How credit cards work in 3 easy lessons
By Erica Sandberg
July 19, 2016
How can I tell when my credit is good enough for a credit card? I didn’t have a credit card or car loan before. What do I do to start? This is new to me and no one ever explained it before. How do I start to build my credit? — Enzo
I’m so glad you asked how credit works before attempting to get a credit card. With a little knowledge you can avoid making big mistakes. Here is what you need to know, in three simple lessons:
Lesson 1: How credit cards work
Banks, credit unions and credit card companies provide credit cards to qualified individuals. When you are approved for a card, both you and the issuer form a binding contract: The issuer agrees to lend you money, and you agree to repay what you borrow according to the card’s terms. For example, the card may come with an annual fee, and you likely will incur late fees if you pay after the due date.
All credit cards come with a credit line, which is the amount of money you may charge. When the bill arrives, you must send at least the minimum payment (which is usually 3 percent of the balance) in 25 to 30 days. If you send the total amount due, interest charges won’t be applied, but if you pay only part of your bill, finance fees will be added to the balance.
The higher your card’s interest rate (the annual percentage rate or APR), the more expensive it will be to carry over or revolve a debt from month to month. Interest compounds, too, which means that interest will be calculated on a debt already grown larger with fees.
Lesson 2: How to get a credit card
The most common credit cards are unsecured. Since no collateral is required, unsecured credit cards are risky for the issuer. If you don’t pay your bill, the card issuer might have to go to great lengths to get you to pay up — and may even lose what’s owed if you can’t pay your debt. For this reason, credit issuers review your income and past history with loans before taking you on as a cardholder. If you have proven to be a responsible borrower over a period of time (by repaying others on time and in full), you can likely qualify for an unsecured card with excellent terms, including a generous credit limit and low APR.
If your income is low, and you don’t have a track record of using credit well or not using it at all in the past, a secured card may be your best option. These cards are terrific if you’re new to credit or rebuilding your credit (such as after a bankruptcy or divorce). All you need to qualify is a job with steady earnings and a cash deposit, which can be as low as a few hundred dollars. While the credit limit is often the same as your deposit, you aren’t using your own money to make the charges. Your deposit is kept in a separate account, and you’ll get it back when you close the account with a zero balance. You’re still borrowing the issuer’s funds when you charge with the card. Watch for fees on these cards, though, and make sure your secured card issuer sends your payment history to the credit bureaus. With a record of card payments made on time and in full, you may be able to transition to an unsecured card in a year or so.
Lesson 3: How to build a positive credit rating
Once you have a card and begin to use it, the issuer will send your payment history information to the three big credit reporting agencies (TransUnion, Equifax and Experian). The credit bureaus collect the data from furnishers (including credit card issuers), and compile it in reports that other businesses can check to see if you might be a good customer. You have the right to see what’s listed on your credit reports, and you can access one report from each agency per year for free at annualcreditreport.com.
Credit scoring systems, such as FICO and VantageScore, use the information on your credit reports in their mathematical models to predict your lending risk. Both scoring systems range from 300 (poor) to 850 (excellent). You can increase your credit scores simply by using your credit card regularly and always paying on time and in full. Never charge something that that you won’t be able to pay off when the bill arrives and never max out your card. These are smart habits to adopt to avoid costly debt and will ensure that your credit scores rise steadily.
When your credit scores are in the mid-700s and above (and presuming your income is also healthy), you’ll be eligible for premium unsecured credit cards with lush rewards programs, as well as better deals on car loans and mortgage financing.
Not so hard, is it, Enzo? This was just a quick lesson plan on credit and credit cards, but it should be enough to help you to become a savvy cardholder.