Episode #14: Your Credit Card Explained - For Beginners
Did anyone ever give you a lesson on how exactly your credit card works before handing you one? Probably not. I think all of us have had the experience of receiving a pre-approved credit card in the mail, which can often feel like ‘wow, that’s so nice of them to offer me money!’ BUT it should be freeking criminal for companies to be allowed to do this, especially to younger adults who many not have ever had the chance to learn how a credit card works, and to understand how they can actually get themselves into deep financial trouble by using their card incorrectly.
In today’s episode we’re going to cover how credit cards work, the mistakes people make with credit cards that get them into trouble, the three golden rules you NEED to follow to use your credit card properly, and 5 reasons why having and using a credit card responsibly is really beneficial to you.
How Credit Cards Work
A credit card is different from a debit card. When you spend money on your debit card, you’re taking cash that you already own directly out of your bank account. When you have a credit card, even if it’s through your bank, when you make a purchase with your credit card you’re borrowing money from the credit card company, and it’s then up to you to make sure you pay them that money back out of your bank account. So, debit card = money out of your bank account. Credit card = borrowing money and then paying it back out of your bank account.
How Credit Card Companies Make Money
It’s important to understand that your credit card is a business. Getting people to use their credit cards is the business of credit card companies, and businesses need to make money. Credit cards make money in two ways. First, they charge a small percentage fee to the business you make a purchase from, that’s not that important for you to know unless you run a business. The second way they make money is off of the people, like you and me, who use their credit cards and pay interest on the money they’ve charged to that card. Interest is a percentage fee that you pay on money that you’ve spent through your card, and credit card interest rates are insanely high. In Canada, at the time that I’m recording this, there are interest rates as high as 30% charged on some credit cards.
How Credit Card Fees Work
The way that interest fees work with most credit cards is this: you make a purchase on your credit card, and for a window of time called a ‘grace period’ you don’t pay interest on that purchase. Depending on the card, grace periods are usually around 1 month. If you haven’t paid back that purchase within the grace period, the credit card company then starts charging you interest on that purchase, making that single purchase cost you more, and more, and more money the longer you go without paying the full amount off. THIS is how credit cards make a tonne of money, and THIS is how many people end up with huge and unmanageable credit card debt over time if they don’t pay off their purchases.
Now, unlike a loan, which has a specific end date and a scheduled monthly payment system, paying off your credit card debt looks a little different. If you’ve ever gone into your online banking to pay your credit card, you’ve probably seen the three options they give you. Paying the ‘minimum’, making a partial payment, or paying in full. The ‘minimum payment’ and ‘partial payment’ options look really nice, and really understanding of them, BUT remember this is how they make money off of you. This is how the credit card industry works, and really the ONLY way you should get used to using a card is to pay the balance in full, every month.
Understand How YOUR Credit Card Works
Each credit card is different, and it’s important that you understand the fine print of YOUR card and how it works. This is just one of those life things where you NEED to read the fine print before you throw that credit card brochure in the garbage. BUT, I’m going to teach you what to look for in the fine print, to understand your individual card.
The two most important things to understand about your card is how much interest you’ll be charged, and what the grace period is. When you’re looking for the interest rate in the fine print, you’ll probably see it referred to as the APR, this stands for the annual percentage rate. Make sure you read all the fine print though because some cards offer a 0% APR for the first few months that you have the card. This doesn’t mean the interest rate is 0, the interest rate will never be 0%, so keep on reading to find what the APR is after the promotional period of the card has ended. You can shop around and find cards with lower interest rates than others, which might be a worthwhile point to consider when you’re weighing the pro’s and con’s of different cards rather than just looking at the rewards that cards offer. Those higher interest rates can quickly eat up the value of rewards if you accidentally miss a payment.
The next piece of information you need to understand is how many days your grace period is. Most cards are around 30 days, or 1 month, but some cards are shorter, so make sure you don’t just make an assumption that you’re on a monthly cycle and start accidentally racking up interest. From there, just read the fine print to familiarize yourself with the other benefits you can have by using the card, but most importantly know your APR (aka the interest rate) and how often that card needs to be paid off.
Three golden rules to using your credit card responsibly, and how to avoid making expensive mistakes with your card.
NEVER spend more on the card than you have in your bank account. Remember, they’re not connected, so when you spend money on your card it doesn’t automatically come out of your account like it does with a debit card. This means you have to keep an eye on your bank account, and make sure you’re not accumulating a credit card bill each month that will be impossible to pay back with the amount of actual existing cash you have available in your life.
Make sure you pay off your balance in full every single month. Do not let yourself be tempted by the ‘minimum balance’ or ‘partial payment’ options. Again, the ONLY way you should be using your card is to click the full balance payment option and just pay that card back. Remember, by not paying the full balance back you’ll be carrying the balance forward to the next month, which means you’ll be outside the grace period of the card, and you’ll start to pay interest to carry that debt. Really really high interest. Credit card interest is basically the highest interest amount you could possibly be paying. Another important point here is to make sure you don’t forget to pay your card off. You need to be managing financial tasks like this each month so you don’t just forget to do it one time, or miss it by a day, and suddenly be paying interest on the balance even though you could have paid it off. That is a massive waste of money, it’s easily avoidable, and you just need to set up a little financial management day that reoccurs each month in your calendar to make sure you don’t forget. Now, some cards have automatic payment options, but I definitely advise you just get into the habit of going in and doing it manually each month, because credit card theft and fraud is rampant these days, and you definitely DON’T want to accidentally automatically pay off a massive credit card bill that somebody else has racked up on your card. So, as soon as you get a card, figure out what your grace period is, and set a reminder for yourself to go in and pay back that balance in full.
Only use 30% or less of your available credit limit. Using 30% or less of your limit, and then paying it off in full every month is one of the ways you can start to build a good credit rating using your credit card. So when you get a credit card, most cards will have what’s called a ‘limit’. If you have an absurdly high limit on your card that makes you uncomfortable, you can call the company and have them lower the limit. Conversely, if your limit is too low for this 30% rule, then you can call in and most likely will be able to raise the limit.
Why You SHOULD Be Using A Credit Card
Now I hope I haven’t totally scared you off credit cards all together. They’re not bad and they won’t trip you up and get you into trouble as long as you understand how your card works, and know that you’re using it properly. In fact, as long as you know you can handle your credit card, it’s actually really good to have and to use credit cards in your life for five reasons.
A credit card is a really good way to build credit, and throughout your life you WILL need to have a good credit score. Think of your credit score like an adult GPA of your finances, it shows that you’re responsible with money and that you can safely manage debt, so places like banks feel comfortable letting you borrow money in the future. There are other ways to build credit, like taking out loans or lines of credit, but using a credit card properly, and following the three golden rules we just talked about, is a really good way to start building a strong credit score, and it’s often a way to start when you’re young. So, if you can manage your card properly, definitely use it and start building a strong credit score early. I use my credit card for basically every single purchase I make.
Credit cards can offer you great rewards like cash back cards, or travel points cards. It can really be worth taking advantage of the different programs offered by different cards. When you’re comparing cards and rewards programs though, keep in mind that credit cards are businesses, their business is to make money, so make sure the rewards program makes sense financially. For example, if you get a cashback card, but don’t actually use it for much, it’s possible you could find that you’re paying an annual fee for the card that’s higher than the amount of cashback rewards you get. Just use common sense when you’re choosing a card, and remember to read the fine print. Personally, I like travel rewards cards, and during normal times when I’m actually traveling the perks more than pay for the annual card fee I pay, like getting travel insurance coverage, and deals with car rental agencies etc.
Your credit card is safer to use all the time than your debit card. And I speak from experience here. Credit card theft and fraud is rampant these days, and it’s in the best interest of credit card companies to offer great customer service and deal with these issues painlessly and easily for you. It can be way more of a challenge to deal with if someone steals your debit card. Credit card companies are also much better set up to handle credit card fraud to protect you as their customer. For example I once rented an apartment through a fraudulent listing on VRBO. The rental company wouldn’t take any responsibility for letting a fraudulent listing advertise on their site, so I called the credit card company, they checked it out that the fraudulent listing was for real, and quickly made sure I was made whole again. Unfortunately this is just the time we seem to be living in right now, and credit card companies are actually looking out for you as their customer.
Credit cards are a really useful tool in your personal finance budgeting system. At the end of every month you’ll have access to a statement that shows what you spent and where, making it easy for you to track your purchases and how much money you’re spending each month. It’s much more straightforward to look through and understand your credit card statement at the end of the month, than it is to understand your debit card statement, again because credit cards are trying to keep you happy as a customer, and make it easy for you to see what you spent and where.
Credit cards are great in case of emergency. When I was young I had a credit card for years that I never used, but it was always there in case of emergency. For example if I ever ended up stuck somewhere, or ran into trouble traveling, or just needed access to the cash for an emergency, I had the card if I needed it. Again, I never used it, but if you’re able to keep a credit card for safety it’s a really good option to have. Now, I want to make it really clear that this is not to take the place of an emergency fund like I’ve talked about in other episodes. It’s still really important to have an emergency fund of accessible cash, but it is possible that you might end up in a situation where you can’t access that cash immediately, like traveling abroad, when it’s useful to have the emergency credit card.
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