To save money and keep the costs of credit as low as possible, it is a good idea to understand how credit cards work. By doing so, once can gain knowledge and understanding that will make getting the best deal much more likely.
How credit cards work
Learning how credit cards work starts with understanding what they are. Credit cards are owned by the banks that issue them. When cardholders use the cards the banks will pay the merchants. At the same time, they are making loans to the cardholders. The amount of loan the cardholder can take out is decided by the credit limit of the card. Since the bank has every intention of receiving payment in full for any loans offered, the credit limit will be decided by what the judge to be the cardholder’s ability to pay.
The workings of credit cards – Knowing and saving
Banks issue credit cards to make money. While the merchant part of the cost with every purchase, the card holders certainly contribute too. However, the money paid by those with credit cards can be limited with the right knowledge.
The grace period and minimum payment
When someone makes a purchase with a credit card, they have a certain grace period in which they will not have to pay any interest if payment is made in full. While this period varies with the bank, it is usually about 25 days. However, if payment is not made in full by the end of the grace period, interest will be charged from the day that the purchase was made.
For the bank, it is better for cardholders to carry some kind of balance on their credit cards so that they can charge the high interest rates that credit cards are known for. This is why they set their minimum payments well below the total amount purchased and lower than what most people could actually pay. Since they offer a revolving credit, the balance is simply carried forward month to month in a revolving debt that can offer the bank a steady stream of income.
For those with credit cards, the goal should always be to keep their cards interest free and pay them off in full every month.
Calculating credit card interest
When interest is paid, the interest, known as the Annual Percentage Rate or APR, is calculated in one of the following methods.
Previous Balance: This method is considered the most favorable to the issuer and thus should be avoided by those who may not be able to pay off their purchases within the grace period. This is calculated by multiplying the outstanding balance of the previous statement by the interest rate. While purchases for the current month are not included, this method will often require the cardholder to pay interest on a balance that has already been paid down.
Average Daily Balance: This method is the most common and is not considered to favor either the card holder or the issuer. It simply takes the average daily balance (adding the daily balances over a period of time and then dividing it by the number of days in that period) of the current billing cycle and multiplies it by the interest rate to calculate the finance charge.
Adjusted Balance: This method is generally most favorable to the cardholder. It takes the remaining account balance (after all payments and credits for charges have been factored in) and multiplies it by the interest rate to get the finance charge.
Whatever the method used, the effective rate on credit cards is going to be higher than virtually any other type of debt and needs to be avoided. While sometimes 0% APR offers are made for new customers with various offers to include credit card balance transfers, these rates will only be temporary. Card issuers continuously adjust rates and keep them high. Apart from paying off the credit card before the grace period ends, the best way to lower what is paid in interest is to maintain good credit since those with the right credit can get the lowest rates.
On top of interest charges, card issuers have other ways of making money. However, people who are careful about selecting and using their cards can avoid many of all of these fees.
Annual fee: This is a flat fee charged every year, but those who have better credit and shop around can often find cards that do not have a fee.
Cash advances and their charges: Cash advances on credit cards will have higher finance charges across the board and should only be used as a last resort.
Exchange rate fees: When purchases are made in a foreign currency, banks will generally use an exchange rate higher than the market rate and keep the difference. Since the cardholder usually just sees the rate they used and not the market rate for that day, this is a hidden fee that will not be seen, unless the cardholder checks the rate for that day. Those who will be using their cards in foreign countries need to select cards that only charge a small spread between the official rate and what their customers pay.
Other fees: Just about any mistake cardholders can make to include late payment or exceeding their credit limit will likely incur fees. Use the card carefully and automatic payment options to avoid these fees.
Some types of cards
There are three major types of credit cards:
- Travel and entertainment cards include American Express and Diners Club.
- House cards are those that are issued by a chain of stores and can only be used at select locations. These include those issued by department stores as well as Sears and other major retailers.
- Bank cards are the most common and are issued by banks. They include Visa, Master Card and Discover.
There are also credit cards for particular situations or that offer the user special incentives.
Secured credit cards: These cards offer a way for those who have not established credit a way to get their first card. With this type of card, the amount that can be charged on the card is limited to the amount they have deposited in a special account at the bank. These cards are also a good choice for those who might misuse a card if they had real credit.
Cash back credit cards: When credit cards are used wisely and payments are made before the grace period expires, they can actually offer a net financial gain for the user. A cash back credit card is the best example of this. They usually offer 1% back on all purchases but will offer more in special circumstances.
Frequent flier credit cards are also popular. Offering a mile or more for every dollar spent and special bonuses at participating merchants, they can be great deals for some people. However, they generally have higher annual fees than cash back cards, which may not have any. As a general rule, cash back cards offer a better overall reward than frequent flier cards, but some users, especially heavy users and frequent fliers, may find a frequent flier card to be a better overall value.