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Responsible use of a credit card allows its holder to retain cash while receiving cashbacks, rewards, and attractive discounts through purchases. A credit card can also serve as an emergency line of credit while providing increased security from fraud. A disciplined credit card holder can shop with it as desired while reaping all its benefits, as long as they know what its disadvantages are and how to avoid them.
The failure to understand credit cards well, combined with the tendency to stimulate impulsive purchases, can lead to overspending—quickly racking up large debts. This is exactly when credit cards get a bad reputation—a person spends all their disposable income and then uses a credit card to spend well above their means, which quickly leads to financial difficulties.
So the trick is to understand the credit card as one of many payment tools a person ought to have. Once you’ve done that, the way you use a credit card will look like a financial superpower to the uninformed.
Just the Nuggets
- Credit cards allow users to access a line of credit.
- They are different from debit cards in that they use debt instead of cash.
- Credit card issuers charge both interest and annual fees.
- Credit cards can bring cashback rewards and improve credit scores.
- Irresponsible credit card use can rack up debt and damage credit scores.
What is a Credit Card?
A credit card is a payment card, issued by a bank or other financial institution (issuer), that allows its user (cardholder) to use a line of credit to make payments for goods and services from a company (vendor) and to withdraw cash if necessary. This is done through a revolving account in the cardholder’s name to which a purchase is accounted for as debt. That debt is then paid back by the cardholder on an automatically created repayment plan or as a one-off. In either case, the money will be moved from the current account to the revolving account to make the repayments.
Credit Card vs Debit Card vs Cash
You may have confused a credit card with a debit card, but you can tell by knowing the account they are connected to. A credit card is connected to the cardholder’s revolving account and creates debt for making payments. On the other hand, a debit card is connected to the cardholder’s current account and uses cash for making payments. So using a debit card is the same as using cash.
How Much a Credit Card Costs
Credit card issuers make money by charging interest and fees from the cardholders. Four factors affect how a credit card debt would be paid back:
- amount owed
- interest rate
- applicable fees
- number and size of monthly payments
Common fees are annual fees, cash withdrawal fees, and late payment fees—all of which are listed in the credit card contract.
Credit card issuers have their own standard number of months for repayment but, usually, 24 is the norm. Despite that, the cardholder has the option to repay the debt sooner by paying a greater amount per month or by taking the vendor’s longer payment plan offer in agreement with the issuer.
For example, a cardholder makes a $1,000 purchase with a credit card that has a 5% interest rate (without grace period) and costs $50 per year to own it, at the issuer’s standard 24-month repayment plan. But the vendor also offers a 48-month repayment plan for the product, while the issuer allows the debt to be repaid in as few payments as desired (say 6 payments). In this case, the cardholder has these repayment options.
|OPTION||1: Standard||2: Extended||3: Shortened||4: One-Off|
|NO. OF MONTHLY PAYMENTS||24||48||6||1|
|TOTAL AMOUNT OF INTEREST||$52.90||$105.43||$14.64||$4.17|
|ADDITIONAL ANNUAL FEE||$50||$50||$50||$50|
|TOTAL AMOUNT TO BE PAID||$1,102.90||$1,155.43||$1,064.64||$1,054.17|
This means, considering interest is amortized, that the cardholder can:
- repay the credit card debt standardly at $43.87 per month for 24 months and pay a total of $52.90 in interest plus $50 annually for owning the card
- take the vendor’s offer at $23.03 per month for 48 months and pay a total of $105.43 in interest plus $50 credit card annual fee
- transfer more to the revolving account, paying $169.11 per month for 6 months, and pay a total of $14.64 in interest plus another $50 per year for owning the card
- pay the entire amount at once for a total of $1,004.17 after a month, of which only $4.17 would be paid as interest, plus $50 annual fee
Types of Credit Cards
Issuers brand their credit cards in various ways. Some brand them for target markets, like student credit cards or business credit cards. Other issuers brand them according to the benefits they offer, such as rewards credit cards. Still, a few issuers go even further and brand their cards with colors and precious metals—platinum, gold, purple, black, etc.—to indicate the credit limit associated or even for no reason at all.
A shrewd spender will notice a theme here—all these types are regular vanilla cards with various conditions and benefits to fluff up their appeal. In order to not get trapped and confused with the branding, you should simply find out the card’s interest rate, fees, repayment schedule, key terms, and benefits.
Before getting a credit card, it is necessary to ask the card issuer if it has the necessary features so that you can get the advantages.
1. Good credit history
If you repay your credit card debt in a timely manner and avoid maxing out your limit, your credit score will increase and positively affect your other loan applications.
2. Financial discipline
If you’re aware of the costs and benefits associated with your credit card, you can strategically use it for spending. Periodically, you can conveniently review your credit card statement to see how much you’ve spent and how much you’ve benefited from the spending.
3. Rewards and cashbacks
Because credit cards can trigger impulsive purchases among users, many companies offer various cashbacks on purchases. So if you strategically use your credit card for $1,000 of your monthly expenses and get 2 cents on every dollar, that’s $20 per month or $240 per year. Issuers may also provide sign-up bonuses and spending rewards. They market these benefits very visibly.
4. Emergency line of credit
The option to borrow funds and make purchases ready and waiting, just in case, provides you tangible security. In an urgent need for funds, the last thing you need is to go through a loan application process. In such an emergency, a credit card may be your best option.
5. Security from irresponsible or fraudulent vendors
The companies producing the cards (major players being Visa, MasterCard, and American Express) are multibillion and multinational conglomerates that base their entire business on trust and security. Should you fall victim to real fraud, these companies are known to go after fraudsters with tenacity. Frauds on credit cards are taken especially seriously because of the associated debt.
In a different case, if a vendor doesn’t deliver on a product or service as promised, a refund can be much easier to get if the payment was made from a credit card.
Using a credit card irresponsibly can also bring several disadvantages to you.
1. Damage to credit score
In contrast to regular payments improving your credit score, late payments can damage it. So you must be mindful of your credit card bills and pay on time.
Since a credit card allows you to purchase products and services beyond your means, it is easy to give into the temptation for shopping and rack up more debt than initially planned. This is why a prudent cardholder should set a personal credit card debt limit, and only go over it in case of a real emergency with a predetermined repayment and/or refinancing plan.
3. Improper purchases
Sometimes, a vendor may offer items with a discount if paid in cash. Other times, you as a cardholder may purchase items on a credit card by habit even if you have the cash—ending up paying unnecessary interest. In cases like these, the benefits from credit cards are lost, and you would’ve been better off not using them. This is why it is important to use the right payment method by knowing when you benefit from a credit card and when you don’t.
4. Brokerage account funding
Many online brokerages accept credit cards for funding the brokerage account. But it is very inadvisable to borrow money for trading stocks and other instruments. There are instruments like futures, options, and CFDs which allow investors to trade on margin. These are the right instruments for using leverage in investing; a credit card is definitely not.
5. Credit card with bad terms
Not all credit cards are created equal; some have higher interest and fees than others, some have less benefits than others. The issuer from which you can get a card will have all the expenses and benefits posted on their websites. It is necessary to list several options and pick the best one before making the commitment and getting a credit card.
How to Use a Credit Card Responsibly
A shrewd cardholder will understand how a credit card works and what it is best used for. To get the maximum benefits out of a credit card, you must decide:
- your personal spending limit, based on current income
As a rule of thumb, never borrow more than what can be paid back with 10-15% of your monthly income in 12-15 months.
- your credit card limit for emergencies, even if the issuer offers more
- which repayment or refinancing plan to choose, if the emergency limit is used
- which credit card is with the best terms for you on the market
- how much cash to hold regularly, so as to decide what to purchase with cash instead
- which regular purchases are better made with a credit card to get benefits
- which purchases offer no benefits when used with a credit card and are better made in cash
- to set a regular credit card statement review and track personal financial discipline with it
- to write a list of never-rules, such as never using all your cash and then maxing out the credit card in order to purchase luxuries
- to have an exit strategy
If you realize that the credit card adds more trouble than what it is worth, you should have the ability to at least refinance it and close it.
Frequently Asked Questions
Should I Get a Credit Card?
Yes, and you should use it strategically and responsibly. It is a misconception that credit cards are a bad financial tool in every way.
Whose Money Does the Credit Card Use?
The issuer’s money, which is owed and paid back by the cardholder. Not the other way around.
What Should the Credit Card Be Used For?
Only for purchasing items that bring benefits like discounts and cashbacks. Not for impulsive shopping.
What Shouldn’t the Credit Card Be Used For?
Purchasing items that bring no benefits or are outside the cardholders ability to easily repay. Credit cards shouldn’t be used for a carefree lifestyle.
What Happens When I Don’t Use My Credit Card?
The card issuer may charge an inactivity fee, depending on the contract. It is a misconception that a credit card must be used all the time.
Can Multiple Persons Use One Credit Card?
Yes, but only if agreed upon in the contract or expressly permitted by the issuer. Another person may not use it without contract or permission.
Can I Pay Off Debt With a Credit Card?
It is possible, but highly inadvisable. Getting new credit cards for refinancing is the quickest way to rack up huge debts.
Can I Withdraw Cash From a Credit Card?
Yes, but this is not what a savvy person would use them for because of the high fees. It is a common misconception that withdrawing cash is the same for credit and debit cards.
5 questions to ask yourself before you apply for a Credit Card by Kate Browne (Greater Bank Limited)
Credit Card Vocabulary
|Credit Card||The plastic card itself|
|Credit Limit||Maximum funds allowed for credit|
|Credit Balance||Amount used and owed|
|Credit Available||Remaining amount available to be borrowed|
|Balance Transfer||Moving debt from one card to another|
|Cash Advance||Withdrawal of cash from credit card at an ATM|
|Revolving Account||The card’s account at the issuer, separate from the current account where cash is kept|
|Line of Credit||Money used by the card|
|Grace Period||Non-interest period on the debt|
|Interest Rate||Percentage of interest charged by the issuer|
|Prime Interest Rate||Initial rate of interest offered by the issuer|
|Variable Interest Rate||Interest rate that can be changed by the issuer|
|Annual Percentage Rate (APR)||A total of the fees and interest over credit, as a rate|
|Annual Fee||Fixed fee for owning the card|
|Late Fee||Fee charged on late payments|
|Overlimit Fee||Fee charged if the cardholder goes over the credit limit|
|Return Fee||Fee for an unaccepted payment|
|FX Fee||Conversion fee when purchasing in foreign currencies|
|Cash Advance Fee||Fee charged on cash withdrawal from credit card at an ATM|
|Balance Transfer Fee||Fee for moving debt from one card to another|
A credit card is a powerful financial tool that can bring great benefits to the savvy spender. But in the hands of an irresponsible one, it can lead to quick mounting of debt and financial difficulties. This is why it is critical for a person to understand how a credit card works and what it is best suited for before getting one.
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