Credit Cards : Types of Debt and How it's Works
Credit card ownership begins as an inspired privilege, but, without responsible behavior, can quickly dissolve into a web of unpaid bills that chokes your financial future.
At its base, card ownership is a limited personal loan to you, whenever you need it. Keep a credit card in your pocket and you have the ability to make purchases anytime, anywhere, without necessarily having the cash needed to pay for it. The bill will come due in 30–45 days — sometimes even less.
When you receive a bill, the card company wants back the money it “loaned” you. If you pay it off in full, there’s no problem. If you leave any of the balance unpaid, the card company slaps you with a pre-determined interest rate (usually somewhere between 12 and 29%, depending on your credit score) and adds that to the bill.
Not paying off the monthly balance is the reason that the average American household has $15,706 worth of credit card debt. The average individual owes $5,234 for the 3.8 cards (on average) he carries in his wallet. Altogether, the total bill for credit cards has soared to $918 billion in October of 2015.
Consumers drowning in credit card debt do have options to regain control. For some, the answer could be to put the cards away, or maybe even cut them up to completely remove the temptation. For others, credit counseling or enrolling in a debt management program could be a solution. Still others might benefit from changing spending habits and learning how to stick to a budget.
For all of them, the long-term repercussions of credit use will be reflected in credit scores that can help or hinder your financial future. The less debt you carry, the better your credit score.
Different Types of Credit Cards
There are several types of credit cards. Although they can be used in different ways, they have one thing in common: they are all considered revolving debts. This means that they allow consumers to carry balances from month-to-month and repay loans over time.
- Traditional Cards – These are standard credit cards that are used to charge purchases. By the end of 2016, most will include the new EMV chip technology that promises to significantly reduce credit card fraud. One key advantage is that traditional cards — Visa, MasterCard, American Express and Discover — are accepted nearly everywhere.
- Rewards Cards – The most popular incentive for choosing a credit card is the perks that come with using it. Those rewards could be as immediate as 1–2% cash back or as long-term as racking up mileage for free airline tickets or points for free nights at a hotel chain. Some other popular rewards include $150 cash back after you charge the first $500 on the card, 50,000 bonus points for spending $4,000 in the first three months, or double-mileage for purchases of groceries, gas or utilities. The problem is that nothing is free. Most rewards cards have some combination of annual fees, high interest rates and limits on rewards that mean your reward is not actually free. Still, who doesn’t want a little bonus every time you pull out your credit card for a purchase?
- Premium Rewards Cards – If you happen to be a big spender, travel a lot, and are responsible about paying off your credit cards at the end of each month, this might be the category for you. Premium card holders are eligible for every award imaginable, including free airline tickets, concierge services, priority baggage handling, travel insurance, cash back and no foreign transaction fees. They even offer unlimited visits to VIP airport lounges. However, it comes with a cost. The annual fees can be as steep as $500.
- Balance Transfer Cards – If you are looking to consolidate credit card debt, this is a popular option. Many card companies offer zero-percent interest for as long as 21 months on the balance transferred and zero-percent interest on purchases for the first 6–21 months. Some even offer premium rewards like double the cash back. It may be necessary to have a good-to-excellent credit rating to be approved. Beware of transfer or annual fees.
- Low Interest Cards – These are similar to balance transfer cards in that they use low-interest rates as an incentive to help you consolidate debt. Consumers could save hundreds of dollars in interest payments by transferring balances on to these cards. The downside is that the low-interest rate expires and you must have a very good-to-excellent credit score to qualify for one.
- Retail Cards – Make sure you know if these cards are closed-loop (for use at that specific store only) or open-loop (available for use anywhere). Cardholders typically receive merchandise discounts when they use the cards. These cards may include online shopping deals. Look out for higher interest rates.
- Gas Cards – Consumers can benefit from these cards, but only if they purchase gasoline at the same chain every time. Rewards can include a price break on gasoline or cash rewards after reaching a certain spending level.
- Secured Cards – These cards are secured by assets — most often a cash deposit — to protect the card issuers. These cards are typically used by students or individuals with damaged credit and can help them rebuild their credit. The credit limit typically starts low, but can increase, depending on how much money the consumer is willing to put down as a deposit.
Why a Student Should Have a Credit Card
There is a (sometimes) raging debate in the homes of every student going off to college over whether they need to pack a credit card along with their toothbrush, flannel jacket and underwear.
The answer is yes, but only if the parent is willing to pack a ton of “conditions for use” on the card before it leaves the house.
That can only happen if the student is added to the parents’ card as an authorized user or if the parents are a co-signer on the student’s credit card. Students can get their own card at 18 if they have proof of enough income to make at least minimum payments. However, most banks prefer the “authorized user” or “co-signer” approach because they get a built-in backstop if trouble arises.
At any rate, the #1 reason students should have a credit card is to establish a credit history and the credit score that ultimately goes with it.
There are plenty of additional benefits for students to own a credit card, including easier to track spending, not having to carry cash, learning financial responsibility, qualifying for rewards programs and, perhaps most important, having a payment method available for use in case of emergency.
The negatives are just as obvious. Having a credit credit can increase a young person’s temptation to spend, can trigger bad spending habits and could do severe damage to their credit score … and yours! That’s right. If you are a co-signer on Junior’s card and he maxes out the card, is late with payments or only pays the minimum every month, it will have a negative impact on the credit scores of both parties.
Most banks have a $500 credit limit as a starting point, which is enough to find out if your student can handle the responsibility without digging too big a hole for either of you to crawl out of. The payoff is establishing a credit history and credit score that will help down the road with getting a lease, starting utilities and maybe even getting a job.
The bottom line for students then is really the same as it is for anyone with a credit card: use it wisely, pay it off at the end of every month and reap long-term rewards.
Credit Cards vs. Debit Cards
The difference between credit cards and debit cards is simple. With credit cards, you are taking out a “loan” to make a purchase. With debit cards, on the other hand, you are using your own money to make a purchase.
Credit card companies lend you money with the anticipation you will repay it at the end of the next billing cycle. If you don’t, they will charge interest on the balance. They also will charge the store where you made the purchase a transaction fee between 1–2%. This is how they make money.
With debit cards, you are spending money that is already in your bank account. The amount spent will be deducted from your account until the account reaches zero or you put more money into it. The bank that issued the debit cards also charges a transaction fee every time you swipe your card.
The debit card’s advantage is a budget matter. The amount of available funds drops as you spend. When it reaches zero, the card will be declined, in which case you won’t owe anyone anything.
Credit cards, on the other hand, compile your purchases and ask you to pay for them all at the end of the month. If you max out your card, it will be declined, but you still owe whatever charges you made with them.
The advantage credit cards have is they are more secure and have better rewards programs. If your credit card is stolen or compromised by identity theft, you are not responsible for charges as long as you report it. Also, some of the rewards programs (e.g. cash back, mileage for airline tickets, hotel stays, etc.) can be significant if you use the card often.
With debit cards, rewards programs are minimal and security is a big issue. The thief can spend however much is available in your bank account. You will have to dispute it and will lose access to that money for however long it takes to settle the dispute. If you report it within 48 hours, the law says you’re only liable for $50. After that, you’re liable for up to $500.
How Credit Cards Work
There are so many credit cards with so many various features and rewards that the first thing to do is research them all and find a card that suits your needs. You can consider offers you receive in the mail, but the best research is available online.
When shopping for cards, think about how often you plan to use the card, whether you plan to carry a balance each month, and what rewards you’d like to earn. Read the fine print before applying, particularly as it applies to interest rate charges when you carry balances over from month-to-month. Pay close attention to all fees associated with the card.
Regardless of what type of credit card interests you, the card works in the same basic way. If you’re approved for a new line of credit, the card company will issue a card along with information about interest rates, spending limits and payment deadlines. Issuers determine your rates and fees largely based on your credit score and history. Although interest rates are capped by law, they can be very high and cost you thousands of dollars over time.
If you are approved for a card, you will receive it in the mail. You will then have to activate it — usually by phone. After that, you’re ready to spend. Depending on the type of card you have, you should be able to charge purchases at most of the stores you visit. Make sure you don’t go over your credit limit, as this could cause you to incur overage charges.
At the end of each month, you receive a bill and statement. Review it carefully to ensure that you made each purchase listed. If there’s something you don’t recognize, you may be a victim of identity theft.
If you have no questions or concerns about the statement, pay the bill. It’s important to pay it on time every month. A late or missed payment could harm your credit score. Also be aware of your total balance, rather than just paying attention to the minimum payment.
The best practice is to pay off your balance in full each month so as not to accrue interest charges and credit card debt. Paying only the minimum amount could keep you in debt for years longer and will end up costing you more in interest.