How Credit Cards Work: Understanding Credit Cards

A credit card is essentially a loan from a bank that can be taken out at any time during your discretion.  When you use credit, you are effectively taking out a loan against the issuer of the credit card.  Therefore, you have an obligation to pay that debt.  A credit card issuer will impose a credit limit on you according to your credit score and credit history.  Those with a bad credit score will usually have a low credit limit as well as those without a credit history.  This is because there is always an inherent risk in loaning someone money.

How Do Credit Card Payments Work?  The Credit Card Billing Cycle 

How do credit card payments work?  A billing cycle typically ranges between 29 to 31 days.  A credit card company then usually gives you a interest-free window (called the billing cycle) to pay back the amount you spent on the credit card.  However, if you do not pay off your whole credit card balance by the end of the billing cycle, you are then charged interest on the remaining balance on the next billing cycle from the previous billing cycle.  This is where people fall into the trap of credit cards.  They spend freely but do not have enough discipline to pay back the whole balance by the end of the billing cycle.  The interest then adds up the longer you have a balance on the credit card.

Minimum Payments On Your Credit Card

You are typically only required to make a minimum payment on your credit card each billing cycle.  The minimum payment is the sum of the interest charges, fees, and 1% pay down of the outstanding balance.  So typically, it is anywhere from 3% to 5% depending on your balance and the interest rate associated with it.  If you pay less than the minimum payment required, you are considered late and credit card companies may charge you a late fee.  However, with the new credit card laws, the late fees are very easy to get rid of.

NOTE: Charge cards such as American Express require you to pay off your whole balance and not a minimum payment.

Credit Card Annual Fees

Most typical credit cards do not have annual fees.  However, for those who want reward cards (such as Alaska Airlines mileage card) or have bad credit, you will have to pay annual fees.  Annual fees for reward cards are usually waived the first year as a sign up incentive.

How Does Interest Rate Work On Credit Cards

Interest rates on credit cards is compounded annually.  When you sign up for a credit card, the interest rate is charged as APR (or annual percentage rate).  So if your credit card has a 12% interest, then you are charged 1% interest every month on the balance remaining on your credit card.  So if you had $100 balance on your credit card after the billing cycle, then you are charged $1 interest on that balance on your credit card.  That interest then compounds onto next month if it is not paid off.  Because of the compound interest on your credit card balance, it is extremely important that you pay more than the minimum payment every month.  Or else, it will take you quite awhile to pay off your card.

A credit card can be a powerful tool with plenty of perks if used properly.  However, not very many people use credit cards with caution and be able to reap the benefits of such.  If you can manage your finances and keep the interest charged to a minimum, a credit card can be a very powerful asset for you.  If not, it can be very unhealthy to your personal finances.