Credit Cards: the Basics

by : James Marshall

Credit cards have greatly enhanced middle class America's access to credit over the past 20 years, increasing the standard of living for millions of families. And yet, credit card usage is often demonized in the popular press. While irresponsible use of credit has led to the financial ruin of many lives, the fact is that it is virtually impossible to function in modern society without at least one credit card, and when used responsibly, credit cards can have a tremendously positive impact on our lives. This is why a solid understanding of credit card basics is so important.

What is a Credit Card?

A credit card is a revolving credit account for which a plastic card is issued. The reason the account is considered to be "revolving" is that your credit limit rolls over from month to month. For example, when you are accepted for a credit card, you are given an initial credit limit - $500, for example. If after using the card for one month you had charged $200 worth of purchases on it, you would be sent a bill for $200 and your "available credit" would be $300. You could choose to pay the full $200, or pay less than the full amount. If you elected to pay less than the full amount, then interest would be charged on your outstanding balance.

Finance Charges

Say for example you paid $50 of your $200 outstanding balance. Once your payment was received, your new available credit limit would be $350, less finance charges. The "finance charges" would be based on the annual interest rate of your unpaid balance. If your annual interest rate were 19 percent, for example, then the monthly equivalent of a 19 percent annual rate would be applied to the outstanding balance. In this case, your outstanding balance was $150, 19 percent of which is $28.50. This doesn't mean you have a finance charge of $28.50 - that would be if 19 percent monthly interest were charged. To find the monthly equivalent of 19 percent annual interest, divide by 12, which gives the result of $2.38.

It's important to note that you can avoid finance charges altogether if you pay your balance each month, in full. This is the equivalent of giving yourself an interest free loan every month. For example, if you charged $250 on the 28th, and you didn't receive your next bill until the 15th of the following month, no interest would be applied. In this case, the due date of your next bill might not be for another 10 to 20 days, allowing you to use your credit card company's money, interest free.

What to Consider When Applying for a Credit Card

First and foremost, you should consider the annual fee. If you plan to pay off your balance in full each month, then the interest rate is less important, but the annual fee is charged no matter what. Many credit cards have no annual fees, however, most "starter cards" (for people with little or no credit) have annual fees ranging from $19 to more than $50.

Secondarily, you should consider the interest rate. Many cards offer low introductory rates that become much higher after three months to a year. Again, this is of little relevance if you plan to pay off your balance each month, however, you may find it necessary to carry a balance from time to time. If you can qualify for a low rate, then carrying a balance can actually be a smart financial decision.

Third, you should make sure you're fully aware of the various fees and charges associated with the card. For example, what is the charge for exceeding your credit limit? What fees are applied to your account if your payment is late or missed? Nobody ever plans on incurring these charges, but things happen.

Credit card ownership can open up many doors, but many people have seen their lives ruined by making poor credit choices. In order to be an intelligent consumer, you must be an informed consumer. Stay tuned for more information on responsible credit usage, as this series of articles will navigate you through the basics of credit card ownership and into advanced strategies for getting the most out of your credit.

Stay safe.