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What is a credit card?

A credit card is a financial tool that provides you with a line of credit with a predefined limit for purchasing goods and services at stores, from catalogues, or online, or for obtaining cash advances. Credit cards enable you to obtain goods and service now, and pay for them later, at an agreed-upon interest rate. Credit cards are issued either by banks or by merchants. Credit cards may either be secured against a cash deposit or unsecured.

How can I get a credit card?

Most people receive numerous credit card offers in the mail. You may either apply for a credit card by responding to one these offers, or apply for a credit card online. You must be at least 18 years of age and meet other requirements to qualify for a credit card. College students should only apply for student credit cards.

How does a credit card differ from a charge card?

Both a credit card and a charge card allow its holder to purchase goods and services without cash. However, a charge card does not allow its holder to make partial payments of the balance each month. A charge card must be paid in full at the end of the billing cycle. Charge cards have almost completely been replaced by credit cards. American Express issues both charge cards and credit cards. Because charge cards do not allow a revolving balance and do not usually charge interest, they typically impose an annual membership fee.

What is the difference between a store/merchant card and a bank card?

Store credit cards, such as a JC Penney card, are only valid at the store or other locations that specifically accept the merchant’s card. Bank cards are issued by banks, and are generally valid at any store that accepts credit cards from the VISA, MasterCard, Discover, or American Express processing network. You can use a bank card just about anywhere, but store cards are usually valid only for purchases form the issuing merchant. Bank cards are more likely than store cards to report payment history to the credit bureaus.

Does it matter whether I get a VISA, MasterCard, American Express, or Discover Card?

You should have at least one VISA or MasterCard credit card. Many merchants accept all four cards – VISA, MasterCard, American Express, and Discover. However, not all do. VISA and MasterCard have significantly wider acceptance than American Express and Discover, particularly among small merchants. If you only plan to carry just one credit card, you should choose a VISA or MasterCard credit card because of its greater utility. However, if you already have a VISA or MasterCard and are looking for an additional card, you should consider the American Express and Discover cards.

Is a credit card the same thing as a check card?

No. A credit card is linked to a line of credit from the issuing bank or merchant. In contrast, a check card is linked directly to your checking account. A credit card allows you to purchase items and pay them off gradually. A check card deducts purchases from your bank account. We explain additional differences between check cards and credit cards in another article.

What is the difference between a secured card and an unsecured card?

Unsecured cards are generally only issued to people with good and substantial credit history. An unsecured card requires no upfront deposit. In contrast, a secured card is generally issued to people with poor and/or limited credit history. Secured cards require an initial cash deposit, which is the basis for the line of credit, and often have up-front account setup fees. Because holders of secured cards are more likely to default on payments, secured cards usually have higher interest rates than unsecured cards. Secured cards exist to establish or rebuild credit. A secured card is useful only if the issuer reports payment history to at least on of the three major credit reporting agencies.

What is APR and how are finance charges calculated?

APR is an acronym for annual percentage rate. This is the annual interest rate that the credit card issuer charges on outstanding balances. For example, a $100 balance on a credit card with a 20% APR would result in $20 of finance charges over the course of a year. Because credit card balances constantly change, the credit card issuer divides APR into a “daily period rate” or “monthly periodic rate.” The daily and monthly periodic rates represent the daily and monthly fraction of the annual percentage rate respectively.

The finance charges in a given month are calculated by multiplying the balance by the periodic interest rate. Since the balance during the billing cycle fluctuates due to purchases, cash advances, and payments, the bank computes an average balance. Most banks use either the one-month average daily balance method or the two-month average daily balance method. Here the two are compared:

• One-month average daily balance method. The bank adds up your balance on each day of the billing cycle and divides it by the number of days in the billing cycle. For example, if you had a $100 balance for the first ten days of the cycle, and made a $100 payment on the twentieth day, your average daily balance according to this method would be $33.33. This method allows your average daily balance, and consequently your finance charges, to change quickly to reflect payments or purchases.
• Two-month average daily balance method. This method is a variation on the one-month method. Instead of computing your average daily balance based only on the current billing cycle, the bank includes the previous billing cycle as well. This means average daily balance, and consequently your finance charges, are more resistant to change. As your balance increases, your finance charges take longer to “catch up.” Similarly, as you pay down your balance, your finance charges decrease more slowly. The two-month method helps you as your balance increases, and hurts you as your balance decreases.

If your credit card balances remain somewhat constant from month to month, it matters little which method your bank uses.

How is the APR determined?

Your annual percentage rate (APR) is determined by two main factors. The first factor is the overall economic climate, as measured by the prime rate. The prime rate is the average interest rate banks charge their best, most risk-free customers. The other factor determining your APR is your creditworthiness. Banks determine your creditworthiness through a variety of measures, such as your income, your employment status, your housing status, and your past credit history as recorded by the credit reporting agencies. Although the first factor, the prime rate, is outside your control, you can reduce your APR by building a good credit history and keeping your level of debt low.

APRs may be fixed or variable. A fixed APR remains constant, regardless of movements in the prime rate. In times of low prime rates, a fixed APR card will often have higher rates than a variable rate card. This is because the bank expects the prime rate will rise at some point in the future, and they want to protect themselves. A variable APR card varies according to the prime rate. The interest rate is given as the prime rate plus a certain percentage. The “certain percentage” reflects the component of the APR that is set by your creditworthiness. In times of low prime rates, variable APR cards will often have lower interest rates than static rate cards. Remember that with a variable rate card, the APR will rise if the prime rate rises.

Credit cards typically have three sets of APRs for purchases, balance transfers, and cash advances.

How are payments credited?

Since credit cards typically have three sets of APRs (one each for purchases, balance transfers, and cash advances), there are also three sets of corresponding balances. Most credit card companies credit payments to the balance type with the lowest APR. This system is designed to maximize the amount of interest you pay.

What is an introductory APR?

An introductory APR is a special interest rate for a limited period of time designed to entice you to apply for the credit card. With such tough competition between credit cards these days, 0% introductory APRs are common.

Not all introductory APRs are created equal. Read the fine print to determine (a) how long the introductory period lasts and (b) to what types of transactions it applies. Beware, as some introductory offers only apply to certain types of transactions. As explained in the “How are payments credited?” section above, credit card companies may credit your payments to your “0% balance” while allowing your higher-rate balances to accrue interest.

What is a grace period?

The grace period is a period of time following the close of the billing cycle in which no interest is charged. The grace period of most credit cards normally applies only to billing cycles where the opening balance is $0. That is, you must pay off your credit card balance in full the previous month in order to be eligible for the grace period.

For example, if you used a credit card with no grace period and 15% APR to make a $1,000 purchase on the first day of the billing cycle, and paid off the balance completely 40 days later, you would pay about $15 in interest. However, if your card had a twenty grace period, you would pay no interest because you paid off the balance before the grace period expired.

The grace period in effect provides you with an interest free loan for about one month. In a related article, we explain how you can take advantage of your card’s grace period to earn interest income.

What is a cash advance?

A cash advance is where you obtain cash from your credit card’s line of credit, rather than using the credit line to purchase goods or services. You can obtain a cash advance either through an ATM or through a “convenience” check often included with credit card statements. Because banks view cash advances as a sign of potential financial trouble, they almost always charge a higher APR for cash advances.

What is a balance transfer?

A balance transfer occurs when you pay off one credit card with another credit card. Credit card companies often include “convenience” checks for balance transfers with the monthly statements. Like cash advances, banks often set a different APR for balance transfers. In the case of balance transfers, the APR may be lower than the regular APR for purchases. Low introductory balance transfer APRs are often used as a marketing incentive for you to sign up for a new credit card. Balance transfers almost always incur some sort of fee, which is usually $5-15 and a small percentage of the balance transfer amount. However, the interest saved by transferring your balance to a lower rate card usually far outweighs the fees incurred.

If you perform a balance transfer onto a card with a lower balance transfer interest rate, it might be wise to not use the card for anything else. Many of these low-rate offers are designed to charge you more interest. See the discussion above under “How are payments credited?” and “What is an introductory APR?” for further information.

What is a rewards card?

A rewards card provides perks based on your level of spending with the card. Common rewards include cash rebates, free gasoline, airline frequent flyer miles, and a credit toward a new car purchase. Some cards have a flexible rewards system, where you can redeem “points” for any combination of the above.

When shopping for a rewards card, pick a reward card that provides the most benefit for you. If you travel frequently, consider an airline rewards card. If you are shopping for a new car, consider a card that gives you a credit toward a new vehicle purchase. Or you can get a cash back card and use it for whatever you want. Read the fine print closely, and keep these things in mind when applying for a rewards card:

• Rewards are often progressively tiered. In the case of a cash back card, the percentage cash rebate increases as the amount you spend increases.
• Some depend on carrying a balance. Other cards, such as the American Express Blue Cash card, pay greater rewards when you carry a balance. Remember, it is never advisable to carry a balance simply to earn credit card rewards. The rewards almost never exceed the extra interest you would incur.
• Some rewards benefits apply only to certain purchases. For example, some cards provide significant rewards only to purchases of gas or groceries.