How Do Credit Cards Really Work?
Understand credit card fees so you can avoid paying them.
Laura Adams, MBA
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How Do Credit Cards Really Work?
Credit cards are financial tools that can save you money or completely ruin your finances, depending on how you use them. One of the biggest money mistakes you can make is to use a credit card without really understanding how it works. I’ll tell you what you need to know so you never allow a credit card to get the best of your personal finances.
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What is a Credit Card?
I’m sure you already know that a credit card is a financial product issued by banks and other financial institutions that allows you to make purchases, take cash advances, and transfer balances from other accounts. I’ll tell you more about balance transfer cards in just a moment.
When you’re approved for a credit card, you’re given a line of credit, which is typically the maximum balance you can accumulate on the card.
Many people use the terms “credit card” and “charge card” interchangeably, but they’re not the same. A charge card requires you to pay off your balance in full each month. A credit card allows you to carry a balance indefinitely as long you make the minimum monthly payments.
What is a Credit Card Finance Charge?
The money you owe on a credit card is subject to an annual percentage rate (APR) that’s called a finance charge. Each card company has different terms that vary depending on the type of card, your credit score, and the type of transaction you make using the card.
For instance, you might be charged 11.99% for new purchases, 18.99% for balance transfers, and 26.99% for cash advances. If you don’t realize that it’s outrageously expensive to take a cash advance on a credit card, you could end up with a massive bill that you can’t pay off.
When you make more than the minimum payment, the card company generally has to use the excess to pay down your highest interest balances first. That means the money would go towards reducing your cash advance balance before it would reduce the balance for your regular purchases.
If you carry a balance from month to month, your goal should always be to use a credit card with the lowest interest rate possible so you rack up the least amount of interest on your outstanding debt.
How to Use a Credit Card for Free
The good news is that you can avoid all credit card finance charges if you pay off your balance before the due date on your statement. Making charges that you pay off in full each month is the right way to use a credit card because you pay no interest and can accrue substantial rewards.
By the way, one of the biggest myths about using a credit card is that you have to carry some amount of debt on one to build credit. That’s definitely not true because when you make a credit card payment on time—whether it’s a full payment or a minimum payment—you receive a positive transaction on your credit report that really helps you build your credit score.
What is a Balance Transfer Credit Card?
I mentioned a special type of credit card that’s called a balance transfer card. They offer low or no interest during a promotional period if you pay down another account—like a credit card or an installment loan—and move all or a portion of your balance to the credit card account.
A typical balance transfer promotion might last from 6 to 24 months after you make a transfer and then the interest rate can increase dramatically. You still have to make a minimum payment during the promotional period each month and each amount you transfer is subject to one-time fee that typically ranges from 3% to 5%.
Here’s an example of a good way to use a balance transfer card: Let’s say you got a car loan a few years ago with a high 17% interest rate because your credit score wasn’t as good as it is today. Your monthly loan payment is $500 and you have about $8,000 left to pay on the car over the next 18 months.
If you transfer your loan balance to a card that offers 0% interest for 18 months and charges a 3% transfer fee, you’ll come out ahead. If you pay $440 per month to the card during the 18-month promotional period, you’d keep the car’s original payoff schedule and save over $1,000 in interest!
Here are a few top balance transfer cards to check out:
- Miles by Discover® Card
- Discover® More Card
- IberiaBank Visa® Select Card
- IberiaBank Visa® Classic Card
Read Should You Use a Balance Transfer Card? for more information. Also, use the online balance transfer calculators at smartbalancetransfers.com and bankrate.com to find out whether doing a balance transfer can save you money.
What Fees Can a Credit Card Charge?
Besides finance charges, there are other ways that credit cards make money. If you mess up and pay your bill late, you’ll be charged a fee as high as $25. If you pay late more than once over a 6-month period, the fee can go up. Additionally, once you’re 60 days late paying your bill, a card company can hike your interest rate.
Another fee to avoid is called an over-limit fee. If you authorize your card company to allow transactions that exceed your credit limit, they’ll process the charges but also penalize you as much as 29.99%. Otherwise, a transaction that would exceed your credit limit will be turned down.
Many cards, especially those that offer cash back or travel rewards, charge an annual fee. If you utilize rewards that are worth more than the annual fee, it may be a worthwhile expense—otherwise opt for a card that doesn’t charge one.
How to Monitor Your Credit Card Account
When you use a credit card, it’s really important to monitor the activity on your account. Always keep your credit card receipts so you can match them against your statement. If you find anything that’s incorrect, contact the card company right away to resolve the issue. They can open an investigation with a merchant who charged you for something you want to dispute.
Be sure you understand what interest rates you’re paying for every credit account you own. Using credit responsibly includes taking the time to go over each statement with a microscope so you watch out for fraudulent charges, fees, or unexpected changes in your interest rate.
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About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.