Understanding how a credit card works can make both the process of using it and paying your bill much easier. Here are some of the basics.
The short answer is that credit cards and loans are both extensions of credit, but how that credit is advanced and repaid differs. There are key differences between these two types of financial options that you may want to consider in your financial plans.
How credit cards work
When you use a credit card to make a purchase, you are borrowing funds to pay the merchant. For each purchase, your credit card issuer will advance funds to pay the merchant for your purchase, and then will charge your credit card account for the amount of that purchase. Depending on the type of account you have, you also may be able to obtain cash advances or transfer balances by using your account to pay other creditors. The issuer keeps track of all charges to your account and will send you a statement, typically once a month. Each statement will show the total balance owed on your account and the amount of your next payment. Depending on your issuer, your monthly payment may be the total balance or only a small percentage of that balance.
The issuer assigns a credit limit to your credit card account. Once you reach this limit, you cannot use your account for new transactions. If you try to make a purchase when your card is “maxed out,” the purchase may be declined. However, as you repay the total balance owed on your account, additional credit will become available to you, and you can again use your account, up to the amount of available credit. Credit cards and other accounts that allow you to use, repay, and reuse credit are referred to as “revolving” credit.
Keep in mind that just because you can spend up to a certain amount doesn’t mean you should. One factor used in calculating your credit score is your “credit utilization rate,” which reflects how much of your credit limit you’re actually using. For instance, if your credit card limit is $10,000 and your balance is $2,000, your credit utilization rate is 20 percent. Experts recommend keeping your credit utilization rate below 30 percent.
How a loan works
A loan works a little differently than a credit card. Because it is not revolving credit, there is no credit limit. Instead, the loan will be provided as a lump sum of money. You must repay the loan over a specified time period, typically by making monthly payments. Depending on the type of loan, the funds may be deposited in your bank account or may go directly toward a purchase, such as a car or a home. If you need more money later, you will have to take out another loan.
Where interest rates apply
Interest generally is charged on most credit extensions. Although credit card issuers may not charge interest on purchases if you pay the total balance every month, they generally charge interest on any cash advances or balance transfers from the transaction date. It is very important for you to read the agreement and other disclosures provided with each credit card and loan you receive to understand when and how much interest you may be charged.
The cost of borrowing money is measured by an annual percentage rate, or APR, which reflects the annual interest rate and, for loans, certain other fees and charges that may be imposed on the credit extension. As you shop for credit cards and/or loans, you should compare the APRs offered by different lenders.
Interest rates can be fixed, variable or adjustable. Credit cards often have variable APRs that fluctuate with changes to the prime rate. Loans, especially mortgage loans, may offer options for adjustable rates, which will change during the term of the loan. If your interest rate can change, find out from your lender how the rate is set and when it may change.
How to be a smart credit consumer
Using a credit card wisely can help you build a strong credit history. This credit history may benefit you later by demonstrating to lenders that you have a good track record when it comes to debt. Having a good credit history can help you qualify for a loan, and also can help you secure a good interest rate, which can save you money.
Making on-time payments is the single biggest step you can take toward a building solid credit score. Using your credit card to make a few purchases each month and making sure you pay every bill by the due date can help your credit score. Paying your balance in full every month will also save you money in interest charges.
The better you understand the terms of your credit card, the more effectively you can use it to meet your financial goals.
