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Oct 21, 2021 / Finance

How Do Credit Cards Work?

How Do Credit Cards Work? image

It seems like most people have credit cards, and at some car rentals and hotels, you need to present a credit card. But if you don’t have a credit card, then you may not know how a credit card works or what the advantages and disadvantages are. In this article, we will give you unbiased information about credit cards and other similar personal credit products.

What Is a Credit Card?

A credit card is a personal credit product that allows users to access small lines of credit without needing approval. The user gets a set amount that they can borrow each month (called a credit limit) without having to tell the credit card company what they plan to use the money for. It takes the form of an electronic card, like a debit card, but instead of the money coming out of your bank account when you tap your card, it comes from the credit card company.

How Does a Credit Card Work?

In terms of purchasing items, a credit card works similarly to a debit card. You tap, swipe, or enter card details to make a purchase. As explained above, the purchase is charged to the credit card company instead of your bank account. Many people find this beneficial because it allows them to spread costs if money is tight before payday. The credit card company will send users a monthly bill detailing their purchases and the total cost. Upon receiving the bill, the credit card user has a few options:

  • Pay the balance in full, so they do not get charged interest
  • Pay the minimum payment amount and get charged interest on the outstanding balance
  • Pay an amount between the minimum payment amount and the full balance and get charged interest on the outstanding balance

Any outstanding balance is rolled over into next month’s statement, and an interest charge is added. Interest rates are usually around 20-30%, so if you are thinking of getting a credit card, shop around to see which is best. There are also 0% interest credit cards that we will explain further in the article.

Why Do People Use Credit Cards?

You may be wondering why credit cards are so popular. Most people have at least one; some people have multiple. Well, the main reason is credit cards are great for spreading the cost of things. Even if you pay your credit card balance in full each month, it can help if your costs do not line up with the date of your payday. For example, if your utility bills are due the day before payday or your kid needs new shoes just before payday. It also allows people to make big purchases that they cannot afford in full, like a washing machine, and pay it off over time. Obviously, they would be charged interest on outstanding amounts each time.

Many credit card companies often offer additional benefits. They may have advantages, like:

  • Ability to be used overseas without extra charges
  • 0% interest for X number of months
  • Cashback on certain purchases
  • Loyalty points (often for store credit cards)
  • Travel miles
  • Gifts and bonuses
  • Discounts on certain products or services

Will a Credit Card Make Me Go Into Debt?

This is one of the major disadvantages of a credit card and one of the reasons you may be reluctant to get one. In all honesty, yes, it is possible you may go into credit card debt. The people who do struggle with credit card debt are the people who overextend themselves and make big purchases (or many small ones) that they know they do not have the means to pay off. Making minimum payments or very small payments will mean you are barely paying off the interest on a credit card, and that outstanding balance is growing each month.

Credit card debt is easy to avoid if you are smart with your money. Most people avoid credit card debt by only making purchases that they know they can afford. If they do make big purchases like a washing machine or holiday that they cannot pay in full at the end of the month, then they have a plan to pay it off within a set period of time.

So, if you get a credit card with the mindset that it is free money, then yes, you are very likely to go into credit card debt. If you use a credit card knowing that you are spending your own money, just slightly delayed, then you are much less likely to go into credit card debt.

What Is a 0% Credit Card?

A 0% credit card is a credit card that offers 0% interest, usually for a short period of time. Because there are so many different types of credit cards out there, some use the 0% interest introductory offer to attract new customers. It is important to read through the terms and conditions, as the 0% interest rate is usually only for the first 12-24 months, and after that term, the interest rate may be higher than other credit cards. A 0% interest rate credit card can be useful for someone who is trying to payday credit card debt. Some credit card companies will let you transfer your debt from the other credit card company onto a 0% interest rate credit card to give you some breathing space.

Advantages of Credit Cards 

  • Great for building credit history (if you use them responsibly)
  • Fantastic for spreading the cost of things across two paychecks
  • When companies “hold” money as a damage deposit, it doesn’t physically come out of your account
  • Possibility of extra benefits depending on the credit card company
  • Great for accumulating travel miles or loyalty points

Disadvantages of Credit Cards 

  • High-interest rates on outstanding balances
  • Additional fees for some credit cards
  • It can be easy to get into a debt hole if you are unable to pay the full balance two or more months in a row
  • High fees for withdrawing money from an ATM
  • Need to pass a credit check to get a credit card

What If I Can’t Get a Credit Card?

If you do not have a credit history (or a poor credit history), you may struggle to get a credit card. If that is the case, you should make an appointment with your bank to see if they will be able to give you a credit card. While your bank may not have the best interest rate or benefits out there, they may be more willing to offer you a credit card because they have more financial data on you.

Alternatively, you should look into ways to increase your credit score and try again in 6 months to a year.

Alternatives to Credit Cards 

If you do not have a credit card or do not want to get a credit card, there are some alternatives to credit cards. We will briefly explain them below but recommend you do a little bit of research before using one of these methods.

  • Overdraft – In the UK, most people are very familiar with an overdraft. It is a feature of your bank account that allows you to make a purchase using your debit card even when you do not have enough money in your account. You will be charged an overdraft fee if you go into your overdraft.
  • Buy Now Pay Later – This is a service that may be offered by a retail store or a third-party company. It allows you to purchase a product in-store or online and pay in smaller instalments. Some of these charge a fee, some do not.
  • Personal Loan – A personal loan is a small loan (usually up to £10,000) borrowed from a bank or other official lender. They are often unsecured, meaning there is no collateral, and therefore can attract higher interest rates than other types of loans. The borrower will pay the loan off over a short-term period, like 5 years.
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Published Oct 21, 2021 |

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