Credit Cards 101: What is a Credit Card?

One of the most popular methods of payment is the credit card.

A credit cared provides you with an easy and convenient way to make payments.  As you plan your finances, it’s not a bad idea to consider incorporating credit cards.

But you  should understand how credit cards work.

If you don’t understand how credit cards operate, you can easily become trapped with debt.

How a Credit Card Works

A credit card is issued by a financial institution, and it provides the holder with the ability to borrow money.

A credit card is basically a way to use short-term financing to make purchases.

It’s important to understand that when you use a credit card, it isn’t “your” money.  You are borrowing and you are expected to pay it back — probably with interest.

When you apply for a credit card, the financial institution will check your credit history, and take your household income into account.  Then, you will be issued a line of credit.

Your line of credit will based on your creditworthiness, as well as your income.  The higher your credit score and income, the higher your credit limit.  If you show that you can handle your credit limit, by making payments regularly, and not maxing out your card, you will see an increase in your credit limit.

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This line of credit is revolving, which means that you can keep using it as long as you pay it down.  If you have a credit limit of $2,000, you can keep using it, as long as you keep paying it down.

If you spend $500 one month, and carry the balance, you only have $1,500 available for the next month.  However, if you pay off the $500, you immediately have the entire the $2,000 available to you again.  There’s no need to apply for another loan or credit card.

Paying Interest on Your Credit Card Loan

credit card

A credit card is more than a piece of plastic that can get you stuff.

Credit card loans come with interest rates that are usually higher than other types of loans.

Someone with good credit might a rate of between 11.99% APR and 19.99% APR.  If you have poor credit, you might pay higher rates, more than 21.99%.

That’s a high rate, especially if you carry a balance.

Credit cards charge interest based on different terms.

Some will base it on the balance you have at the end of the month.  In other cases, the interest you pay might be based on the average daily balance of your credit card.

Either way, if you carry a balance on your card, you pay interest (you want to avoid that).  Usually, if you pay off your credit card each month, you won’t have to pay interest on your balance.  As long as you pay off your balance each month, you can use your credit card without incurring interest fees.

If you use your credit cards too much, without being able to pay off your balance, it’s easy to get caught in the debt trap.

Credit cards are easy to use. It feels like you have “extra” cash.

As a result, you might imagine, you can easily spend more money than you actually have.  Once you start carrying a balance, and paying interest on it, you can get stuck in a cycle of debt and interest.

Bottom Line

Credit cards can be financial tools that make it easy and convenient to make large purchases without having to carry around a great deal of cash.

However, you do need to be careful.

If you don’t use credit cards within the context of your budget, you could wind up in debt.  Plan ahead, and pay off your credit card each month, and you will be more likely to succeed with your finances.

What questions about credit cards do you have? Leave them in the comments and we’ll try to answer them.

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Published or updated May 10, 2012.

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