payment of 10% of their balance per month. The third person just refuses to pay altogether.
Unfortunately, a lot of people end up in this third category and it’s crippling.
Now check out this chart:
If you decided to pay your statement in full every month, then congratulations! You have no credit card debt and are free to live your life!
But if you are person two or three, then you are in a heap of trouble. Let’s jump to the worst-case scenario here and say you decided to never make a payment. In three years you would owe your card issuer over $100,000. How did swiping a credit card all of a sudden turn into you being totally sunk in debt?
To answer this simply, you need to understand compounding interest.
I won’t go too far into depth on how compounding interest works here, just know that your debt is growing off of itself and it’s a never-ending cycle. To read more and learn how you can use compounding interest to make you money, then check out my article: Start Saving Now to Become A Millionaire – Part 2.
Even if you made the minimum payment per month, do you think you could pay off $20,000 in credit card debt over time? That’s a paralyzing thought that is 100% avoidable.
How Credit Card Payments Work
Now that you’ve learned that you need to pay off your credit card in full when each statement is due, the next step is figuring out when each statement is due.
You would be surprised at how many people get this wrong and end up paying late. On the other hand, one of my best friends (who will probably read this), believed he needed to pay off each purchase as soon as he got home. The problem is that its not easily accessible information and who actually reads the 10-page long cardmember agreement that credit card companies send out?
At the end of the day if you haven’t been taught this, then you just won’t know. Nothing wrong with that, it just is what it is. So let’s address it.
I told you earlier that a credit card is technically a loan but you shouldn’t view it as one. You’re going to make one payment and never pay any interest. On a traditional loan or line of credit, you would pay it off over time with interest included.
When it comes to a credit card, you make purchases with it all month. For the sake of example, let’s use January. At the end of January, you spent $500. When do you pay that off?
Well, this is where it gets tricky. You would think that you would need to pay everything off on January 31st but that’s not how it works. Instead, the due date is usually 25-30 days after the close of that billing period.
For this example that would mean that your bill would be due somewhere around the end of February.
Where this gets complicated is when your billing period doesn’t close at the end of the month and instead falls somewhere in the middle. All of your bills are due at the beginning of the month so why not your credit card? The simple answer is that companies start your billing period on the date that you opened the card.
If you opened the card on January 10th then your billing period would be from January 10th – February 10th and you would pay off that bill March 10th. If you are like me, then this process seems extremely inefficient. The good news is all you have to do is call your bank and tell them you want everything lined up with the first of the month. They’ll usually take care of it for you, no problem.
How To Never Miss A Credit Card Payment
I’m guilty of being forgetful and sometimes missing things altogether. Nobody’s perfect! There is no reason this should happen when paying off your credit card though. That’s because you have the life-changing option of not having to manually pay it every month.
I just published an article called: How To Automate Your Bank Accounts To Make Money – A Helpful Illustrate Guide and that ties right into my point here.
Every credit card out there should allow you to set up automatic reoccurring payments each month. When you set these payments, it is going to give you a few options like “make the minimum payment”, “Pay full balance”, and “Set Custom Payment”. From reading this article you already know which option you need to choose.
With the availability of auto payments, you never again have an excuse to not pay off your credit card in full.
Why Should I Get A Credit Card?
Okay, so hopefully the last section calmed your nerves about credit cards. Now lets talk about the pros. Why should you use a credit card, when you have a debit card that works just as well?
It seems like an unnecessary risk to take on when you could just spend the money that’s already in your bank account right?
While this may seem like solid logic, it ignores some of the main benefits of having a credit card. Let me show you some.
Credit Card Benefits
- Building your credit – This is easily the biggest pro of credit cards. Credit cards give you a chance to build credit that will help you down the road. Without a solid credit score and history, the chances of you getting approved for a large purchase like a house or car are not good. If you are lucky enough to get approved, you are going to get slammed with a high-interest rate, costing you thousands of unnecessary dollars. Each time you pay off your card in full when the balance is due, your score will reflect that and go up.
- Rewards – What if I told you that you could take a vacation and pay for it all from rewards points that you earned from using your credit card? It’s possible and all you have to do is spend money on your normal expenses, the things you were going to buy anyway. If you want to know more about using credit cards for their rewards, then subscribe to my email list above.
- Easier to track your spending – If you’re like me and track all your spending online, then using a credit card puts all of that information in one place that can be easily exported. This means you don’t have to track expenses on pen and paper when you’re compiling your budget (which you should be doing).
- Safer than cash – Have you ever lost cash? Me too. If you ever lose your credit card, all you have to do is call a helpline where they’ll cancel the old one and send you a new one.
- Added card benefits – Some cards have benefits that extend beyond reward points. For instance, one of mine allows me to get TSA precheck for free as well as access to airport lounges worldwide.
- An emergency line of money – I’m hesitant to add this to the list but credit cards can be used in emergencies. No matter what. you should go to your emergency fund first but if an expense comes up that you just can’t afford, you can use a credit card. It is important to remember though, that whatever you borrow you must pay back with interest!
The Bottom Line
Who knew a small piece of plastic had so much power to make your life better or worse?
In my mind, the benefits of a credit card far outweigh the risk of them. By following the golden rule of paying off my credit card in full every single month, I have reaped some awesome perks. For one, I have an above-average credit score. Secondly, and more importantly, I haven’t paid for a flight in almost 3 years.
Every single one was paid for using reward points that I received from swiping a credit card versus using cash or a debit card. Crazy right?
Before I end this article, I want to share some myths that Michelle over at Making Sense of Cents addressed in a recent post.
- You will always pay interest if you use a credit card. WRONG
- It’s fine to pay only the minimum payment each month. NOPE
- Credit cards are free money. NOT A CHANCE
- You should ALWAYS carry a balance on your credit card. TERRIBLE ADVICE
For the full list go check out her article here.
Well did you learn anything? If you are new to credit cards, then I hope I helped you in some way. If you are interested in my specific recommendations for credit cards, then click one of the links below.
If you liked this post then please pin the picture below and if you want to read more articles here are my latest: