Key Terms New Credit Card Users Must Understand
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When you first start using a credit card, it's a good idea to understand what you're getting into, as well as know a few key terms. When you know how credit cards work, you can make better decisions about using your credit, and also which credit card is best for you. Here are the key terms to understand before you apply for a credit card.
This is a fee that a credit card issuer might charge each year to use the card. Each year, on a specific date, you will be charged the fee. Some secured credit cards might charge a monthly fee instead. Pay attention to whether or not there is a fee associated with using the card, and how often it is charged. (Note that many issues will waive the first year's fee when you sign up — just remember this if you were planning on cashing in on the sign up bonuses but canceling before the first year is over.)
Annual Percentage Rate (APR)
This represents the interest you will be charged on an annual basis. So if a credit card has an APR of 19.99%, that's how much you will pay on balances that you carry from month to month.
However, credit card issuers don't charge interest once a year. You might be charged different ways each month. Here are two of the methods that might be used when charging you interest: Average Daily Balance and Daily Compounding.
1. Average Daily Balance
With this method, you are charged interest once a month, based on the average balance carried for the month. So, all of your balances each day will be added up and divided by the number of days in the billing cycle. That number will then be multiplied by your monthly interest, which is your APR divided by 12. Say your average daily balance for the month is $1,000 and your APR is 19.99%. You will be charged based on monthly interest of 1.6658%, so your interest charge is $16.66 for the month.
2. Daily Compounding
In some cases, the credit card issuer will compound your interest daily. This means that, at the end of each day, interest is charged on your balance and added to the total. Your APR is divided by 365 to determine the daily interest rate. In our example, your interest charge is 0.054767% each day. So, if you have $1,000 at the end of one day, the charge for that day is about 55 cents. That is added to your balance, and interest is charged on $1,000.55 the next day.
These aren't the only two methods, but they are among the most popular. No matter what method is used, if you carry a balance, your effective interest rate for the year will actually be higher than the listed APR, because of when interest is charged each month — or each day — and then added to your balance. With credit cards, you pay interest on your interest charges. The only way to avoid this is to pay off your credit card balance each month.
Credit Line or Credit Limit
This is the amount that the credit issuer is willing to let you borrow. On a credit card, how much you have available to you revolves based on how much of your credit limit you have available. If you have a $2,000 credit limit, that is how much you can have outstanding at any one time. If you charge $1,500, then you only end up with $500 left. You have to make a payment to free up more room on your credit card.
Credit Balance and Credit Utilization
Your credit balance is how much money you have borrowed so far. The closer you are to your credit limit, the lower your credit score will be. Your credit utilization is a percentage that reflects how much of your credit line you have used. If you have a balance of $1,500 on a $2,000 credit limit, your credit utilization is 75%. If you carry high balances, lenders see you as a risk, lowering your credit score.
This is a number (three digits) that offers an at-a-glance summary of how well you have managed your credit and debt in the past. A higher number is more attractive. Your credit score is based on information in your credit report. Your credit report lists all of your loan accounts, including credit cards. Credit issuers report your credit line, your credit balance, and whether or not you pay on time. This information is then represented with numbers and fed into an equation that produces your credit score.
If you have a good credit score, you will be approved for loans and other other financial products, like insurance, at good rates. If you have a low credit score, you might have to pay higher interest to offset the risk you represent to a lender. In some cases, you might be rejected for a loan — especially a home loan — altogether.
The two most important factors in most credit scoring models are your payment history (whether you pay on time and pay at least the minimum) and your credit utilization. Other factors that influence your credit score include how long you have had credit, the number of inquiries on your credit report, and the types of credit accounts you have.
Many credit card issuers offer a grace period. This is the time during which you won't be charged on your balance. Many credit card issuers won't start charging interest on new purchases for at least 21 days. If you pay your credit card bill off each month, before the end of the grace period, you can avoid interest charges. Not all credit cards have grace periods, though; in some cases you start accruing interest as soon as you start spending. And you should realize that even on credit cards with grace periods, they don't often apply to balance transfers and cash advances.
This is the lowest amount of money required by your credit issuer each billing cycle. A credit card issuer typically charges 3%, 4%, or 5% of your balance as the minimum. If you have a balance of $1,000 (including fees and interest) at the end of the month, your minimum payment will be $30, $40, or $50, depending on the policy used.
It's important to realize that how your interest is compounded matters when it comes to how your balance is reduced. Since a minimum payment typically includes your interest charges, your principal will only be reduced after the new interest is taken care of. If your minimum payment is based on 3% of your balance, and your interest is $16.66 per month, your $30 minimum isn't very effective. After paying interest, only $13.34 goes toward reducing your principal. So your balance ends up being $986.66.
You can see how only making the minimum payment can mean years and years of debt — and thousands of dollars paid just in interest.
Your credit card statement, which is the bill you receive each month detailing your purchases and interest charges, should have a box that highlights the cost of paying only the minimum, versus what you can save if you take three years to pay off your debt.
It's best to charge only what you can truly afford, and pay off the balance each month. However, if you find yourself carrying a balance, you should always pay more than the minimum payment.
The Schumer Box is included with credit card marketing materials and the application. It summarizes the key terms of the credit card. You should read the Schumer box carefully so you understand the basics of the credit card.
Terms and Conditions
Detailed explanations of how the credit card works are including in the terms and conditions. You can find these in your cardmember agreement. Various benefits are outlined, as well as information about how interest is charged, and what to expect in different scenarios. Read through the cardmember agreement and the terms and conditions prior to using your card. Once you make your first purchase, you are agreeing to everything in the agreement.
Have you been confounded by any terms in your cardmember agreement? Let us know in comments and we'll try to unconfound you!
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.