Everything You Need to Know About Credit Cards
According to CNBC, a majority of Americans are currently in debt due to credit cards with “the average American having a credit card balance of $6,375″. This results in America having a total debt of 1 trillion dollars.
Can we blame credit cards for being at fault? Or is it the users? If you are an individual thinking about getting a credit card then read this blog post first. I will discuss the things you should know before anyone gets their hands on a credit card. Hopefully, then, you will be able to decide if it makes financial sense for you to get one.
In this blog post, you will learn the basics of credit cards.
- Why You Should Have A Credit Card
- What is a Grace Period
- How Is Credit Card Interest Calculated
- What Happens If You Miss A Payment
- How is Your Credit Card Affecting your Credit Score (credit utilization, late payments, etc)
- What Is A Good Credit Card for Beginners
- How to Get Yourself Out of Credit Card Debt
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1. Why You Should Have A Credit Card
Believe it or not, credit cards are not evil.
Like most things, moderation, and good habits are key to keeping a healthy balance. Abusive use of credit cards along with poor control is the reason why so many people are in debt. If you are responsible enough to pay your bills on time and not make any impulsive buys then you will be able to reap the rewards of credit cards.
The benefits of having a credit card are
- Convenience to make purchases when you’re out of cash or your debit card fails.
- Earn points and redeem offers
- Cash-back %
- Travel Points and Rewards
- Insurance and Warranty (Car rental, Trip-Cancellation, Travel Insurance, and more)
- Fraud Liability Protection
- Low-Interest %
- Redeem introductory welcome offers (credit card churning)
- Build your credit
Building Your Credit Explained
If you’re looking to one day take out a loan or a mortgage then it’s crucial to have some sort of credit history to allow lenders to see your reliability and the likelihood of you making your payments on time.
A customer with no credit history is viewed as an individual who is just as risky as someone with a low credit score because, without a credit history, you show no signs of any reliability to pay.
Your credit score is a three-digit number that shows lenders the likelihood of you paying back your dues. One of the factors that go into your credit score is the age of how long your accounts have been opened for.
Even if you are not looking into taking out a loan or a mortgage, a good credit score can help you get a lower interest rate on your credit card or car loan.
Credit Cards are like a double-edged sword
Credit cards are one of the leading causes for people who are in debt. There are great benefits to owning a credit card, but it is SO EASY to fall into debt and ruin your credit score!
If you want to avoid these disastrous outcomes then you need to follow these simple rules when owning a credit card.
- If you can’t pay it off right away then don’t buy it.
- Pay off your credit card balance immediately (at most a few days).
Get into the habit of automatically paying off your credit card.
2. What Is A Credit Card Grace Period
A grace period is a 21-25 day window from the closing date of your monthly billing cycle to the due date.
Within this time frame, you do not accrue any interest on any of the purchases that you make.
Grace periods are a margin of safety allowing you to make purchases without having the consequences of having interest calculated immediately.
That means that if you’re carrying over a balance from the previous month, you won’t be charged any interest on your owing balance and any purchases that you make in the following month…as long as you pay it off within 21-25 days.
Unfortunately, if you have yet to pay off your balance in “full” by the 21-25 days, then you lose the grace period and you accumulate interest on any new purchases a day after along with the remaining balance of any previous charges.
When I quoted the word “full”, I mean the whole balance, not a minimum payment. Some people have this belief where, if they constantly have a small balance in their account then they can improve their credit score and that is incorrect.
3. How Credit Card Interest is Calculated
In order to calculate the interest on your credit card, you need to know the average daily balance and the APR % rate of your credit card. These two numbers are crucial in order to calculate the interest on your credit card.
Assuming you no longer have the grace period on your credit card, how do you calculate the interest?
Average Daily Balance
This number is the average of all the beginning balance of each day of the statement period.
For this example, let’s assume your new statement period starts on January 1st and ends on January 31st. On January 1st, you made a purchase for $100, and on January 15th, you made another purchase for $200.
The opening balance that you still owe on your credit card is $100 on January 1st, 2nd, 3rd… etc, until the end of January 14th. The opening balance of your account from January 15th until the end of January 31st is $300.
Next you need to find the average.
Your Opening Balance MULTIPLIED by the # of Days that your balance stays at that balance.
Including the second half of our “purchases”, the equation would be = ($100 x 14 days) + ($300 x 17 days) = $6500
Now divide it by the number of days in that statement period. In this case, January 1st to January 31st is a total of 31 days. We will divide by 31. $6500/31 days = $209.68
Your average daily balance is $209.68.
Using the Credit Card APR
APR stands for annual percentage rate: this is the rate that you are charged on your credit card if you have any outstanding balance at the closing period.
This can go up to as high as 20%, but double-check with the detailed information that came with your credit card.
This amount is expressed in an annual percentage, so you will need to divide this percent by 365 days first. Dividing it by 12 months will only give you an inaccurate number.
Once you’ve converted your APR into a daily rate, multiply it by the number of days in the billing period. In this case it would be 31 days.
New Rate= .20 / 365 x 31 days = 0.0169863
Take that new rate and multiply it by your average daily balance and you will have your accrued interest for that billing period.
0.0169863 x $209.68 = $3.56
4. What Happens If You Miss Payments
There will be moments where you will be unable to pay off your credit card; perhaps an emergency occurred and you need to use your available funds or maybe you flat out forgot to pay your credit card.
There are 4 major consequences for missing a payment on your credit card.
Credit Card Payment Late Fees
Any payments that are paid after the due date or paid not in full will result in a late fee usually around $15-35. This late fee will be billed on your credit card statement each month that the payment is late.
Increase in Interest Rate
Late payments being more than 60 days past the due date will cause an interest rate increase to your penalty APR. This rate can go up to as high as 29.99% (depending on the credit card terms). Your creditor can cancel your 0% introductory APR if they decide it is necessary. 6 months of on-time payments will reset your APR back to normal
Added to your Credit Report
Any payments past 30 days will result in an entry to your credit report that can last up to 7 years. This can severely damage your credit history.
Decrease your Credit Score
Payment history makes up a whopping 35% of your credit score. Low credit scores can damage your chances of taking out a loan or receiving a low-interest rate.
5. How Is Your Credit Card Affecting Your Credit Score
A credit score is a 3-digit number that lenders use to determine how reliable you are as a borrower. Using the FICO Score, your credit score is made up of many variables and not just your payment history alone.
I will explain what your credit score consists of in regards to your credit card but keep in mind that your score is made up of other loans too.
35% Payment History
As mentioned earlier, 35% of your score is related to your history of late payments. Late payments on your credit card can significantly lower your credit score if done consistently. The easiest way to avoid this big chunk would be to pay off your credit card on time.
30% Credit Owed
The next biggest chunk of your credit score has to do with your credit utilization ratio. That means “how much do you owe compared to what you are allowed?”. Simply put it, if your credit limit is $1000, do you charge all of the $1000 (100%) or do you only borrow $100 (10%)?
According to Thebalance, a good utilization score would be to below 30%. That means using below 30% of your allowable credit will keep you in a green zone of your credit score.
To calculate your credit utilization rato simply = owing balance “divide by” allowable credit
How To Lower Your Credit Utilization Ratio
To lower your credit utilization ratio you can:
- Pay off your credit card early – Pay off any existing balance on your credit card before making any new purchases. If you immediately pay off your credit card, it will reset your balance back to 0 which means your credit utilization will be 0.
- Credit Limit Increase – Will allow you to borrow more
- Using multiple credit cards – Dispersing your purchases among different credit cards will keep your credit utilization ratio lower.
- Don’t close unused credit cards – Closing credit cards will cause you to lose that available credit room. Which will increase the likelihood of increasing your ratio.
15% Credit History Length
The longer you’ve had your credit cards open, the better (assuming you paid on time and didn’t abuse it). Having a long active credit history will show lenders that you are capable and trustworthy to lend money.
Which is why it is highly recommended for you to open a credit card as soon as possible to start building your credit history. The same can be said for inactive credit cards: Keep any credit cards open, even if you don’t use it. Keep them active by making purchases on those credit cards once a month to continue developing the credit history length.
10% New Credit
Opening multiple credit cards in a short amount of time is a red flag on your credit report because generally people who are experiencing cash flow problems generally take out multiple debts in a short amount of time.
Applying for a new credit card requires a “hard inquiry” where the creditor will pull your credit information to evaluate if you should be accepted for the new credit. Multiple hard inquires will negatively affect your credit score, so you should only apply for new credit cards once in awhile.
10% Credit Mix
The last 10% that makes up your credit score is the mix of credit that you have. That is a mixture of credit cards, mortgages, loans, etc. The question as to what is the best mix of credit to boost your credit score is unknown (sorry!)
6. What Is A Good Credit Card for Beginners?
Now you know the pros and cons of having a credit card; if having a credit card is something you can handle then look into grabbing a credit card that has no annual fees and some perks.
Different credit cards will have different perks such as travel rewards, cash-back, low-interest, and more. Consider researching on the web to find a credit card that best suits your needs.
Don’t be fooled by the bankers by getting the most expensive credit card. The annual fees and welcome offers can only be justified if your annual/monthly spending benefits rewards you to cover for those fees.
If you are a Canadian then consider signing up for the credit card I am using right now. You can read more information on it here! I love this credit card!
7. How To Get Out of Credit Card Debt
One of the worst situation that you can find yourself stuck in is credit card debt; not only do you have money owed to a creditor, but you have that nasty interest that is going to kill you. Most credit cards will charge 19.99% interest if payments are not paid after the due date.
So what if you’re stuck in the gutters? How do you get out?
You can check out my blog post on “Paying Off Debt 101” blog post to read ALL THE STEPS in details. In terms of this blog post, I will give you 3 alternatives to help you pay off credit card debt.
Negotiating A New Interest Rate
The easiest method out of these three would be to negotiate a new interest rate. Depending on how long you’ve been with the creditor and how well your credit history is, you can try to negotiate in order to lower the interest accruals.
Taking Out A Loan to Pay Off Your Credit Card
Taking on a new debt may seem scary, but taking out a personal loan that usually charges 6% interest is definitely a lot better than your 19.99% credit card. The idea is to take out a loan to pay off your credit card, so you will only be left with a 6% personal loan.
Make sure to crunch the numbers to see if this method will actually work in your favour. Depending on your credit score and the conditions of your credit history, you may be charged a high personal loan rate plus additional fees that might make this method useless.
Balance Transfer Credit Cards
A balance transfer credit card generally has a 0% APR introductory rate, that means you will not be charged any interest on any new purchases for the first 6 to 12 months (depending on the credit card).
Transferring the balance from your current credit card to your new credit card may result in a small fee and a charge of a few percentages of interest every month on your balance, but this method will help you steer away from your current credit card’s APR.
Keep in mind, this method defers the interest charged on your credit card, not get rid of it. You want to pay off your credit card as soon as possible before the introductory interest rate is over because after the introductory period, you will be charged the normal interest rate (around 20%)
So, should you get a credit card?
If you can pay off your credit card in full before the interest is charged and you can keep track of how much is in your balance then I would say do it!
Take advantage of the benefits that a debit card don’t provide and start building that credit history. Even if you don’t need it, make purchases once a month to keep it active just so you have someone to fall back on when the time comes for you to take out a loan.
Now, if you can’t commit to paying on time and paying in full then I honestly don’t recommend you to get a credit card. The worst thing you can do is to spend and spend until you’ve dug yourself a grave. It’s so easy to dig yourself into a hole, but getting yourself out is another story.