A credit card is a form of unsecured credit (meaning a loan without collateral) that you can use to make everyday purchases. All credit card purchases are made using a loan. You borrow money from your credit card issuer to make the purchase and pay it back later, plus interest.
Credit Cards Vs Debit Cards
Credit cards can be used at the same places you use debit cards. However, some business, such as rental car agencies and many hotels, only take credit cards because they know your credit card works as a line of credit. A business accepting a transaction paid by credit card knows it will be paid immediately.
Even when you have both a debit card and a credit card, you should choose carefully which to use most for your everyday transactions.
Advantages over Debit Cards
There are some good reasons to use credit cards for every-day purchases instead of your debit card:
- Your debit card may have a transaction limit or transaction fees; credit cards typically do not include these
- Credit cards often offer “cash back” and other rewards for most purchases
- Credit cards are accepted more widely than debit cards, especially if you are travelling overseas
- Using your credit card will build your credit history, which can lower your interest rate and increase your credit limit on other loans
- You can “float” credit card purchases, using it as a short-term loan before your next paycheck
Disadvantages over Debit Cards
There are also some good reasons to use your debit card instead of a credit card:
- If you miss your grace period, your purchases will be charged interest with a credit card, making them more expensive
- Since you do not need to pay the full balance on credit card purchases every month, it makes it easier to over-spend
- If you start to fall behind on your payments, it can be very difficult to fully escape credit card debt
- Credit card billing cycles are usually 20-25 days instead of one month, making it more difficult to schedule payments compared to other types of bills
Credit Balance Types
When you use your credit card, there are several different types of balances that will appear on your credit card statement.
New purchases are the things you’ve bought using your credit card during the current billing cycle. You will not be charged interest on this balance until the end of your grace period, so it is usually a good idea to pay off this balance first to avoid finance fees. If you miss your grace period, you will be charged interest on the balance for every day you had it.
A balance transfer occurs when you move your debt from one credit card to another. Sometimes people do this because the interest rate being charged is lower, so they know that transferring what is owed on a higher interest rate card to a lower interest rate card will cost less money in the long run. Most credit card companies charge a balance transfer fee on the amount being transferred.
Cash advances occur when you take money out of an ATM using your credit card. This is the most expensive type of charge you can make on your credit card because cash advances typically do not have a grace period and they are usually charged interest at a higher interest rate than for everyday purchases. Most credit card companies charge a cash advance fee, so carefully consider your need for cash before using this option on your credit card.
Finance Charges and Interest Rates
Credit card companies have finance charges as a condition to using the credit card. The finance charge is calculated using your interest rate. Each balance type uses a different method to calculate interest.
How Interest is Calculated
Different credit cards calculate the interest you owe differently, and this difference might make a big difference on your monthly bill. The two most common methods are “Daily Balance” and “Average Daily Balance”. All methods include knowing the credit card balance, the APR, and the length of the billing cycle.
The previous balance method uses your balance at the beginning of the billing cycle to calculate your interest. This means that payments you make during the billing cycle will not lower your total interest payment, but will only impact your bill next month.
This method is similar to the previous balance, but also subtracts any payments you make. This method gets you the lowest total interest charges, but is very rare for credit card companies to offer it.
The ending balance adds your previous balance to all the charges you made during this billing cycle, and subtracts any payments you made. The interest is then calculated based on that final total.
Average Daily Balance
This method is the most common. Your credit card company takes the average balance of all days in the billing cycle and multiplies that by your daily interest rate. Those numbers are added together for every day in the billing cycle.
Every credit card has a grace period, usually about 21 days. If you pay off any new purchases during the grace period, you will not get charged interest for those purchases. If you miss the grace period, you will be charged the full interest amount. There is no grace period for balance transfers or cash advances, so you will be charged interest for every day you have an outstanding on these transactions.
As long as you owe money on your credit card, you will have a minimum payment every month. This amount represents the absolute least you can pay to keep your account in good standing. Your minimum payment is based on your outstanding balance. The payment is generally enough to pay off new interest, plus some of the principal balance.
Making only the minimum payment each month is the absolute longest way to pay off credit card debt, and it results in the absolute highest possible amount you pay in interest.
Note: In some situation, the minimum payment will be lower than the interest charged. In which case you will never fully pay off the debt. If your minimum payment is lower than or equal to your interest charge, you will continue making payments on interest forever without ever paying off your debt. To avoid this situation, try to pay more than the minimum payment every month.
Missing your credit card payments can result in defaulting on your account. Defaulting on your account has a few impacts:
- If you were receiving a promotional interest rate, you will retroactively lose it. All of your previous outstanding balances will revert to the higher interest rate instead of the promotional rate, making your bill even higher.
- You will get charged “late payment” fees which will be added to your previous balance in the next billing cycle.
- Missed payments are reported to the credit reporting agencies and will lower your credit score.
- Your credit card issuer may lower your credit limit and increase your interest rate.
If you miss a certain number of payments, your credit card issuer may cancel your line of credit entirely and send your case to a collections agency. This will further damage your credit score and make it extremely difficult to get any new credit cards or loans for the next several years.
The CARD Act of 2009
In 2009, the federal government passed the Credit Card Accountability, Responsibility, and Disclosure Act of 2009 which bans certain types of behavior from credit card companies. It also gives credit card holders more tools to help keep their credit cards in good standing.
The CARD act bans credit card companies from:
- Increasing your interest rate on existing balances. If your rate goes up, it only applies to new purchases. This doesn’t apply to removing introductory promotional rates.
- Raising your interest rate in the first year of holding your account. However, if you have a variable rate credit card, then your base rate can’t go up but the variable rate can.
- Processing your payments late. All payments must be processed on the day they are received.
- Charging fees for different methods of payment
- Using a double billing cycle where you would be charged interest based on the last period’s balances instead of just the current period
- Issuing credit cards to people under the age of 21 without a co-signer
As the card holder, you also get certain rights with your credit card:
- If you default on one credit card, credit card companies can’t automatically charge you a higher “penalty rate” on other cards you have.
- You have at least 21 days after your bill is mailed to pay it without any interest being charged.
- If you pay more than the minimum payment, the extra money is applied to the balance with the highest interest charges first. For example, if you pay $30 more than the minimum payment, the extra $30 would go towards your cash advances before being applied to your current balance.
- You can opt-out of over-the-limit fees. If you opt-out and then try to make a purchase that would put you over your credit limit, the transaction would be declined. If you don’t opt-out, you would be charged an over-the-limit fee.
- You can opt-out of interest rate increases. If you do, your credit card will be cancelled once you pay off your balance. (This might impact your credit score.)
This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!Learn More
- What is the difference between Credit and Debit?
- How does a credit card company make its money?
- How can credit cards help you and hurt you financially?
- In your own words, explain what the Card Act of 2009 is.