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Credit Cards

A credit card is a small plastic card issued by a bank, business, etc., allowing the holder to make purchases or withdrawals on credit, which is a form of unsecured loan from the issuer. There is a maximum amount of credit that a card can provide, called a credit limit, that should not be surpassed. Exceeding the limit may require the credit card holder to pay a credit limit fee. At the end of the month, the credit card holder can choose to repay the entire amount or leave an unpaid balance that is subject to interest until it is paid off. Note that credit card interest rates tend to be relatively high compared to other common loans such as mortgages, car loans, or student loans, and as such, the balance should ideally be paid off monthly to avoid paying large amounts of interest. Examples of credit card issuers include banks, credit unions, or retailers, and examples of credit card networks include Visa or MasterCard. American Express and Discover are both issuers and networks. Networks charge a small fee (<3%) for handling the processing of the transactions. Issuers profit from interest payments on revolving balances, late fees, annual membership fees, fees for cash withdrawals, interchange fees, etc.

APR

Different cards offer varying rates of interest, often referred to as the annual percentage rate, or APR. Some cards have variable APRs, based on specific indexes, and others have fixed APRs. There are some credit cards that are specifically advertised as having a zero, introductory, annual percentage rate (APR).

Cash Advances

It is possible to withdraw credit from a credit card for physical cash. This is called a cash advance, and they usually have very high 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. Normally, credit card cash advances are not very advantageous, and should generally be reserved for emergencies.

Balance Transfers

It is possible to transfer the balance from one credit card to another. People who carry revolving credit from month-to-month should probably consider applying for a favorable balance-transfer credit card, usually in the form of one with a low or zero introductory rate. For instance, a spender who has accrued lots of debt on a high-interest rewards credit card may want to apply for a credit card geared for balance transfers, which usually comes with a period of interest-free accumulation of debt. The interest-free period is generally 6-21 months, after which the credit card will require payment of interest on top of the 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.

Most people also have debit cards that look and function very similarly to a credit card. Banks or financial institutions provide debit cards with checking accounts, which allow purchases or withdrawals to be made that are deducted directly from the checking account. There is usually no fee associated with debit card purchases or withdrawals except under certain circumstances such as use in a foreign country or withdrawals from third-party ATMs.

Advantages

Different types of credit cards (each type is in a section below with more details) have different advantages. Some of these are listed below.

Disadvantages

Impulsive use of credit cards can cause people to find themselves in financial trouble. It is understandably easy for credit card holders to use them recklessly, and to be suddenly confronted with payments that can't be met each month. This is playing right into the hands of the issuers because they make their profits from insolvency. Not only will this spell financial trouble for most people, but their credit scores will also be affected negatively due to late or missing payments.

In the case that a credit card holder falls very deeply into debt, debt consolidation, which is a method of combining all debt under a new line of credit, can offer temporary relief. For more information or to do calculations involving debt consolidation, please visit the Debt Consolidation Calculator. However, for the average Joe, the most effective approach is probably to scale back standards of living and work diligently towards paying back all debts, preferably starting on the highest APRs first. People who find themselves in this situation should also consider getting a secured credit card and using it in a responsible manner to immediately begin repairing their damaged credit score. For more information about or to do calculations involving paying off multiple credit cards, please visit the Credit Cards Payoff Calculator.

Although undisciplined use of credit cards can result in significant debt, when credit cards are used responsibly, they can be an excellent payment method.

Types of Credit Cards

Different types of credit cards suit the needs of different types of spenders. For simplicity, it would be wise to find one that aligns best with the user's financial intentions; for instance, a person who is not an extravagant spender and not interested in anything except getting the best bang for their buck can probably live with just a no-fee cash back card. However, it is very possible for people to carry multiple credit cards for their different advantages, even if it requires a bit of management. What's important is that they are all paid off in a timely manner.

Cash Back: These offer cash-back on all purchases, usually 1%, 1.5%, or 2%. Another type may have up to 5% cash back on selected categories of merchandise or services, which normally rotate quarterly.

Rewards: These make up the bulk of most credit cards. The types of rewards usually range between airline miles, hotel bookings, and dining benefits. Credit cards that offer more rewards or miles will generally require annual fees, and it is up to each spender to evaluate their spending habits to decide whether a no- or low-fee card with low rewards is preferable to a high-fee card with high rewards.

Charge: These usually work the same way as any other credit card, except that they have either no spending limits or very high limits, and balances cannot be rolled over 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.

Balance Transfer: These are best for spenders who plan on carrying lots of credit card debt in the future because interest on credit cards are quite high. It is possible to transfer an existing balance from one credit card to another. Unlike most credit cards, some carry low, or even zero, introductory APRs for the first 6-21 months, which allows the holder to effectively roll debt from one card to another without paying interest. Balance transfer credit cards are typically more useful for people who have significant amounts of existing debt on high APR cards.

Secured: Secured credit cards are useful for younger people with no credit history who are interested in getting started, or people with bad credit history. To be issued a secured credit card, the applicant must make a security deposit that acts as collateral; if they prove to be financially responsible with the secured credit card and no longer wish to use it (as there are many other credit cards on the market to be had that do not require a security deposit after the requisite credit score), they can close the account and receive their deposit back.

Prepaid: A prepaid credit card is more akin to a debit card in that it is preloaded with an amount to be used, and cannot exceed this amount. 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: Some retail stores issue credit cards that offer big discounts only at that particular chain. They are usually offered at department stores by a cashier during checkout and packaged with a discount like 10% on the sum of purchases. These tend to be more useful for users that shop at the stores frequently enough to warrant their financial benefits. They also make good options for people with bad credit looking to rebuild because they often accept lower credit scores relative to other credit cards. However, interest rates on store credit cards are generally higher than other types of credit cards.

Business: 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 credit cards are useful for separating personal expenses from business expenses when it comes time to do taxes.

How to Calculate Interest Charges on Credit Cards

Average Daily Balance Method

The most widely used method credit card issuers use to calculate the monthly interest payment is the average daily balance, or ADB method. Since months vary in length, credit card 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 = 
APR
365

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.

ADB = 
(day 1 balance) + (day 2 balance) + ... + (day n balance)
number of days in 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 credit cards in the month of June. It carries an APR of 15%. Calculate his DPR using the equation above:

DPR = 0.15/365 = 0.00041

During the first 15 days of the June billing cycle, there was a balance of $500. Midway through the month Jon made a payment of $100, so the remaining 15 days had a balance of $400. Calculate his ADB utilizing the equation above:

ADB = (15 × 500 + 15 × 400)/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 credit card 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 less 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 mostly an interest payment. It is important to make this payment. Failure to do so may lead to a cancellation of the card, legal proceedings, and a steep drop in the credit rating of the holder.

Unless a credit card has a zero, or low, introductory, APR, interest paid on the balance is quite high. Credit card APRs average about 20%, which is relatively high for any loan. Good APRs average about 8-12%, though it is possible for someone with excellent credit to get even lower rates. This is because credit card 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 rate. Secured debt in comparison requires collateral, such as real estate. If the borrower defaults on the secured debt, the lender can foreclose and take possession of the real estate.