A Beginner’s Guide to Credit Cards

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Credit cards are not evil; just understand the maths to use it smartly

How do credit cards work?

A credit card can be used to make a purchase of goods or services in-person or online. When you apply for and are approved for a credit card, you’re given a line of credit based on your credit score and other factors like your income.

A potential advantage to using a credit card over paying cash or a debit card is that a credit card can function like a short-term loan. By using a credit card, you’ll normally have until the end of the credit card billing period (also known as a “grace period”) to pay back from your bank account what you charged to the card. You can also earn rewards like cash back or travel rewards with some types of cards, along with extras like purchase and travel protections. The downside is that if you don’t pay the entire amount that you charged to your card, you’ll accrue interest on your purchases which can be expensive over time.

How do credit card rewards work?

When you make a purchase on a rewards credit card, you’ll earn a percentage back on your spending as either cash back, points or miles depending on the type of card and what type of rewards it’s offering. Airline credit cards, for example, will typically earn miles, cash back cards will earn you cash back and general purpose rewards cards may earn points that can be used for things like a statement credit or to redeem for travel, merchandise or other options.

Some rewards credit cards will earn the same flat rate back on all spending, like a card that earns 2% back on every purchase. Others will have tiered rewards where a certain type of purchase, like gas or groceries, may earn at a higher reward rate then other types of purchases. Before choosing a rewards card it’s important to consider your spending habits and the type of rewards you think you’ll get the most benefit from and then compare that to the various options available to you.

How does credit card interest work?

Most credit cards calculate interest using the average daily balance method, which means your interest is compounded and accumulates every day, based on your daily rate of interest. In other words, every day your finance charges are based on the balance from the day before.

The daily rate of interest is determined by dividing your card’s APR by 365 to find the daily rate of interest and then multiplying that number by your balance. For example, to determine the average daily balance on a card with a $10,000 balance on the first day of the billing cycle and an APR of 17%, you’d divide 17 by 365, which equals a daily rate of 0.0466%. This means the next day, your card would have a balance of $10,004.66, which is what you get when you multiply the balance of $10,000 by 0.000466.

Since the average daily balance is compounded, every day the calculation is based on the day before.

APR vs. APY vs. Interest

APR is a card’s annual percentage rate over the course of a year. A balance of $10,000 with an APR of 17% would accumulate $1,700 in interest. But since most credit cards use an average daily balance method to calculate interest, it can be an incomplete view to look at a card’s APR and try to estimate how much you’d pay in interest.

APY is not a term typically applied to credit cards as it refers to the amount of interest you’d earn over the course of a year on things like deposit accounts such as savings accounts and certificates of deposit (CDs).

In other words, APR refers to the amount of interest you’d pay on a credit card balance or other line of credit and APY refers to the amount of interest you can earn on a deposit account.

Credit Card Application

In general, there are several steps to applying for a credit card: First, check your credit score through a credit card issuer or by ordering it from one of the three main credit agencies. Once you know where you stand with your credit score, decide which type of card will be the best for you based on what you’re planning to use it for. Credit cards typically fall into one of three categories: rewards, low APR or credit-building.

Next, check to see if you’re pre-qualified. Many issuers, including American Express, Bank of America, Capital One, Chase, Citibank, Deserve and Discover will let you check to see if you’re pre-qualified for any of their cards. Keep in mind that pre-qualification doesn’t ensure approval.

Choosing the right card may be difficult, but applying for the card you’ve chosen is easy. Most cards can be applied for online, although you can go to the issuing bank and apply in person or call them on the phone. If you’re approved, the next step is to make sure you understand the card’s terms and conditions, listed in the fine print of the cardmember agreement.

source:Forbes Advisor.com

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