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How Do Credit Cards Really Work?

Understand credit card fees so you can avoid paying them.

By
Laura Adams, MBA
December 27, 2011
Episode #248

Page 1 of 2

Credit cards are financial tools that can save you money or completely ruin your finances, depending on how you use them. One of the biggest money mistakes you can make is to use a credit card without really understanding how it works. I’ll tell you what you need to know so you never allow a credit card to get the best of your personal finances.

What is a Credit Card?

I’m sure you already know that a credit card is a financial product issued by banks and other financial institutions that allows you to make purchases, take cash advances, and transfer balances from other accounts. I’ll tell you more about balance transfer cards in just a moment.

When you’re approved for a credit card, you’re given a line of credit, which is typically the maximum balance you can accumulate on the card.

Many people use the terms “credit card” and “charge card” interchangeably, but they’re not the same. A charge card requires you to pay off your balance in full each month. A credit card allows you to carry a balance indefinitely as long you make the minimum monthly payments.

What is a Credit Card Finance Charge?

The money you owe on a credit card is subject to an annual percentage rate (APR) that’s called a finance charge. Each card company has different terms that vary depending on the type of card, your credit score, and the type of transaction you make using the card.

For instance, you might be charged 11.99% for new purchases, 18.99% for balance transfers, and 26.99% for cash advances. If you don’t realize that it’s outrageously expensive to take a cash advance on a credit card, you could end up with a massive bill that you can’t pay off.

When you make more than the minimum payment, the card company generally has to use the excess to pay down your highest interest balances first. That means the money would go towards reducing your cash advance balance before it would reduce the balance for your regular purchases.

If you carry a balance from month to month, your goal should always be to use a credit card with the lowest interest rate possible so you rack up the least amount of interest on your outstanding debt.

How to Use a Credit Card for Free

The good news is that you can avoid all credit card finance charges if you pay off your balance before the due date on your statement. Making charges that you pay off in full each month is the right way to use a credit card because you pay no interest and can accrue substantial rewards.

By the way, one of the biggest myths about using a credit card is that you have to carry some amount of debt on one to build credit. That’s definitely not true because when you make a credit card payment on time—whether it’s a full payment or a minimum payment—you receive a positive transaction on your credit report that really helps you build your credit score.

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