Credit cards are a great tool to help you make the most of your finances. But if you think of them as magical pieces of plastic that let you buy whatever you want, you could be in for a rude awakening down the line. Understanding the basics of credit cards will allow you to take advantage of the numerous benefits they provide while avoiding the pitfalls.
Credit account basics
A credit card is tied to a credit account, which is just a loan account. Unlike a car loan or a mortgage, however, credit accounts offer a revolving line of credit. Users can take money out (by purchasing goods and services or taking out a cash advance) and pay it back at their convenience.
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Each account will have its own credit limit. That’s the maximum balance a user can carry on their account. Separately, the account might have a cash advance limit, which is the maximum amount the bank is willing to extend as a cash withdrawal from the account.
The bank will provide an interest rate for both the regular balance as well as cash advances. If a user doesn’t pay off his balance in full every month, or takes out a cash advance at any time, the bank will start compounding interest daily. That means interest will start piling up quickly.
If you don’t want to pay off the entire balance, the bank will issue a minimum payment. This is usually a percentage of the balance or the bank may set floor price if the percentage falls below it. This is the amount you must pay every month to keep the account in good standing.
How credit card companies make money
There are a lot of different ways for banks to make money from credit cards. It’s important to understand, banks don’t always make money off of cardholders, and you can be a great customer for a bank even if you don’t pay them any fees directly.
Credit card companies earn revenue every time you use your credit card at a merchant. They take a few pennies plus a percentage of every sale. That’s why credit card companies offer massive sign-up bonuses if customers show they can regularly spend a lot of money on their credit cards. Those fees also go toward providing cash-back and travel point rewards, as well as additional perks like price protection and extended insurance.
That said, credit card companies can still make a lot of money off their cardholders. The main ways cardholders end up paying for their credit cards are:
Annual fees — high-end credit cards often charge annual fees. The fees help cover the costs of the added benefits and rewards compared to no-fee credit cards.
Other fees like late fees, balance transfer fees, foreign transaction fees, and cash advance fees. Your credit card will come with a whole fee schedule detailing all the fees associated with your account.
Interest. Credit cards typically charge some of the highest interest rates in commercial lending. While cardholders get a grace period of about 25 days after their statement closes to pay off their balance interest-free, be aware that cash advances start accumulating interest immediately.