How Do Credit Cards Work?
A credit card can be used to make a purchase of goods or services in-person or online. When you apply for and are approved for a credit card, you’re given a line of credit based on your credit score and other factors like your income.
A potential advantage to using a credit card over paying cash or a debit card is that a credit card functions like a short-term loan. By using a credit card, you have until the end of the credit card billing period (also known as a grace period) to pay what you charged to the card. You can also earn cash-back or travel rewards with some types of cards, along with extras like purchase and travel protections. The downside is that if you don’t pay the entire amount that you charged to your card, you’ll accrue interest on your purchases which can be expensive over time.
How Do Credit Card Points Work?
When you make a purchase on a rewards credit card, you’ll earn a percentage back on your spending as either cash back, points or miles depending on the type of card and what type of rewards it’s offering. Airline credit cards, for example, typically earn miles, cash-back cards earn cash that can be used as statement credits or direct deposits and general purpose rewards cards may earn points that can be used for a variety of redemptions including travel, merchandise or other options.
Some rewards credit cards will earn the same flat-rate back on all spending, like a card that earns 2% back on every purchase. Others have tiered rewards where a certain type of purchase, like gas or groceries, may earn at a higher reward rate than other types of purchases. Before choosing a rewards card, consider your spending habits and the type of rewards you’ll get the most benefit from and then compare it to other various options available to you.
How To Maximize Credit Card Rewards
Maximizing credit card rewards can be done both while earning and redeeming.
To maximize the number of credit card rewards you earn, choose a credit card that offers strong earnings on the types of purchases you make most. Cards with category bonuses in groceries, gas or travel might allow you to earn 3% or more on eligible purchases. If your purchases are all over the place, you may do best with a flat-rate 2% cash-back card.
You can also maximize the value of your credit card rewards when redeeming rewards. Most importantly, you should focus on rewards that match your goals—whether that’s airline miles, flexible points, cash back or other rewards. Then, compare redemption options to see if any in particular are worth more. The best redemptions typically yield a minimum of 1 cent per point.
Pro Tip
Don’t go overboard trying to optimize all your purchases. It can be tempting to maximize every type of purchase, but getting an extra 1% back on a category you only spend $500 per year will only put an extra $5 in your pocket. Focus on your major expenses and use a flat-rate card for everything else.
How Does Credit Card Interest Work?
Most credit cards calculate interest using the average daily balance method, which means your interest is compounded and accumulates every day, based on your daily rate of interest. In other words, every day your finance charges are based on the balance from the day before.
How To Calculate Credit Card Interest
The daily rate of interest is determined by dividing your card’s APR by 365 to find the daily rate of interest and then multiplying that number by your balance. For example, to determine the average daily balance on a card with a $10,000 balance on the first day of the billing cycle and an APR of 17%, you’d divide 17 by 365, which equals a daily rate of 0.0466%. This means the next day, your card would have a balance of $10,004.66, which is what you get when you multiply the balance of $10,000 by 1.000466.
Since the average daily balance is compounded, each day’s credit card interest calculation gets a little more expensive.
APR vs. APY vs. Interest
It’s important to understand the difference between APR and APY.
APR stands for annual percentage rate and refers to the amount of interest you’d pay on a credit card balance or other line of credit over the course of a year. On the other hand, APY stands for annual percentage yield and is used to define the amount of interest you earn on a bank account or other savings vehicle over the year.
In other words, APR is used when you’re paying interest and APY is used when you’re earning interest.
How To Apply for a Credit Card
In general, there are several steps to applying for a credit card:
- Check your credit score through a credit card issuer or by ordering it from one of the three main credit agencies.
- Once you know where you stand with your credit score, decide which type of card will be the best for you based on what you’re planning to use it for. Credit cards typically fall into one of three categories: rewards, low APR and credit-building.
- Choosing the right card may be difficult, but applying for the card you’ve chosen is easy. Ways to apply for a credit card:
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- Via online application
- By phone, working with an agent
- By mailing a paper application
- By visiting a financial institution to apply in-person
How To Get Preapproved for a Credit Card
Many issuers will let you check to see if you’re pre-qualified for any of their cards before you formally apply. Keep in mind that pre-qualification doesn’t ensure approval and should be considered more of a best guess.
Checking whether you’re pre-qualified is often as easy as entering your name and address on the card issuer’s website and then perusing offers, if any, that are available to you. This will not impact your credit score. These preapproved credit cards make it easy to check if you’re likely to be approved in advance.
How To Improve Your Credit Score
There are several steps you can take to improve your credit score. First, check your credit report to make sure there aren’t any errors that could have an adverse effect. Paying your bills on time, every time will have the single biggest impact on your score. After payment history, the next biggest factor in your credit score is the amount of debt you have. Since credit reporting agencies don’t have your income information, they use something called credit utilization instead of a debt-to-income ratio.
Credit utilization is the amount of debt you owe relative to the amount of credit you have. So if you have a balance of $3,000 on a card with a $10,000 limit, you’re using 30% of your credit. Total credit utilization is based on the aggregate amount across all your lines of credit, both what you owe and how much you have available. It’s typically suggested that utilization of 30% or below should be the goal.
Credit Cards for Good Credit
What is considered a good credit score can vary among lenders, and you typically aren’t told what a particular lender’s exact cutoff point is between a good credit score and a bad one. However, FICO, the most widely known credit scoring model, shares some helpful information you can use as a guide. The most common scores feature a scale of 300 to 850. On that scale, a credit score between 670 and 739 is generally considered “good.”
You can check out London Reviews’s list of best cards for good credit of 2023 to see what might work for your particular circumstances.
Credit Cards for Fair Credit
The definition of a fair credit score varies among lenders, and you typically aren’t told what a particular lender’s exact cutoff point is between a good credit score and a fair one. However, FICO, the most widely known credit scoring model, shares some helpful information you can use as a guide. The most common FICO scores feature a scale of 300 to 850. On that scale, a credit score between 580 and 669 is generally considered fair.
You can check out London Reviews’s list of best cards for fair credit of 2023 to see what might be a fit for your particular circumstances
Credit Cards for Bad Credit
While there’s no exact number that counts as the threshold between “bad” and “good” credit, generally a FICO Score below 580 is considered poor.
The lower your credit score, the more limited your options when it comes to credit cards. Someone with bad credit will typically only be able to get approved for a secured card or a card with high interest rates and other additional fees. See London Reviews’s list of best credit cards for bad credit of 2023 to see what some of the options are if your credit isn’t stellar.
What Are the Three Credit Bureaus?
There are three major credit bureaus in the U.S.:
- Experian
- Equifax
- TransUnion
Each of these agencies may use a slightly different method of evaluating your credit behavior, so it’s not uncommon to have a slightly different credit score with each agency. All three companies serve the same function: to analyze your credit behavior to generate a three-digit credit score used to determine your creditworthiness and in turn, the rates you’ll be offered on loans like a credit card or a mortgage.
