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How do credit cards work?

By Ben Woolsey

How do credit cards work? It's an important question for people new to credit.

Credit cards 101: what is credit?
Most American adults have at least one credit card. We see credit card ads everywhere we turn, from TV and radio to the sides of buses. Credit card offers are even mailed directly to our homes. But what are credit cards and why should you have one?

Put simply, a credit card, or credit, is an agreement between you and a financial group, such as a bank, that you will pay them back in the future so that you can buy something now. The financial group lends you the money you need and in return expects you to pay them back over a period of time. You will be required to pay the entire amount you spent plus a small additional fee, called an interest rate if you do not pay your balance in full and on time each month.

For example, you want to buy a new TV in time for a Super Bowl party at your house. The TV you want costs $1,000. However, you can’t afford to spend $1,000 on a new TV all at once. Credit allows you to buy that TV today, in time for your party, and then pay it off over time in whatever amounts you can afford. In the end, the TV will cost you more than $1,000 when you add in the finance charges.

Credit can provide many advantages for the everyday person:

  • Convenience – In addition to enabling the purchase of items now, it also allows a person to carry less cash and to order out of catalogs. Additionally, it is the only way most online stores will accept payment.
  • Emergency protection – Situations arise when extra money is needed fast. Credit cards allow for emergency car repairs, health care or any number of contingencies when access to savings or checking accounts is not possible.
  • Budgeting – Buying on credit allows for predictable payments of large-ticket items in installments you can afford. Credit Cards are also a good way of keeping a detailed record of your spending.
  • Security – Once cash is lost, it is gone. There is no way to get that money back or to keep someone else from using it. If a credit card is lost or stolen you can cancel the credit card. Additionally, a new card can generally be sent to you within a matter of days.
  • Traveling – No matter whether you’re traveling across town or across the country, it is usually easier with a credit card. Most hotels and rental car companies will not take a reservation without a credit card.

Credit cards are a great way to enhance our daily lives. When used responsibly, credit cards not only help us to buy things we need but also to pay for them on a budget and time line we can afford. If you want to understand how credit and credit cards will affect your specific financial or credit needs, talk with a financial adviser before applying for any credit cards. This extra step will ensure you are making the best decisions for you.

How to qualify for a credit card
If you're at least 18 years old and have a regular source of income, you are well on your way to qualifying for a credit card. However, even though you may receive many invitations and special offers from credit card companies in the mail, you still need to demonstrate that you are a good risk before such issuers will grant you credit. The proof lies in your credit record. If you've financed a car loan or other purchase, you probably have a record at a credit reporting bureau. This credit history shows how responsible you've been in paying your bills and helps the credit card issuer decide how much credit to extend.

Before you submit a credit application, get a copy of your credit report to make sure it's accurate. The three major national credit bureaus are:

Anyone who takes action against you in response to a report supplied by a credit reporting agency -- such as in denying your application for credit -- must give you the name, address and telephone number of the credit bureau that provided the report. Based on the information in your credit report, you can clean up errors and fix any past credit problems.

Establishing a credit history
Suppose you’ve never financed a car loan, a computer or some other major purchase. How do you begin to establish credit? First, consider applying for a credit card that is issued by a local store and use it responsibly. Ask if they report to a credit bureau. If they do – and if you pay your bills on time – you'll establish a good credit history.

Second, consider a secured credit card. It requires that you open and maintain a bank account or other asset account at a financial institution as security for your line of credit. Your credit line will be a percentage of your deposit, typically from 50 to 100 percent. Bear in mind that application and processing fees are not uncommon for secured credit cards. In addition, secured credit cards usually carry higher interest rates than traditional unsecured credit cards. If these stipulations don’t appeal to you, another option is to look at prepaid credit cards or debit cards.

Third, consider asking someone with an established credit history – perhaps a relative–to co-sign the account if you don't qualify for credit on your own. The co-signer promises to pay your debts if you don't. You'll want to repay any debt promptly so you can build a credit history and apply for credit in the future on your own. An example of this type of credit is a student credit card designed specifically for college students. A parent or guardian will co-sign the student credit card, but the student will gain the benefit from having his/her credit activity appear on his/her own credit history report. Typically, student credit cards have lower credit limits.

A positive credit history is an asset, not only when you apply for a credit card, but also when applying for a job, insurance or financing for a car or a home mortgage.

If your credit card application is denied
If you are turned down for a card, ask why. It may be that you haven't been at your current address or job long enough, or perhaps your income doesn't meet the issuer's criteria. Different credit card companies have different standards. Contact the credit card issuer directly if you are unsure of their minimum credit requirements. However, if you are turned down by several companies, it may indicate that you are not ready for a credit card or that there is a problem in your credit history.

If you are denied credit because of information supplied by a credit bureau, federal law requires that creditor to give you the name, address and telephone number of the bureau(s) that supplied the information. If you contact that bureau within 60 days of receiving the denial, you are entitled to a free copy of your report. If your file contains accurate negative information, only time and good credit habits will restore your creditworthiness. If you find an error in your report, on the other hand, you are entitled to have it investigated by the credit bureau and corrected at no charge.

You should dispute any inaccuracy in your report with the credit bureau as well as with the company that furnished the incorrect information to the credit bureau.

Getting the best credit card deal
Fees, charges and benefits vary among credit card issuers. When choosing a credit card, shop around and compare these important features:

  • Annual Percentage Rate (APR)
    The APR is a measure of the cost of credit and is expressed as a yearly interest rate. Also, be sure to check out the "periodic rate," which is the rate the issuer applies to your outstanding balance in determining your finance charge for each billing period. For example, if there is an outstanding balance of $2,000, with 18.5% interest and a low minimum monthly payment, it would take over 11 years to pay off the debt, with an additional cost of $1,934 being racked up just for interest. That added interest almost doubles the total cost of your original purchase.
  • Grace period
    A grace period is the time between the date of a purchase and the date when interest starts being charged on that purchase. If your card has a standard grace period, you have an opportunity to avoid finance charges by paying your current balance in full. Some issuers allow a grace period for new purchases, even if you do not pay your balance in full every month. If there is no grace period, the issuer imposes a finance charge from the date you use your card or from the date each transaction is posted to your account.
  • Annual fees
    Many credit card issuers charge an annual fee for granting you credit, typically $15 to $55. Some issuers charge no annual fee.
  • Transaction fees & other charges
    Some issuers charge a fee if you use their card to obtain a cash advance, if you fail to make a payment on time or if you exceed your credit limit. Some may charge a flat fee every month whether you use the card or not. In order to avoid surprises and excess costs, understand what all the additional fees are before applying for any credit card.
  • Customer service
    Many issuers have 24-hour, toll-free telephone numbers where you can contact a person to discuss issues with your account.
  • Other credit card benefits
    Issuers may offer additional benefits, some with an associated cost, such as insurance, credit card protection, discounts, rebates and special merchandise offers. Look closely at all costs, benefits and rewards to decide if these options would be beneficial to you. For example, if you pay your balance off promptly, a cash back reward may be of interest to you.

Steps to take with your new credit card
Once you get a card, sign it immediately so no one else can use it. Note that the accompanying papers have important information, such as customer service telephone numbers, in case your card is lost or stolen. File this information in a safe place. Call the card issuer to activate the card. Many issuers require this step to minimize fraud and to provide you with additional information.

Keep your account information to yourself. Never give out your credit card number or expiration date over the phone unless you know who you're dealing with. A criminal can use this information to steal money from you or to even assume your credit identity.
Keep copies of sales slips and compare charges when your bill arrives. Double check the charges listed against your receipts. If you find a mistake or a charge that you did not authorize, promptly report any questionable charges in writing to your credit card company. Don't lend your card to anyone, even to a friend. Your credit privilege and history are too precious to risk.

You are responsible for your credit card
While a credit card makes it easy to buy something now and pay for it later, you can lose track of how much you've spent by the time the bill arrives if you're not careful. And if you don't pay your bill in full, you'll probably have to pay finance charges on the unpaid balance. More importantly, if you continue to charge while carrying an outstanding balance, your debt can snowball, and before you know it, your minimum payment is only covering the interest. If you start having trouble repaying the debt, you could tarnish your credit report. This situation can have a sizable impact on your life. A negative report can make it more difficult to finance a car or home, to get insurance and to even obtain a job.

Federal protections
Federal law offers the following protections when you use credit cards.

  • Errors on your bill – Notify the card issuer in writing within 60 days after the first bill containing the error was mailed to you. In your letter include your name, you account number, the type, date and amount of the error and the reason why you believe the bill contains an error. In return, the card issuer must investigate the problem and either correct the error or explain to you why the bill is correct. This must occur within two billing cycles and no later than 90 days after the issuer receives your billing error notice. You do not have to pay the amount in question during this investigative process.
  • Unauthorized charges – If your credit card is used without your authorization, you can be held liable for up to $50 per card. If you report the loss of a card before it is used, the card issuer cannot hold you responsible for any unauthorized charges. If a thief uses your card before you report it missing, the most you will owe for unauthorized charges is $50. To limit your liability, you should be prompt in reporting the loss or theft of your card.

Types of credit accounts
Credit grantors generally issue three types of accounts. The basic terms of these account agreements are:

  • Revolving agreement – A consumer pays in full each month or chooses to make a partial payment based on the outstanding balance. Department stores, gas and oil companies and banks typically issue credit cards based on a revolving credit plan.
  • Charge agreement – A consumer promises to pay the full balance each month, so the borrower does not have to pay interest charges. Charge cards, not credit cards, and charge accounts with local businesses often require repayment on this basis.
  • Installment agreement – A consumer signs a contract to repay a fixed amount of credit in equal payments over a specified period of time. Automobiles, furniture and major appliances often are financed this way. Personal loans usually are paid back in installments, too.

Credit cards are fantastic tools. The information provided herein is designed to furnish you with basic information about credit cards, and to help you figure out what kind of credit card is right for your specific needs.

 

Published: September 5, 2005


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Updated: 09-28-2016


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