How do credit cards work?

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Credit cards are an important personal finance tool for many households, but when used irresponsibly they can cause serious financial harm. By learning how credit cards work, you can take advantage of credit card benefits without paying expensive interest and fees.

How credit cards make money

When you get a credit card, it is important to understand that it is a financial tool. You can use credit cards to help your finances or hurt your finances. Keep in mind that credit card issuers are in business to make money. By understanding how they make money, you will be better prepared to avoid handing it over.

Credit card companies make money a few ways:

  • Interest – The first and most obvious way credit card companies make money is charging interest. If you have a credit card balance at the end of the month, you will see an interest charge. This is the cost of borrowing that amount from the card issuer.
  • Annual fees – Some credit cards charge an annual fee. In some cases they are worth it, in many cases they are not. It depends on the card and how you use it.
  • Usage fees – Some activity including late payments, returned payments, and using a card in a foreign country may incur usage fees.
  • Interchange – Every time you use a credit card, the merchant pays a fee to the credit card companies. The fees are split up between several processors and businesses. Those include the credit card issuer. Even if you never pay interest or fees, if you use the card, the bank or issuer makes money.

How to avoid paying credit card interest and fees

To make credit cards work in your favor, you have to avoid paying interest and fees. Luckily for you, that is something relatively simple to do. But simple does not mean easy for everyone.

To avoid credit card interest, you have to pay off your entire balance every month before the due date. That’s it! As long as you use your credit card inside the constraints of your usual budget, you can use your credit card for regular purchases and never pay interest.

To avoid fees, make sure to always pay on time – automatic payments help. Never take a cash advance. Never do a balance transfer (unless you already have credit card debt and are using a balance transfer to save money). And never use a credit card with a foreign exchange fee out-of-state. If you follow those rules, you will be in good shape.

How credit cards can hurt your credit score

Your credit score is a rating used by banks and other lenders to judge your creditworthiness. Behind your credit score is your credit report, which is a listing of details of your history with credit accounts going back about ten years.

If you make a late payment or miss one altogether, the credit card company reports the late payment to the credit bureaus, who then put it on your credit report. A late payment stays on your credit for seven years, and a series of late or missed payments can cause serious damage to your credit score that takes years to repair.

Credit card balances also impact your credit. You should keep your credit card balances less than 20% of the total available credit to maintain a high credit score. But the best balance for your credit score is zero, and if you pay off your cards in full every month that shouldn’t be a big problem for you.

But it isn’t all bad news! Credit cards can very much help your credit score too. Next, we will dive into how credit cards help your credit score.

How credit cards can help your credit score

One of the factors in your credit score is the average age of open credit accounts. When you apply for and open a new account, your score will temporarily fall by a few points. This is because you had both an inquiry on your credit report and added a new account that lowered the average age of credit.

But what happens to a new credit account when you wait a while? It gets older. Eventually, the card will help your average age of credit. If you pay the card off in full every month and do so on time, your credit score should go up over time.

Multiple credit accounts with a perfect payment history are the perfect recipe for an excellent credit score.

How credit card rewards work

I saved the best for last: credit card rewards! Remember back in that section about how credit card companies make money where we talked about interchange?

Banks make a LOT of money from interchange. And they want you to use credit and debit cards as much as possible so they can keep making more money. They love interchange so much they are willing to give you a share through credit card rewards.

Most rewards credit cards offer cash back, miles, or points each time you make a purchase with the card. The more you spend, the more you earn. Just be careful not to spend extra for rewards. Overspending costs you more than the value of the rewards, as does credit card interest.

The best rewards cards also give you a big signup bonus, which can be worth hundreds of dollars in cash back or even more value when redeemed for travel. If you are going to spend money anyway, you might as well get a reward!

Use credit cards for good

Credit cards have the potential to open doors to valuable cash back and free travel rewards while boosting your credit score, but only if you use them responsibly. Before you get any new credit cards, it is important to look at your own spending habits and decide if you can handle staying in your budget, paying on time, and paying in full each month.

If you can’t, don’t worry. You can keep one emergency credit card at the back of the drawer and don’t have to use it. You can stick with a debit card instead. But if you do feel confident about managing your money, you are in a great position to take advantage of every reward and benefit credit cards have to offer.

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