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How do credit cards work? Here’s everything you need to know



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Whether you’re ready to start using your first credit card or you’ve had one for years, you may need a refresher on some of the credit card terminology. Maybe you skipped learning about APRs in favor of getting to know the rewards program.

But learning credit card lingo helps you know what to look for in a card agreement, avoid extra fees, and generally understand how credit works. We’ll start you with the basics. Here are 20 credit card terms to know.

Annual percentage rate (APR)

When it comes to credit cards, the APR is simply the interest rate you pay when you don’t pay off the balance at the end of your billing cycle. APRs are expressed as a percentage and come in two main types.

  • Variable APRs can increase or decrease over time.
  • Fixed APRs will never change.

The average APR is about 16%; you can check your cardmember agreement to find your rate. The card issuer may apply a different APR to your purchases, balance transfers, and cash advances. If you break the terms of the card agreement, you may have to pay a higher APR, called a penalty APR, for a certain time frame.

Authorized user

A person who is authorized to use someone else’s credit card account. The primary account holder owns the account and is responsible for making the credit card payments. Being an authorized user allows you to piggyback on the primary account holder’s credit standing.

Balance transfer

A process that lets you move debt from one credit card to another. This can help you save money and simplify payments, though you may have to pay a balance transfer fee and a special APR on these transactions.

Billing statement

A periodic statement from your credit card issuer that lists the card balance, minimum payment due, rewards earned, fees and interest charged, and a list of transactions you’ve made during the billing cycle. Check your statement each month to look for transaction errors, extra fees you’re paying, and how long it will take to pay off the card using just the minimum payment.

Cash advance

A short-term cash loan against your credit card. You can usually withdraw the money at a bank or ATM up to a certain limit. Although you access cash in a pinch, you may have to pay a cash advance fee and a special APR on these transactions.

Cardmember agreement

This contract outlines the terms and conditions of using the card, lists all of the costs involved, and explains how the issuer can change the APR and calculate interest. Make sure you understand all the costs explained in a cardmember agreement before applying for the card. Browse the Consumer Financial Protection Bureau’s database of credit card agreements to know what to look for.

Compound interest

A way of calculating the interest you pay on a credit card balance. Compounding means you pay interest on both your principal (the charges you’ve made to the credit card) and any interest that’s already accrued on the card balance. Depending on the card, interest can accrue daily, monthly, yearly, or on another schedule specified in your cardmember agreement.

Credit: Getty Images / PeopleImages

Credit

Credit is the ability to borrow money, but it’s important to understand how using it impacts your overall financial health.

  • As you use a credit card, the issuer reports your account activity to agencies called credit bureaus. (The three main ones are TransUnion, Equifax, and Experian.)
  • The bureaus use this information to create statements called credit reports.
  • Credit-scoring companies (such as FICO and VantageScore) analyze the information on your credit reports to calculate your credit scores. The scores are designed to communicate how well you’ve used credit in the past, and they predict the likelihood you’ll pay back money on future credit accounts.

Credit card

A credit card account allows you to borrow money with the agreement you’ll pay it back. There are two main types of credit cards. A secured credit card requires you to pledge collateral to open the account. The lender can take this collateral if you fall behind on payments. An unsecured credit card doesn’t require collateral.

Credit card issuer

Any bank or credit union that issues credit cards, such as Capital One, Discover, Bank of America, and Chase. The credit card issuer manages your credit limit and rewards program (if applicable), provides your billing statements, and sends payments to merchants when you make purchases with your credit card.

Credit limit

The maximum amount you can charge to your credit card. Once you hit the credit limit, you need to pay down some or all of the balance before the issuer replenishes your credit line.

Credit utilization

The amount of your credit limit you’re using. Credit-scoring companies base some of your credit score on your utilization ratio, which is calculated by dividing your card balance by the card’s credit limit. For example, if you have a $1,000 balance and a $5,000 credit limit (1,000 / 5,000 = 0.2), your utilization ratio is 20%. Experts generally recommend keeping it at 30% or less, as a higher ratio indicates more risk and may damage your credit scores.

Federal protections

Three major laws provide consumer protections to credit card holders. Among the most important provisions:

  • The Fair Credit Billing Act allows credit card holders to dispute billing errors.
  • The Fair Credit Reporting Act regulates who can collect and review your credit information, provides you access to a free credit report each year, and allows you to dispute credit report errors.
  • The CARD Act regulates how issuers can charge interest and fees and creates more transparency about these practices.

Fees

Extra costs you pay for using the credit card, which should be explained in the cardmember agreement. These may include:

  • Annual fee, charged every year for the privilege of carrying the credit card. While there are plenty of no-annual-fee cards, about 30% do have them, according to a U.S. News & World Report fee survey, and the average annual fee is $110.
  • Balance transfer fee, typically ranging from 3% to 5% of the amount transferred.
  • Cash advance fee, typically ranging from 3% to 5% of the amount borrowed.
  • Foreign transaction fee, usually about 3% to 5% of each transaction made abroad.
  • Late payment fees, which are capped by law. A card issuer can charge a late payment fee up to $28 the first time you’re late, then up to $39 if you’re late a second time within the next six billing cycles.

Grace period

When you have a credit card balance, the issuer will charge you a minimum payment. You typically have a grace period of at least 21 days between the end of the billing cycle and the date your payment is due. If you pay off your purchases in full before the due date, then you won’t have to pay interest on those charges.

Credit card glossary late payment

Credit: Getty Images / mareesw

Late payment

A credit card payment that’s made after the due date or is less than the minimum payment required. The card issuer may charge you a late fee and could report the late payment to the credit bureaus. A large part of your credit scores is based on payment history, so it’s important to always make on-time payments.

Minimum payment

The minimum amount you can pay each billing cycle and still be in good standing. To calculate your minimum payment, the card issuer first determines your statement balance, which includes:

  • any outstanding balances
  • the transactions you made during the current billing cycle
  • accrued interest

Then, the issuer either calculates the minimum payment as:

  • a flat percentage of the statement balance, usually between 1% and 3%
  • a smaller percentage of your statement balance, such as 1%, plus the interest and fees accrued during the statement period

Payment processing networks

These companies work behind the scenes to process transactions and facilitate payments between merchants, credit card issuers, and credit card holders. Visa and Mastercard act solely as payment processing networks, while American Express and Discover act as both credit card issuers and payment processing networks.

Prime rate

The interest rate that lenders charge their best customers. When setting a credit card APR, the issuer usually starts with the prime rate and adds a certain margin. The prime rate moves in tandem with the federal funds rate, which is controlled by the Federal Reserve. So when you hear about the Fed adjusting the borrowing rate, it may impact your credit card APR.

Rewards program

An incentive for using your credit card. Depending on the card, you earn cash back, points, or miles based on each dollar you spend. Then you redeem the points or miles for things like cash, statement credits, flights, hotel stays, and merchandise. Cards that come with a welcome bonus provide you a set number of points or dollars when you spend a certain amount after opening the card. Some programs give you more rewards for every dollar spent in defined bonus categories, such as dining out and travel.

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