It’s not uncommon for people to try and sway others away from opening credit cards. Stories are told all the time about runaway credit card debt and parasitic banking practices. While many of these stories are valid cautionary tales, a lot of people are using their credit cards responsibly, and are benefitting from it.
Not only is a credit card one of the best ways to build a credit history, but it’s also an opportunity to save money with rewards and benefits. Learning how to use a credit card properly is one of the keys to financial success. They’re a way to develop good money management habits while also opening up new financial opportunities. Continue reading to learn exactly how credit cards work and how to use credit cards responsibly.
How do credit cards work?
A credit card is essentially a loan from a bank in the form of a credit line. The credit line is the maximum amount of money you can spend (borrow) before needing to pay the balance off. As long as the card is routinely paid off, you can use it as often as needed. However, there are situations in which you should not use a credit card, and we will go over it in this post.
To pay off a credit card, you will need a way to transfer funds to your credit account. Usually, people have a checking account where funds are initially deposited, and these can be linked to your credit account for secure transfers. Banks that have physical branch locations may also allow cash deposits to pay off a credit card balance. Your bank may even grant you a credit line increase if you’re good about paying off the balance on time.
Every credit card allows you to either pay the balance off in full, pay a custom amount, or pay a specified minimum amount. Minimum payments are usually a small percentage of the overall balance. It’s attractive only to pay the minimum balance each month regardless of your total balance. However, this is an easy way to fall into a debt trap due to interest charges.
Interest charges apply to your credit account for any balance that isn’t paid off by the next monthly billing cycle. Average interest rates for credit card purchases are around 14-24%, and this is how banks end up making most of their money from cardholders. Late fees also apply if the minimum payment is not made each month.
Why use a credit card?
Credit cards are one of the primary tools in building your credit history. Making on-time payments, minimizing overall utilization, and owning a credit card for an extended period are all factors in determining your credit score.
Your credit score, in large part, determines what types of financial options you can use in the future. Everything from apartment leases to car loans and mortgages usually requires solid credit to get the best deals. Sure, you can still pull out a loan with bad credit, but you will most likely end up spending more money over time because of high-interest rates and other limitations. Good credit will afford you the best loans with the lowest interest rates and shows institutions that you’re responsible and low risk.
Aside from credit-building, credit cards also offer money-saving tools such as cashback rewards, insurance, and fraud protection.
How to build a credit history with a credit card?
Make purchases and on-time payments. A large part of your credit score is based on payment history alone. Missing credit card payments will not only cause late fees and interest charges, but it will significantly damage your credit score if done too often. The best practice is to make at least a couple of purchases a month and quickly pay them off.
Keep credit card utilization below 35%. Credit card utilization is a ratio between your overall credit line and the amount of that credit line you’ve already used. For example, if you have a credit line of $1,000, then ideally, you’d want to keep the balance below $350 at all times. Your credit card utilization is reported to the credit bureaus routinely, and high credit card utilization will hurt your credit score.
Increase your average account age. Lenders like to know that you have experience in dealing with credit accounts, which is why your average account age affects your credit score. Getting started early in life with building credit is an excellent way to ensure your average account age stays high. Any time you open a new credit line after that, your average account age goes down, so new cards should be opened sparingly.
When to use a credit card
Use a credit card on everyday essentials, such as gas and groceries. After making these purchases, pay that balance off as quickly as possible. One of the most important rules with credit cards is to make sure you’re making purchases when you have the funds available. Either in cash or in a checking account. Making a purchase and paying it off fast is the best way to let your bank know you’re a responsible cardholder.
Obtain rewards and benefits. Responsible, goal-oriented cardholders stand to earn rewards and benefits for making daily purchases with their credit cards. Many banks offer a small percentage of cashback on valid purchases, usually ranging from 1-5%. Additionally, some banks offer sign-up bonuses after spending a certain amount within a specified range of time, which can be redeemed for cash or travel depending on the card. Other cardholder benefits include fraud protection, travel insurance, and renter’s insurance, which can potentially save you lots of money.
Finance large purchases. Pay with a credit card and you can often break large purchases up into smaller payments. Vendors often allow no-interest financing for a certain length of time. Meaning you can make small payments on your large purchase without the added weight of interest charges.
Emergencies. As long as you maintain a high available balance, credit cards can act as a safety net when faced with an emergency. It’s not recommended to run up your balance without a plan to pay it off. However, if there’s no other option, you can use your credit card as a buffer.
When to avoid using a credit card?
Don’t use a credit card if you don’t have the funds or a stable income available to pay off the balance. Using a credit card on non-essential purchases when you have no money to back it up is the easiest way to get caught in a debt trap.
Likewise, common sense suggests that you should not make credit card purchases if you are not in the right frame of mind. It means while intoxicated or suffering from mental ailments like depression. These lead to impulse buying — or making purchases without putting constructive thought into it — and is a detrimental habit to form.
Finally, avoid using a credit card if you’re about to apply for a big loan, such as a mortgage or car loan. Lenders will make a hard inquiry into your credit report and will be able to see things like your credit utilization and payment history. Make sure all of your debt is paid off before applying for these types of loans.
Bottom line
If you know how to use a credit card, it is a great way to build credit history and reap cashback rewards. The key is to use it responsibly. The number one rule is not to use your credit card if you have no solid plan to pay the balance off before the next monthly billing cycle. An exception to this rule is if it’s an absolute emergency. But as long as your balance is paid off on-time, you can avoid debt, open up new financial opportunities, and potentially make extra money on essential purchases.