Out of all the debt a person can take on, signing up for a credit card is among the most common.
While a credit card can give you access to a certain amount of money for a single purchase, it should be treated with a high level of responsibility.
Failing to handle debt in a responsible way can quickly bring about serious financial repercussions that have long-lasting implications.
Learn everything there is to know about the structure of a credit card and how to be a more responsible borrower.
What is Credit?
Starting with the basics, credit is simply an obligation between a lender and borrower in which the lender provides the borrower with money.
In return, the borrower promises to pay back the money, typically with interest, by a certain point in time.
This payment can either come in installations or it could be a single payment, depending on the type of credit. Specifically, credit comes in three primary forms that all borrowers should be aware of:
- Revolving: First and foremost, revolving credit is what most borrower is familiar with. This is where a borrower has access to a certain amount of funds, with a limit, that they can draw on continuously. Revolving lines of credit can be paid down so that more funds up to that limit can be accessed. A credit card falls into this category.
- Installment: Installment credit debt refers to a borrower receiving a lump sum of money and, in return, being responsible for fixed monthly repayments for a set period of time in the future. Loans are the most common type of installment credit.
- Open: A lesser known form of credit, open credit refers to revolving credit, except for the fact that the amount you borrow in a set period of time (typically a month) is owed back in full when that period ends.
What is a Credit Card?
As mentioned, credit cards are a form of revolving credit. This plastic or metal card gives a holder access up to a certain amount of funds, known as a credit limit.
The amount outstanding at the end of a billing cycle begins accruing interest that the borrower will pay.
Credit cards are issued by banks and third-party lenders and can sometimes come with annual fees or certain perks such as no interest for up to a year.
Key Terms of a Credit Card to Be Aware Of
Before making the leap into applying for a credit card, it’s important to be aware of the different components associated with it.
This will help ensure that you understand the terms of your agreement so that you don’t accidentally fall into a cycle of debt. The primary five components involved with credit cards include:
Credit Score
A person’s credit score is simply a number assigned to them which indicates their likelihood to repay debt.
There are three primary credit bureaus who gather information on a borrower to determine this score.
The three categories used by these bureaus to calculate your score include:
- Your payment history with debt
- The amount of debt you currently have outstanding
- The length of your oldest credit account
- The type of credit accounts you have
- Recent inquiries into your credit
A credit score can range from 300-850, with the higher the score the better. To get a credit card, you will need to qualify for whatever minimum credit score the lender requires.
Credit Limit
Once you actually have your credit card, you will be assigned a credit limit. This simply refers to the maximum amount of money you are allowed to borrow.
For new borrowers this amount could be as low as a couple hundred dollars, but experienced borrowers can have credit limits in the tens of thousands of dollars.
Interest Rate
This is the rate you will be charged for any debt outstanding at the end of a billing cycle. For example, 10% interest on a $1,000 loan means a borrower needs to pay $1,100 back to the lender.
This amount does not include any fees associated with a credit card.
Fees
Credit card fees are a major component of credit cards. In fact, Americans spend $120 billion per year on credit card fees alone, going to show their prominence.
Annual fees, monthly interest fees, late payment fees, and fees for cash advances are some of the most commonly seen.
APR
Finally, a borrower’s APR (annual percentage rate) is the combination of interest and fees that a person is charged for the amount outstanding at the end of a billing cycle.
It’s not unusual to see an APR that is above 20%, but this rate will vary depending on your creditworthiness.
Tips for Using a Credit Card Responsibly
As a borrower, it’s important to use a credit card responsibly so that you don’t accumulate debt.
To that end, it’s worth learning a few important tips that can help any borrower be more responsible with their credit card(s):
- If you can’t make the purchase out of pocket right now, don’t buy the item
- Don’t use more than 30% of your total credit limit
- Focus on paying more than the minimum payment each billing cycle to reduce the interest you are paying
- Make all of your payments on time to avoid late payment fees or a default
- Use your credit card only for needs, not for wants
- Start with a 0% introductory APR card that won’t charge interest for a number of months
Build a strong relationship with credit
Building a strong relationship with credit should be the goal of any borrower as taking out debt is a serious responsibility.
Just because you have access to potentially tens of thousands of dollars on a credit limit doesn’t mean you should be spending that type of money.
As a general rule of thumb, only use your credit card for purchases that you could afford out of pocket right then and there.