Whether you have a pocket full of credit cards or are shopping for your first one, having a solid understanding of credit card basics will prepare you to apply for the right card, at the right time.
What Is a Credit Card?
Unlike debit cards, credit cards allow you to make purchases without immediately deducting money from your checking account. When you use your credit card, you are borrowing money from a bank or credit union (called the “issuer”) to buy something. The amount of money you can borrow is your line of credit.
Using a credit card requires you to pay your bank at some time in the future. Your options include paying the entire balance on the card each month or paying the minimum required amount. The minimum is either a percentage of the full balance or a set dollar amount, depending on your card agreement. If you only pay the minimum required amount, you will owe interest on what you borrowed in addition to the remaining balance on the card.
Banks determine the maximum amount of money available to you on your credit card (a credit limit) and its interest rate after reviewing your creditworthiness. This happens either at the time of your application or after an introductory offer period ends.
Factors that affect your credit card approval and rates include your income, credit score, and credit history. Banks use this information to determine how likely you are to repay them.
Why Do Banks Offer Credit Cards?
Banks generate revenue from the number of credit cards owned and the frequency of their use. Sources of revenue include:
- Interest payments: payments made by customers when their balance is not paid in full
- Annual fees: fees charged to customers for owning an annual fee credit card
- Transaction fees: fees paid by merchants to banks for the ability to accept credit card payments
- Late fees: fees paid by customers when they do not pay their minimum required payment by the due date
Reasons to Get a Credit Card
1. Raise your credit score. Using a credit card wisely by making on-time payments and maintaining a low balance can help you raise your credit score. A high credit score will make you a better candidate for other kinds of loans such as a mortgage or a more lucrative credit card with lots of rewards.
2. Beef up your credit file. Banks prefer applicants with “thick” credit files or files with a combination of positive credit history and several open accounts. Credit cards can help you build your file and are easier to attain compared to student loans or car loans.
3. Make yourself eligible for offers and deals. Some credit cards offer attractive introductory offers like a sum of cash back after reaching a spend threshold or 0% interest on all purchases for a number of months. Cards may also offer ongoing benefits like an extended warranty on items purchased with that card.
Types of Credit Cards
Card types determine how you can earn and use rewards made from purchases.
- Secured cards. Secured cards use a down payment of your money as a credit limit. This money is not borrowed from a bank. Secured cards can be used as a first credit card when your credit history is too short or your credit score is too low to qualify for another type of credit card.
- Cashback cards. Cash back cards offer money back on all purchases, or purchases that fall into certain categories.
- Travel cards. Travel cards let you gain points that can be redeemed for free hotel nights or airline miles.
- Store cards. Cards that offer exclusive discounts or store credit dollars at particular brands.
Credit Cards, Ranked
When selecting a credit card, it is helpful to think about a card’s annual fee and its rewards. Think low annual fee, few rewards; high annual fee, many rewards. While selecting credit cards, you can determine a strategy to maximize your return.
Low/No Fee: Secured cards and no fee cards. Secured cards may have an annual fee between $0 and $50. Banks also offer unsecured cards with no annual fees. Secured cards and no fee cards are a good starting place for people who are building their credit. Both types of cards can earn rewards with little or no cost.
Mid fee: Annual fee between $95 and $250. Cards with a mid-sized annual fee classification typically offer welcome bonuses that vary in value. They usually have a reward of about one to two points per dollar spent that you can redeem to get cash back or airline miles, among other rewards.
High fee: Annual fee $400 and above. Cards in this category may offer a concierge service to their clients and private airport lounge access. High annual fee cards are more difficult to get approved for. The requirements include high income, excellent credit, and a minimum amount of money in your checking or investment account. Some high fee cards are invite-only, meaning applications are not made available to the public.
Incentives and Risks
While credit card rewards can be valuable, it is important to evaluate your current spending habits when selecting a card. If you tend to overspend, there is a greater risk of being unable to pay your balance in full and receiving an interest fee.
All potential rewards from a credit card lose their value if the cost of having the card becomes too high. Carrying a balance or using a high percentage of your overall credit limit will lower your credit score which hurts your ability to apply for other cards.
When you consider applying for a card, think about its annual fee and welcome bonus, if applicable. For example, if the annual fee is $100, but the welcome bonus is $150, you are earning a profit by using the card.
Welcome bonuses are earned by spending a required amount in a specified length of time, so as long as the amount is less than what you would typically spend in the introductory period anyway, the card may work for you. Welcome bonuses can create a temptation to overspend, however, so make sure you are getting a card for the amount that suits your finances.
A card’s reward complexity should be considered, too. Some cards offer cash back on all purchases, while others only offer cash back on certain categories that change throughout the year.
If you own multiple cards, it is best to consider which card returns the most value on different types of purchases. Your willingness to understand these complexities and strategize your card use should be part of your decision making.
How Many Cards Should I Apply For?
When you complete an application for a card, banks will create a hard inquiry on your credit file to review your information. If you apply for too many credit cards at once, the number of hard inquiries on your credit file increases. This creates a red flag for banks and lowers your credit score. Therefore, it is important to review your credit score and research the requirements for the cards you are applying for.
If you have an interest in earning multiple welcome bonuses by applying for more than one card, there are ways to avoid multiple hard inquiries. If you apply to cards from the same bank on the same day, inquiries will be combined resulting in a smaller impact on your credit score. Some banks have a maximum number of cards you can receive from them in a year, so review those rules when completing multiple applications.
Things to Keep in Mind
Credit cards are great assets to have only when you pay your balances in full and the rewards outweigh the fees. Keep your financial goals in mind when selecting a credit card to maximize your return.