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Most people have debit cards and are familiar with how to use them. Banks provide debit cards with checking accounts, which allow payments to be made that are deducted directly from the account. Money is withdrawn instantaneously for transactions. Usually, there is no fee associated with debit card payments except for things like transactions in a foreign country or withdrawing from third-party ATMs, two things that are easily avoidable.
On the other hand, a credit card is a form of unsecured loan and must be applied for and approved through an issuer such as American Express. They are a type of revolving credit, one that does not require a fixed amount of payments. The opposite is installment credit such as home or auto loan, which contains fixed payments amortized. There is a ceiling amount called a credit limit that cannot be surpassed. If so, the credit card (CC) holder may have to pay a credit limit fee for overreaching their limit.
At the end of the month, the CC holder can choose to pay the entire amount back or leave an unpaid balance that will continue to accrue high interest until paid off unless it has a zero introductory APR. This is largely how credit cards make money for their issuers and networks. Examples of issuers would be Chase, Citibank, or Deutsche Bank, and examples of CC networks include Visa or MasterCard. American Express and Discover are both issuers and networks. Networks charge a small fee (between 2-3%) for handling the processing of the transactions for the issuers. Issuers profit from interest payments on revolving balances, late fees, annual membership fees, fees for cash withdrawals, and interchange fees.
Quick Tip 1: The golden rule concerning all credit cards is to never miss a payment. Teach your parrot to yell it every morning, permanently tattoo it to your bicep, no matter what, don't miss a payment!
Compared to debit cards, CCs are better in several ways. The biggest advantage involves fraud. When a fraudulent charge is involved, the issuer, not the borrower, is liable for fixing the situation even though the holder made the transaction. This is because it is the issuer's funds in question. Under the Fair Credit Billing Act (FCBA), a CC holder's maximum liability for fraudulent credit card transactions is $50, although most credit cards have zero liability for all fraudulent transactions. With a debit card, the holder must go through the painstakingly difficult task of sorting out the situation themselves in order to retrieve the lost funds.
CCs also reward their holders with things such as cash back, hotel bookings, or miles, which will be discussed below. They can have a slew of purchase protections in place to protect the holder, some of which can re-price transactions for goods that have since dropped in price, defective goods purchased, car rental insurance, roadside assistance, travel insurance, and many other perks. By using a CC responsibly, one can also improve their credit rating, resulting in drastic savings through more favorable loans when the time comes to buy a car or home.
Quick Tip 2: Continually strive for an attractive credit score and credit report, which can generally be achieved by making and not missing timely payments for many years. Credit card providers will begin to offer more credit at higher limits. It is not required for CC holders to accrue more and more credit card debt in order to build credit history. This is a popular myth, as carrying a balance from month to month will not improve credit ratings or credit reports. Anyone can check this for themselves by getting their credit report once a year for free from Equifax, Experian, or TransUnion. There are many scams out there. Never pay for fake credit reports!
Undisciplined CC holders run into trouble when they use their credit cards impulsively. It is understandably easy to use CCs recklessly, even if in small increments, and to be suddenly confronted with payments that can't be met each month. This is playing right into the hands of the CC issuers at the CC holder's detriment because they make most of their money from CC holders' insolvency.
Quick Tip 3: Do not view CCs as gateways to new, higher standards of living, but instead as ways to reap financial rewards through fraud protection, cash back, hotel bookings, or as havens to tuck away existing, low interest debt. Live within your means (or below), and please remember to spend responsibly!
In the extreme case that a CC holder falls very deep into CC debt , they can choose to arrange debt consolidation, which is a method of combining all debt under a new line of credit. It can help temporarily improve a situation and is beneficial for anyone in debt trouble seeking employment in the near future. But for the average Joe, it would be better to simply scale back on their standard of living and work diligently to pay back all debts, starting with those with the highest APRs. Anyone in this situation should also consider getting a secured credit card and using it in a more responsible manner to immediately begin repairing their damaged credit score. Our Credit Cards Payoff Calculator can help with planning the CC payoff.
CCs carry a bad stigma with them and for good reason; many people do not use them with discipline, and for a few unfortunate folks, it ends up ruining their lives. When CCs are used responsibly and consciously, they are an excellent avenue to spending as a consumer and there are many benefits with not much to lose.
Different cards offer varying rates of interest and the amount offered depends largely on the credit rating of a potential card holder along with other small factors such as the type of card and issuer. When it comes to CCs, interest rates are often referred to as the annual percentage rate, or APR. Some cards have variable APRs, based on specific indexes, and others have fixed APRs.
Average Daily Balance Method
The most widely used method in which CC issuers calculate the monthly interest payment is the average daily balance, or ADB method. Since months vary in length, CC issuers use a daily periodic rate, or DPR to calculate the interest charges. DPR is calculated by dividing the APR by 365, which is the number of days in a year.
|Daily Periodic Rate, DPR =||
Then find the ADB. The equation for finding this is a bit more tedious, but just add up all the balances for each day in the statement billing cycle and divide by the total number of days in the billing cycle.
Finally, multiply this by the Daily Periodic Rate calculated before it and the number of days in the billing cycle to determine the interest for that month's statement.
Monthly interest payment = DPR × ADB × number of days in billing cycle
Example: Jon needs help calculating the interest payment for one of his CCs in the month of June. It carries an APR of 15%. Calculate his DPR using the equation above:
For the billing cycle in June, for the first 15 days there were balances of $400. Midway through the month he made one transaction for $100, so the remaining 15 days carried balances of $500. There were no more purchases or payments. In the real world however, an often-used CC should have differing and wildly fluctuating balances everyday due to daily usage. This will be kept simple for simplicity's sake. Calculate his ADB utilizing the equation above:
ADB = (15 × 400) + (15 × 500)/30 = $450
Multiply the DPR, ADB, and number of days in billing cycle to find the monthly interest payment:
Monthly interest payment = 0.00041 × $450 × 30 = $5.54
Jon's interest payment for the month of June is $5.54.
There are several other ways in which CC issuers calculate the monthly interest payment, including the previous balance method and the adjusted balance method, though they aren't used all that often.
Previous Balance Method
Multiply the DPR by the previous month's balance by the number of days in the billing cycle. Assuming that Jon's balance at the end of the previous month was $300:
Monthly interest payment = 0.00041 × 300 × 30 = $3.69
Adjusted Balance Method
Multiply the DPR by the adjusted balance, which is the previous month's balance minus payments made. Then multiply that result by the number of days in the billing cycle. Assuming that Jon's balance in May was $300 but he made payments totaling $200:
Monthly interest payment = 0.00041 × (300 – 200) × 30 = $1.23
The calculation of monthly payments will lead providers to charge a minimum payment, which is almost entirely an interest payment. It is important to make this payment and failure will lead to a cancellation of the card, legal proceedings, and a steep drop in the credit rating of the holder.
Unless a CC has a zero or low introductory APR, interest paid on a credit card balance is quite high compared to say, a mortgage or federal student loans. CC APRs average at about 20 %, which is relatively high for any loan. Good APRs average from about 8-12%, though it is possible for someone with excellent credit to get even lower rates. As tools of comparison, a mortgage averages around 3-5% and student loans 4-6%. This is because CC debt is unsecured, meaning there is no collateral backing the loan. If the borrower defaults, the lender cannot seize any assets and this risk is reflected in the high interest. Secured debt in comparison requires collateral, such as the real estate of mortgage. If the borrower defaults on the secured debt, the lender can foreclose and take possession of the real estate.
Quick Tip 4: You can give yourself peace of mind by simply paying all balances in full every time they're due instead of carrying them from month to month, relieving yourself of the task of having to read this guide on APRs and all the intricacies concerning them. No interest is good interest!
Types of Credit Cards
Different types of credit cards suit the needs of different types of spenders. It is best to find one that aligns well with what the holder majorly intends to do with it.
Rewards CC: These make up the bulk of most CCs. Some offer enticing travel deals and hotel bookings. Others offer cash-back on purchases, usually 1, 1.5, or 2%. Another type has drastic discounts for quarterly categories. CCs that offer more rewards or miles will require annual fees. It is up to the spender to evaluate their spending habits and decide whether a no fee card with low rewards or high fee card with high rewards is more worthwhile.
Quick Tip 5: Don't let an annual fee CC with high rewards dictate spending habits, reinforcing unhealthy financial irresponsibility. Many high rewards card holders fall victim to chasing after the rewards without the proper income backbone to do so. It helps for some people to visualize it as a debit card and not a credit card at all. Use the CC for things that would have been bought anyway such as gas, food, or basic necessities.
Charge CC: These usually work the same way as any other CC except they have no spending limits or very high ones and cannot roll over balances from one month to the next. It is expected for the holder to pay the balance in full at the end of every month. The only real benefit of having one is the heavy spending a charge card allows; just make sure to pay it in full at the end of every month. Aside from that, there is no real practical reason to pursue a charge card.
Balance Transfer CC: These are best for spenders who plan on carrying lots of CC debt in the future because interest on CC as opposed to other loans are quite high. It is possible to transfer an existing balance from one CC to another. Unlike most CCs, some carry low or even zero introductory APR for the first 6-21 months, which allows the holder to effectively roll debt from month to month without paying interest! Balance transfer CCs are highly recommended for people who have lots of existing debt on high APR cards and would rather refinance or move them to an interest-free haven.
Secured CC: Secured credit cards are useful for young students with no credit history interested in building it up or people who were financially irresponsible in the past with bad credit history who are on a new path to right their past wrongs. For secured credit cards, the consumer must put up a fixed amount of money acting as collateral before they are issued a credit card for personal use. Secured credit cards are also a great way for people with bad or nonexistent credit to build up their reputation.
Prepaid CC: A prepaid CC is more akin to a debit card in that it is preloaded with an amount to be used. In general, there are reloadable cards, multi-use cards and single-use cards. These are often given as gifts or mailed back from companies as compensation for rebates on their purchased goods.
Store CC: Some retail stores issue credit cards that are valid only at that particular chain that come with drastic discounts on their merchandise. They are usually offered by a cheery cashier during check out and packaged with a 10% discount on the sum of purchases that entices many shoppers. Macy's and other department stores are good examples. It is recommended not to pursue these unless the CC holder shops at the store frequently enough to warrant the financial benefits from doing so. They also make good options for people with bad credit looking to rebuild because they often accept lower credit scores than other CCs. Interest rates on store CCs are generally much more than other types of CCs because of this.
Business CC: There are some cards geared to help benefit business needs. They offer things such as discounts on products and services for the business, intricate ways to help track expenses, emergency travel assistance, medical assistance, and travel agent services. Business CCs are useful for separating personal expenses from business expenses when it comes time to do taxes.
There are many different resources on the internet to help determine which CC is best. CardBenefit.com is one example.
Financially responsible CC holders who do not carry revolving credit from month to month will not have to worry about transferring balances from one CC to another because they do not accrue interest on their cards. But people who do should probably consider applying for a favorable balance transfer CC, usually in the form of one with a low or zero introductory rate. Interest is the bane of all borrowers, why not have as low a rate as possible , or even none at all? This is what the superhero balance transfer CCs help with: refinancing to friendlier loan terms. For instance, a spender who has accidentally accrued lots of debt on a high interest rewards CC may want to apply for and receive a CC geared for balance transfers, which usually comes with a short period of interest-free accumulation of debt. The interest-free period is generally 6-21 months, after which the CC will require interest payment on top of principal. Some cards can charge a fee of 3 or 4% of the total amount transferred. Try to avoid these unless the low or zero interest provides a bigger financial incentive to do so. Balance transfers generally do not count towards rewards or cash back features.
Quick Tip 6: If carrying balances, be aware of the interest rates and the required payments in the coming months. When viewing statements online from different issuers, they may deploy sly methods to complicate things in order to make a quick buck. It is important to understand the differences between balances. A current balance is the sum of all debt owed that hasn't been paid back since the inception of the CC account. A statement balance consists of everything between the date the statement was generated until the end of the billing cycle. Then there is the minimum payment, which is the payment that must be made at the end of each month to avoid fees. While it is of utmost importance to at least make the minimum payment, which is the payment that must be made at the end of each month to avoid fees, it is highly, highly recommended for a financially responsible person to just pay the current balance month to month. It is helpful for some people to set up automatic payments towards their current balance and to go on with their busy lives without a worry.
It is possible to withdraw credit from a CC for physical cash. This is called a cash advance, and they are usually slapped with skyrocketed APRs. There is no grace period as interest accumulates immediately, cash advances don't count towards rewards, and there is usually a cash advance fee. On top of that, the ATM used will probably also charge a fee.
Quick Tip 7: Stay away from cash advances except for emergency situations!