A credit card may seem like just another tool to help you make purchases, but it can be much more. When used responsibly, a credit card can help you build a good credit history, allowing you to get loans at favorable interest rates, cheaper insurance and even a new cellular plan. Credit cards can also help you earn rewards on your everyday purchases and protect those purchases in case of theft or damage.
1. What a credit card is
A credit card looks just like a debit card. However, instead of having the funds removed directly from your checking account when you make a purchase, you’ll essentially take on a short-term loan. This loan may or may not accrue interest, depending on when you pay it off.
For the purchases made in any given billing cycle — which is around 30 days — you’ll have a small grace period before your payment is due. If you pay the balance in full by that date, you won’t have to pay interest. If you pay less than the entire balance by the due date, you’ll accrue interest on your average daily balance.
» MORE: What is a credit card?
2. Why you should get a credit card
Credit cards come with numerous benefits. First and perhaps most important, a credit card used wisely will help you build your credit. Good credit can help you obtain future loans — such as a mortgage — at favorable rates. It can also help you get approved for an apartment or cell phone, avoid utility deposits and get lower insurance premiums.
Many cards also give you cash back or travel rewards, typically equivalent to 1% to 2% of the amount you spend. Many rewards cards offer sign-up bonuses that can be worth hundreds of dollars cards, as well as shopping or travel benefits that can save you money. Many cards have a promotional 0% interest period. When you get a card, check your benefits statement for details.
3. The difference between secured and unsecured credit cards
Secured credit cards are backed by a cash deposit, generally equal to the card’s credit limit. This acts as collateral and reduces the risk of nonpayment for the card issuer. Secured credit cards are great options for those who haven’t built a solid credit history yet.
Secured cards aren’t the same as prepaid cards. With a secured card, your cash deposit doesn’t run out as you spend, as it does with a prepaid card. You’ll make payments the same way as you would with an unsecured card, and you’ll pay interest if you don’t pay off your balance in full. Once you transition to an unsecured card or cancel your secured card, you’ll receive your deposit back, provided you’ve paid off the balance.
Unsecured credit cards aren’t backed by a cash deposit or any other collateral. You’ll get a credit limit based on your income level and credit history, so most likely your first card’s limit will be low. Issuers take on more risk when they approve unsecured cards. Because of this, those without credit history generally need to start with a secured card, or get an unsecured card with a cosigner. Alternatively, you can ask to be added to a relative or friend’s credit account as an authorized user. As an authorized user, you’ll be able to use a credit card and will likely benefit from the primary cardholder’s good credit habits, but you won’t be legally obligated to pay the balance.
4. How a grace period works
One of the many benefits of using a credit card is that you essentially get an interest-free loan and a grace period of 21 and 25 days. Here’s how it works: Say you have a credit card period of Jan. 5 through Feb. 4, with a due date of March 1. Any purchases made within the period can be made interest-free until the payment due date. However, if you don’t pay your balance in full on or before March 1, you’ll owe interest on your average daily balance.
5. How credit card interest is calculated
Many people think that credit card interest is assessed on the card balance remaining after the payment due date. However, if you don’t pay your balance in full, you’ll accrue interest on your average daily balance during the month.
Say you have a card balance of $1,000. On day 11 of accruing interest, you pay off $200. Then on day 21 of accruing interest, you pay off another $350. Your average daily balance would be $750.
If the card’s annual percentage rate (APR) is 20%, the periodic interest rate is 0.0548%. Your periodic interest rate is calculated by dividing your APR by 365. Multiply your average daily balance by the periodic interest rate and the number of days in the month to get the interest accrued for the month. In our case, this is $12.33.
To avoid accruing interest, you need to pay the new balance on your credit card statement each month. The minimum payment is enough to keep you in good standing, but paying interest is unnecessary if you spend within your means.
Keep in mind, if you take a cash advance, you may have to pay a higher interest rate and you won’t have the benefit of a grace period. You may also have to pay an increased penalty interest rate if you make a late payment or spend more than your credit limit. You’ll be able to find these alternative rates on your card issuer’s website.
6. How minimum payments are determined
A minimum payment is the smallest amount of money you can pay each month without damaging your payment history and incurring a late payment fee. There are a few different methods for calculating minimum payments, but here are the primary two:
- Percentage method: Your issuer may calculate your minimum payment based on a percentage of your balance. This is generally between 1% and 3%. So if you have a balance of $2,000 and the minimum payment is 2% of your balance, you’ll have to pay a minimum of $40 to stay in good standing.
- Percentage + interest + fees method: Your issuer may also take a percentage of what you owe plus any applicable interest and fees. Let’s say you have a $1,000 balance and an interest rate of 18%, and you pay late. Your issuer might charge you a minimum payment of the sum of 1% on your balance ($10), your interest accrued ($14.79) and a late payment fee ($35). Your minimum payment in this case would be $59.79.
If your balance is relatively low, you may be required to pay a flat minimum payment, which typically ranges from $25 to $35 a month. But we always recommend that you pay your balance in full by the due date.
7. How credit cards affect your credit score
Credit cards can affect your credit score in several ways. Before we get into the specifics, take a look at the five factors that go into your FICO score, the most widely used scoring model among lenders today:
- Payment history (35%)
- Credit utilization (30%)
- Length of credit history (15%)
- Types of accounts in use (10%)
- New credit (10%)
Using a credit card can affect your credit score in several ways, either positively or negatively. You can positively affect the most important credit score factor, payment history, by making your payments on time, 100% of the time. A late credit card payment likely won’t be reported within a few days, but it can be reported to the bureaus and hurt your score.
Credit utilization, or the percentage of your credit limit that you’re using at any given time, is the second most important FICO score factor. We’ll discuss how to calculate this in the next section, but essentially, you should try to keep your debt balance below 30% of your credit limit.
The ages of your newest and oldest accounts, as well as the average length of all of your credit accounts, make up your length of credit history. The longer, the better. You can influence this factor with a credit card by keeping old accounts open and active. And, of course, be patient, because building a great credit score takes time.
Types of credit in use refers to the mix of different types of credit accounts you have, such as student or auto loans, or a mortgage. Diversity is preferable to only one type of account, but this factor has a small influence on your FICO, so you shouldn’t go out of your way to take on interest-accruing debt.
When you apply for a new credit card, your score may take a small hit. To combat this, avoid applying for several cards in a short period of time, especially if you haven’t been building your credit for very long.
8. How to calculate your credit utilization
There are two different utilization ratios that FICO pays attention to: your line-item utilization and aggregate utilization. Line-item utilization is the percentage of a specific card’s limit that you’re using. So if you have a credit card with a $5,000 limit, and your current balance is $1,000, you have a 20% line-item utilization percentage on that card.
Aggregate utilization is the total utilization across all of your cards. Let’s say you have three credit cards:
- Card A has a limit of $500 and a balance of $120
- Card B has a limit of $3,000 and a balance of $200
- Card C has a limit of $1,000 and a balance of $800
Your aggregate utilization would be just under 25%, which is within the acceptable limits.
Both line-item and aggregate utilization ratios are important when it comes to your FICO score. Keep both below 30% at all times to favorably affect your credit.
9. Where rewards come from
Many credit cards offer cash or travel rewards on your purchases. These rewards come from interchange fees, or the fee paid by a merchant’s bank to a customer’s bank when you use your credit card to make a purchase. Interchange fees vary, but are usually 2% or more, which is enough to cover the rewards rates on competitive rewards credit cards.
Some credit cards have rewards of 5% or 6% on certain types of purchases. However, these tend to be capped at a certain monthly, quarterly or annual dollar amount. If your rewards seem a bit too good to be true compared to typical interchange fees, check your benefits statement for details on spending limits.
10. What an EMV chip is, why it matters — and when it doesn’t
An EMV chip is a small microchip embedded in your credit card that helps prevent fraud by generating a one-time code every time the card is used. This can prevent stolen transaction data from being used to make fraudulent purchases. Traditional cards, by contrast, have only unchanging data stored on a magnetic stripe. However, the EMV chip comes into play only when the card is physically used for a transaction — for a purchase in a store, for example. Purchases made over the phone or online do not involve the chip.
EMV chips have two major verification methods — chip-and-signature and chip-and-PIN. With chip-and-signature cards, which are more popular in the U.S., cardholders verify their identity with a signature (although that requirement is going away in many cases). With chip-and-PIN cards, which are more popular in Europe, cardholders enter a four- to six-digit number. (Many overseas merchants won’t accept magstripe-only cards, so make sure you have a chipped card with you when traveling abroad.
Rules that took effect in October 2015 shift the liability for fraudulent credit card transactions to banks that don’t issue EMV cards and merchants that don’t have EMV-enabled card terminals. Even so, it’s still fairly common to have to swipe your card’s magnetic stripe rather than insert the chip when making a purchase.
11. Which fees you may be charged
There are a host of potential credit card fees you may need to pay, but many of them are easily avoided. Here are the most common fees:
Annual fee: Annual fees are often charged on high-value rewards cards, as well as on cards for higher-risk consumers with lower credit scores. You can avoid them by getting a card without an annual fee, but if your spending is high enough, a fee card may net you higher rewards.
Balance transfer fee: Charged when you move a balance from one card to another, typically 3% to 4%. Balance transfers are usually made by people with credit card debt who have found a balance transfer offer with an introductory APR of 0%. You should only pay a transfer fee if the interest you would pay on your current card is greater than the balance transfer fee you’ll pay. And if you qualify, there are credit cards without balance transfer fees.
Foreign transaction fee: Charged whenever you make a purchase overseas, typically between 3% and 4% of your purchase. To avoid this fee, you can get a credit card without foreign transaction fees. If you ever travel overseas, you should absolutely have a card without these fees and preferably with an EMV chip.
Late payment fee: Charged if you don’t pay at least the minimum payment by the due date on your credit card statement, typically around $35. Avoid this by always making your payments on time.
Over-the-limit fee: Charged if your balance exceeds your credit limit. You have to opt in to this fee, per the Credit CARD Act of 2009. Keep in mind that if you choose not to opt into this fee, your purchases may be