Understanding Credit Cards: The Power of Plastic

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Credit cards are safe, convenient, and a great way to build credit – but only if you use them properly!

Credit cards are fantastic!

Well, they CAN be, but they can also be dangerous.

Credit cards are great because they offer users convenience, an array of consumer protections, as well as the ability to build credit, as long as they are used responsibly.

If you are irresponsible with your credit card, you can do a number on your credit, negatively affecting your future borrowing power. Irregardless of your intent, credit cards can be irritative, so don’t be irrational.

When we understand credit cards and how they work, we can make intelligent decisions about which cards are suitable for us, how to manage them properly, and, most of all, how to save money.

You know how much I like saving money, don’t you? It’s my FAVORITE!!

What Are Credit Cards?

Credit cards are cards typically made of plastic (some fancy ones are made of metal to make you feel extra special). This allows the owner to make purchases without using your own money when the purchase is made. You’re given credit like Wimpy in the old Popeye cartoons.  “I’ll gladly pay Tuesday for a hamburger today.”  The idea is Wimpy gets the hamburger today, but he’ll pay you back on Tuesday.  Credit cards allow you to buy almost anything you usually pay cash for, on credit, that you will have to pay back later.  You’re borrowing money from a company like a bank. And, there are some big names out there.

Each time a person uses the card to pay for something, they borrow money to pay for the purchase. But, you, as the credit card holder, are responsible for paying the money back, just like Wimpy. However, you get to choose when you pay it back.  If you don’t pay it all back in the same month, you have to pay back a “minimum amount” as defined by the bank, and delaying your payment costs you extra cash in the form of interest. YIKES, YOU SHOULD REALLY TRY TO LIMIT THIS!

How Does a Credit Card Work?

First, you have to fill out an application, and many are online or can be done at a bank or even over the phone. They want your name, address, social security number, and other information. Once they have that, they have access to massive amounts of data and can figure out if you’re any good at paying your money back.

But, once approved for your shiny new card (which in some cases can be with your favorite professional team’s logo or a design or picture), the bank will set its credit limit.

A credit limit is the maximum amount of money you can have outstanding or borrow for purchases at any one time. If it’s $500, then in your first month, you can spend $500.  If you buy all your friends new running shoes, which cost $497, you only can spend THREE more clams and you are CUT OFF!!  But, if you pay off the $497 at the end of the month.  Voila!  That’s French for, you get to use the $500 all over again.

The approved credit limit depends on a couple of things.  Do you make a big fat salary?  If yes, you’ll probably get more.  Do you have a lot of other money you owe? If so, you probably get less.  What’s your history in paying back the money you borrowed?  If you have a great credit score, you’re more than likely going to get a lot more. Once they do a calculation on all of these pluses and minuses, they get to a total limit.

The major payment networks are the ones that move all the money around for a credit card.  Have you ever heard of American Express, Discover, Mastercard, and Visa? These are payment networks. When you make a purchase and SWIPE your card, insert the card, or “tap it,” a whole bunch of electronic processes happens in the background, where the bank pays for the purchase, and you get charged! It’s the job of these networks to make sure that the merchant receives their money and your bill is calculated each month correctly. Don’t worry, they are seriously good at making sure you get ALL of your charges.

When you receive your monthly credit card bill, you will have an option to pay a predetermined minimum amount. Actually, they’re doing a little prayer that you pay the small amount because they can charge you LOTS of INTEREST.  So, they are very INTERESTed in your payment habits.  We want to MINIMIZE that and highly encourage you to pay the entire credit card balance. Then, no interest, but you can also pay some other amount between the two.

Paying the minimum amount each month is the most costly option because of interest. Paying the amount in full will always be the best move because there is no interest, and I’ll give you a couple of gold stars. The credit card company will give you a little something called a “grace” period which gives you a couple extra days to pull your money together and avoid interest.  I wanted to name Makenna, “Money” but mom wasn’t having it.  So, I at least got her middle name as “Grace.”  A small win, but a win nonetheless!

Credit bureaus collect HUGE amounts of data to calculate credit scores.  They also will give you a credit report.  Think of the report like a kids report card.  It gives a grade for the different credit cards and other things you borrow and payback money on.  If you pay your bill after you were supposed to, that’s NOT a passing grade. If you pay on time, every month for 10 years, that’s an A+. 

So, where does a credit bureau get some of the information to fill out your report card? They get it from the card issuer, who regularly reports to them. It’s kind of like Mak & G’s teacher. They give input which goes into their report card. Your payment history from your credit card is a HUGE part of your credit score (35%). And, we all know that a person’s credit score is a number that lenders will use to assess the risk of lending money (in addition to insurance rates, getting a job and more). So, to avoid any late fees or potential credit score damage, you must pay the minimum amount due each month on time, or suffer some pretty major consequences.

For more information on how credit cards work, check out these awesome videos we made to help explain credit cards when Mak & G were young:

Are Credit Cards Different from Debit Cards?

Accountants talk about debits and credits all the time (BORING!!!). So, why shouldn’t a CREDIT card have a close relative called a DEBIT card?  They act differently, just like your cousin Johnny acts differently from you.  A standard debit card is linked to your bank account, just like a check. It’s like writing a check, but instead of paper, you use a plastic debit card. That means that each time you use it to make a purchase, the money is automatically taken out of your bank account. You don’t have the choice of when to pay and how much.  The decision is made for you.

By using a debit card, you use your money rather than borrow money from someone else and pay it back later. It’s no different than using the cash in your pocket.  While some debit cards will offer rewards programs to users, they are typically not as good as those provided by credit card issuers. The main reason is that credit card companies charge the companies that accept them.  So, they make some money and can pass some of the benefits on to those of us who use them.  Credit cards also generally have more protection against fraud and people who want to steal your money.  It’s a bit of peace of mind when you’re limited by the amount a thief can get if it’s done on a credit card.

Another widely used debit card type is the “prepaid” debit card. These cards are not linked to a bank account. Instead, the cardholder “loads” money on the debit card. The amount of money you can spend using the card is capped at the amount you have loaded onto it. So, if you want to give a kid an allowance, you can put their allowance on it, and they can NOT spend more than the balance on the card.

Often, prepaid debit cards charge various fees not associated with standard debit cards. As you can imagine, prepaid cards also have some limitations, particularly when compared with traditional debit cards. For instance, most prepaid style debit cards do not allow mobile banking options or access to ATMs. Plus, you may not be able to use them everywhere you’d like.

The good news (or bad news, depending on how you look at it and how responsible or irresponsible you are) is that prepaid debit cards and traditional debit cards do not affect credit scores. That’s because it doesn’t give the credit bureaus any information on how well you pay back the money you borrow since you can only use the amount put on the card. 

Credit Card Types

From “miles” for free flights, hotels, or travel discounts to “points,” you can turn these benefits into cash to ultra-low interest rates and cards with no annual fee. Credit card companies offer their customers many features and options in hopes of earning your business.

With so many types of cards to choose from, it makes your head spin. This section will break down the types of credit cards available with a brief explanation of each one.

Rewards Cards

A rewards card is a credit card that gives “rewards” to the cardholder when they use it to make a purchase. Typically, rewards cards are given to individuals with a good credit score.

These cards work best when you pay your total credit card bill each month. If you do carry a balance, you can expect that the interest charges could quickly negate the value of the rewards you earn.

Some of the most popular types of rewards offered by credit card companies are as follows:

  • Cashback Rewards. Cashback rewards cards give the cardholder “cash” each time they use the card to make a purchase. The money usually comes in a check, mailed directly to the cardholder, or directly deposited into their bank account. Cashback rewards may also be used to pay down the credit card balance. Me likey, likey free cash!
  • Airline, Hotel, and Travel Rewards. Some credit cards offer “points” or “miles” that can be exchanged for flights, hotels, and other travel discounts. Often, these rewards come with restrictions, like when you can travel. You have to be prepared to do some math, work through the fine print, and understand the number of points needed for reward travel.  Some rewards may only be redeemed through airlines and hotels that partner with the card issuer, while others offer more general travel rewards that are more flexible and can be used for most travel expenses. So, be careful and choose wisely!  Travel cards are good, and sometimes you can pair them with your other miles.  Mak & G loved when I used our points to do the Disney cruise in the Med!!
  • Store Rewards. Store-branded credit cards often reward cardholders for their loyalty by offering discounts and benefits when using their card at the store or with store partners. We all like to feel special, and the Kohl’s card has been a personal favorite with special discounts, Kohl’s cash, and other benefits that make us feel like we’re saving all the time. 

Low-Interest Credit Cards

While low-interest credit cards won’t give you travel rewards or cash back, they have their benefits through lower interest rates, making it affordable to carry card balances. That’s the key, you don’t get a benefit if you don’t have a balance, and we’re TRYING to avoid carrying a balance if possible.  

Often, low-interest credit cards will offer 0% introductory annual percentage rates (APR) during a specific period, allowing the pay off of large purchases without paying interest. Be careful, because sometimes, once you go past the introductory period and you haven’t paid off the transfer, they’ll add the interest from the BEGINNING of the introductory period.  It feels like a big slap in the face.  But, sometimes, juggling these cards (in the short run) can be helpful if it gets you out of a bind. We’ve all been there. But, to qualify for a low-interest credit card, you generally need a good credit score.

Balance Transfer Credit Cards

Credit cards offering balance transfer programs allow you to move debt from other credit cards so you can take advantage of lower interest rates. These types of cards generally require good to excellent credit scores. Juggling can get confusing, and you have to be on your game.  Plus, make sure you have a plan, because when the music stops (the intro transfer rate is over), it can turn out to be very painful as mentioned above, with interest back to the beginning!!

Credit Cards for Those with Average to Bad Credit Scores

There are limited options for individuals with average to bad credit scores. These cards rarely offer rewards, and the interest rates typically end up being much higher than with other cards. Ok, let’s be honest, the rate can be SKY HIGH!!  Using these types of credit cards can help you improve your credit score to qualify for better credit card options in the future. So, there is a benefit, but not as apparent as other rewards programs.

If you have average credit, the credit card company may not charge annual fees or offer certain types of rewards only for a fee. 

The best option for those with bad credit is what is known as a “secured” card. The idea is that a credit card company doesn’t want the risk of lending money if they don’t have something they can access to repay an outstanding loan if the cardholder doesn’t pay.

So, the card owner will generally have to pay a set fee as a security deposit which is returned once the cardholder closes the credit card account or upgrades to an unsecured credit card. That’s only if you close it in good standing, and don’t owe them anything.  Over time, the secured card offers a less expensive option for those with bad credit because unsecured cards usually charge insanely high-interest rates.

Student Credit Cards

College students are not automatically qualified to receive a credit card (which is a good thing). In fact, Federal law prohibits credit card companies from issuing cards to anyone under 21 without proof of regular income or co-signer. A co-signer is someone that is willing to use their credit score to help an applicant boost theirs (for instance, I’ve co-signed for Mak & G to get a credit card). In situations where none of this is an option for a college student, secured credit cards are an option for them to establish a credit history.

Reasons Why You Should Use Credit Cards

No one should be racking up mounds of bad debt. Bad debt is usually money that’s owed for stuff that was a “want.”  It doesn’t provide any future benefit, or wasn’t something needed, like surgery.  However, there is good debt, which creates wealth.  Buying a business with debt can produce income, or purchasing an asset that becomes more valuable (like a house) is good.

If you have problems differentiating between wants and needs, then debit cards can be great! By the way, a video game system is a want and not a need, even though it provides future benefits to you as a parent (Grant leaves us in peace for hours at a time :)).

One issue with a debit card is that it won’t help you to establish any type of credit history or build a good credit score. There are times in your life where you may need to borrow money.  So, it may not be your best option. Credit cards, without a bit of guidance, can be dangerous, just like fire.  But, there are several other benefits, depending on the card you choose.

These benefits include:

  • The sign-on bonuses. When offered, sign-up bonuses can help you squirrel away some money for a rainy day fund (from cashback sign-up bonuses) or start you saving for your next vacation (in the case of extra miles or travel point bonuses). Another great word that begins with a “B.”
  • The rewards. Over time, you are rewarded for the money spent using the credit card. Who doesn’t like to get rewarded? Some cards can get you VIP access to events, which sometimes makes me feel extra special too.
  • You need something. Sometimes, there is no other way to get what you need without a credit card.  Have you ever tried to rent a car?  How about a rental truck? Sometimes you need to hold a reservation, like a hotel room.  Or, the only way to pay is with a card online.  Sometimes, you get cut off from access without it.
  • The ability to build your credit. By establishing a record of on-time payments, you will make it easier to borrow money at a lower interest rate down the road. That can be especially useful when purchasing a new car or a home.
  • Keep track of your spending.  I know this sounds weird, but tracking your spending can be tough.  How do you know if you’re within your budget if you aren’t tracking?  Credit cards can help organize your spending quickly.  Downloads can be organized on a spreadsheet and quickly OPEN YOUR EYES to where all the money is going.
  • Reducing your costs? This is strange, for sure.  However, sometimes it’s cheaper with a credit card. When living in Illinois, and you had a “transponder” to use on the toll roads, you were almost required to have a credit card.  Using the transponder was ½ the price of paying cash.  Did you hear that?  Half the price.  Yes, half!
  • The introductory APR offers. As I mentioned earlier, if you are lucky enough to get a credit card with a 0% APR for an initial period, you will avoid interest charges on any purchase or balance transfer during that time. Sometimes, that’s a huge win.

The flexibility. While you should pay your credit card in full at the end of each billing cycle, one benefit of credit card use is the ability to pay off items over time. That helps if you have to make a significant purchase or pay for some financial emergency. We’ve all been there.  Thank goodness kids only need braces once (I think???).

The Costs Associated with Credit Card Use

Credit cards often come at a price, but if you play your cards right, you can avoid many of the costs when you use them responsibly.

The following section lists some of the most common costs associated with credit card use.

Interest Payments

Different credit cards have different APRs or interest rates. These rates will also differ depending on how you use the card. In other words, credit cards often have different rates for cash advances, balance transfers, and purchases. You will not accrue interest if you pay your credit card balance in full each month. It also depends on your credit score.  The lower the score, the higher the rate.  You have to treat it with care, and if you do, it will take care of you in the long run when you need it.

Annual Fees

Generally, I say, “Heck no to annual fees!”.  But, sometimes, it does make sense depending on your needs.  Credit card companies will sometimes charge you an annual fee for the privilege of using their card. Annual fees can range from $25 to more than $200. The sales pitch is easy.  With the fee, you get EXTRA rewards.  These are supposed to offset the cost. I have one card like this.  It didn’t charge fees when I used it overseas, gave me extra points, some insurance benefits, and a good cashback rate.  Every year, I run some calculations and see whether it was worth it.  So far, so good.  However, you should not have to pay annual fees in most cases, especially if you have good credit.

Late Fees

Late payment fees will vary, and federal laws limit the amount companies can charge. However, these fees can really add up, and if you can’t afford to pay your credit card payments on time, you probably shouldn’t be using the card. Being late to a family recital may be good if you don’t want to go, but being late paying a credit card is NEVER a good idea.

Transfer Fees

The average balance transfer charge on a credit card is between 3% and 5% of your transfer amount. Certain credit cards will waive that fee if you transfer debt from another card within a particular promotional period. You really have to make sure this makes sense, because a one-time fee in this range makes me cringe just writing about it.

Fees for Foreign Transactions

Credit cards will typically charge between 1% and 3% of any transaction made with merchants outside of the U.S. If you like to travel, and this adds up, take a look around for a card that doesn’t charge for this. I did, and it was really helpful when on that wonderful European cruise with Mickey and the kids.

Using Your Credit Cards Wisely

The benefits can really outweigh the costs of using credit cards if you use them wisely. Plus, you get to keep your sanity because you’re not carrying a checkbook or cash. That’s a pain.  Plus, with COVID, do you really want to be touching money?

Here are a few good credit card habits that you should internalize:

  • Always pay your credit card bill in full and on time each month.
  • Always keep your credit card balance at or below 30% of the card’s credit limit.
  • Wait for six months or more before applying for a new credit card. Nobody likes a waffler.
  • Perform a weekly review of your account (which you can do online) to track your spending, as well as avoid fraudulent charges. You’d be surprised what you might find.
  • Credit cards without an annual fee that you use should remain open to maintain a good credit score. Sounds strange, but true.  You still need to watch your statements, though.
  • By using credit cards responsibly, you can quickly and efficiently establish good credit. 

If you are a responsible human being, give yourself some credit.  If not, take it slow and build up some good habits before taking on too much.  If you work it right, you’ll get the rewards, the extra perks, insight into your spending, and you’ll have access to affordable money when you need to borrow it without any hassle down the road.  That will make me smile, and I’m sure it will make you smile too.

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