Credit cards are a very popular financial tool that many of us use every day. There is a problem, however.
When people don’t know the ins and outs of credit cards they can get into trouble. This is especially true for people with bad spending habits.
In this article, we dive deep into credit cards. Terms you should know, what are the characteristics of a credit card, how your use affects your credit score, and much more.
Terms you should know
- APR - Annual percentage rate. The amount of interest charged to your balance. For example, if you have a $1,000 balance and the APR is 20%. You will be charged $200 in interest for the year.
- Annual Fee - Some credit cards charge a fee annually to be a cardholder. They can range from $25 to $500.
- Chargeback - Basically a chargeback is a refund for a credit card purchase, and was designed as a consumer protection mechanism.
- Credit score - On a scale of 300 to 850, it’s how responsible you are with your credit. There are 5 things that impact your credit score:
- Payment history - Percentage of on-time payments
- Credit utilization - How much credit you’ve used versus how much you have available
- Length of credit history - How old your credit accounts are
- New credit - Credit accounts recently added or applied for
- Type of credit - Credit cards, loans, utilities, etc.
- Credit report - A break down of those five components from above. It will show the percentage of on-time payments, credit available, your outstanding balance, utilization rate, the age of credit, and the various credit accounts you own.
- Utilization ratio - Briefly explained above, but this explains how much credit you use compared to how much you have available. For example, if you have an outstanding balance of $2,000 and you have a credit limit of $10,000. Your utilization rate is 20%.
- Minimum payment - Exactly how it sounds. It’s the minimum amount your credit card company or loan provider needs to service your debt.
- Over-the-limit fee - You can’t use more credit than you have available. If you do, you are going to get charged a fee. Not to mention your utilization rate will be through the roof, and that’s bad for your credit score/report.
- Secured card - This is a credit card that you open in order to build your credit score. You use a deposit to open the card, and that deposit becomes your credit limit.
- Unsecured card - A deposit is not required to open an unsecured credit card.
- Variable interest rate - Most credit cards have this type of rate. A variable rate is one that changes with the Federal Funds Rate. The FFR has been rising for the last couple of years, so interest rates on credit cards have been going up as well. This makes it more expensive for people to service their debt.
What qualifies you for a credit card?
- Age - You have to be at least 18 years of age to open a credit card on your own. If you have a co-signer (more on that below) you can start earlier.
- Income - The credit card company wants to know that they’ll get paid back. They will ask you for your income and where it’s coming from.
- Credit History - Basically, what’s in your credit report. Do you make on-time payments? Is your utilization rate low? Any bad marks like a bankruptcy?
- Current Debt - Your level of debt compared to your level of income. Most companies like to see the debt to income ratio below 30%.
- Co-signer - Someone, usually a parent, with a good credit history that is willing to sign with you so you can be approved for a better card and a higher limit. Be careful, though, if the cardholder can’t meet the obligations, the co-signer is stuck with making the payments and servicing that debt.
What should I look for in a card?
- Interest rate - The lower the better. Also, a fixed rate is often better, except for in a low-interest rate environment.
- Rewards - Rewards will vary by card.
- Travel miles
- Fees - Ideally, you want a credit card that has no annual fee.
Credit limit - Depending on how much self-control you have and how responsible you are, you might want a lower limit. If you are confident in your abilities, then a higher limit may be suitable.
- Goals - What do you plan on using your card for? Do you want to earn points or miles for traveling? Or are just looking to earn some cash back on everyday purchases?
How do I apply?
- Get pre-approved - Checking for pre-approval is a soft credit inquiry and doesn’t go on your credit report. A hard credit inquiry does and it negatively affects your score. Be careful, if you are sent something in the mail, saying you are pre-approved, you can still be denied.
- Fill out the necessary information
- Time at residence
- Phone number
- Income (level and source)
- Assets (retirement accounts, housing)
What should I be careful of?
- Interest rate - If you carry a balance from month to month, you will be charged interest. It’s costing you money to use your credit card.
- Credit utilization - A high utilization negatively affects your credit score. Keeping this low is very important.
- Paying late - This is the number one factor for your credit score. Late payments negatively affect your credit so it is vital that you pay on time.
- Defaulting - If you fail to make a payment on your credit card, your account will be sent to collections. This is also bad for your credit score/report.
How do I use a card effectively?
- Pay on time - Having a 100% on-time payment history is huge for your credit.
- Pay full balance - Paying your balance in full each month is a great way to use your card effectively because it saves you money on interest.
- Take advantage of rewards - Most credit cards have rewards that focus on different things. Some cards give you more cash back on groceries or gas. Some cards give you more miles when used on certain items. To take advantage of the rewards available, look at the specifics of your credit card rewards program.
What if I have bad credit?
The best thing you can do you for your credit is to make steady progress. If you have a large outstanding balance, you need to do your best to pay it off.
- Cut your expenses in order to make larger payments.
- Develop a plan to pay off multiple accounts. There’s a section in this article about debt repayment strategies.
- Here’s an article I wrote previously on repairing bad credit.
- Open a secured card - small purchases and immediately paying them off is a great way to start building your credit up.
Credit cards can play a very important role in our financial toolbelt. It is vital, that you use credit cards effectively and efficiently. If you don’t, it can have a detrimental effect on your finances and your financial future.