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How do Credit Cards work?

Updated: Feb 3, 2022

*This article is not financial advice. Please do your own research before making financial decisions*

We’re not taught about credit cards in school. When in reality, 62.8 million credit cards were issued to UK residents as of January 2021. So it makes sense to be taught about them, right? We won’t dwell on why we’re not taught about them, but instead we will provide you with a basic guide to credit cards.

First things first, what is a credit card?

A credit card lets you borrow money (that isn’t yours) to finance a purchase. Most credit cards have a credit limit, which means you can only spend up to a certain amount on the credit card. The money available on a credit card is usually owned by a credit card issuer, and as a pre-condition to borrowing the money, you agree to pay the amount you’ve borrowed back (and interest). This can either be in full, or in monthly instalments (with most credit cards, there is a minimum repayment each month that has to be met).

There are 2 financial institutions to consider when we talk about credit cards. First there’s the credit card issuer — think of this as the bank or credit union that provides the credit card and lends you money. Citi and Capital One are well-known credit card issuers. Then there’s the credit card network. Popular ones are MasterCard, Visa and American Express - these companies process the credit card transaction and handle the technical aspects of electronically moving money around.

Both credit card networks and credit issuers need to make money - but how do they do it?

Credit card issuers make money by charging interest and fees on the amount spent on the card. Let’s breakdown these fees:

  • Interest.

Interest is typically charged on the money you borrow. You may have heard the term annual percentage rate (APR), which combines interest and fees into one rate to help you understand how much the credit card will cost. APRs can be quite high (for example 15% — 30%), so avoiding these fees by paying bills on time every month is vital. Even missing one payment will see your outstanding balance and interest start to add up — quickly spiralling into a lot of debt. It’s unlikely your APR will be the same as your best friends APR as it varies by lender and is based on your creditworthiness.

  • Annual fees.

Annual fees may be charged on rewards cards and on cards for people with bad credit. Again, they can be quite high. For example the Platinum Card® from American Express, charges an annual fee of $695!!!!! There may also be over fees such as; cash advance fees, balance transfer fees, foreign transaction fees and fees or penalties for exceeding the credit limit, or missing a payment to contend with.

Let's move on to credit card networks. Have you ever tried or heard of people trying to pay but the store not accepting American Express cards? This is because credit card networks, such as American Express charge stores a fee to process their card transactions, so to save money some stores only accept certain cards.

Credit cards can come in all shapes and sizes (and by that we mean there are various different types, most are 85.60mm by 53.98mm). But before we delve into that, we’ll answer the question — why use a credit card? We’re not saying the use of credit cards is good for everyone, but they do have a bad reputation as many people envision credit cards in the hands of people that can’t manage their money or are spoilt (probably due to too many episodes of Paris Hilton reality TV shows being watched). But that’s not true in every circumstance.

There are a number of reasons why people use credit cards. Ever been confronted with a massive bill? For example a dental treatment costing you £3000? Credit cards allow you to spread the cost of large or expensive purchases and repay the balance over the course of several months. Buying a fridge soon? There is a law (for those that want to know it's Section 75 of the Consumer Credit Act) that can protect you when you make a purchase between £100 and £30,000 with a credit card. If anything goes wrong with that purchase, say the fridge is faulty then Section 75 of the Consumer Credit Act may help you get a refund. Credit cards are often safer than cash — if your credit card is lost or stolen, it just takes a few taps or a phone call to cancel it. If it’s stolen and used fraudulently, you’re much more likely to get your money back. Another common reason to get a credit card is to build your credit score. Even having a credit card with a £50 limit, using it to buy your coffee in the morning then paying it back instantly means there is credit history on you and institutions can see how well you can manage debt (pretty well if you pay it back instantly). A credit card can help you build up a good track record of paying off debt, so that when it comes to applying for larger loans like a mortgage, your history will prove you're responsible. On the flip side, if you miss a payment or go over your credit limit, this can ruin your credit score. We will never say that a credit card is a suitable substitution for an emergency fund (because it's, always have your emergency fund ladies) but a credit card can help cover unexpected expenses if any come up.

Types of credit cards include:

Reward credit cards

These cards allow you to build up cash-back, or travel points when you spend on it. They usually come with an annual fee and high interest rates (so it’s important to ensure the rewards are worth it) The rewards are usually in cash-back, points, and travel... think bougie. Amex or British airways card are examples of reward cards.

No frills credit cards

A basic credit card. Usually these offer average interest rates or they may have a lower annual fee, but with little or no additional features.

Credit builder cards

Low credit score? These cards may help you build your credit history. They typically have low credit limits and high interest rates, as they’re designed for people who’re seen as ‘high risk’ i.e more likely to miss a payment. But paying the monthly bill on time and in full can show lenders you’re reliable, helping you get better credit offers in the future.

Balance transfer credit cards

If you have multiple credit cards or multiple debts, balance transfer cards are there to move your existing debt into one place and reduce paying the excessive interest fees across various different types of credit.These cards typically offer a 0% or low interest rate for a set period.

Student credit cards

Designed for when you’re at university and have little or no credit history. It’s normally easier to get approval for these and they come with a lower interest rate.

Secured credit cards

Secured cards require a deposit (a security) to be placed on the card when in use. They are an option for those who don't have a credit history or who have damaged their credit status.

Prepaid credit cards

Prepaid cards require the cardholder to load money onto the card before the card can be used.

Travel credit cards

Credit cards that come without charges when used in a different country, are perfect for holiday spending.

Purchase or store credit cards

These are usually tied to a certain store, for example a John Lewis Credit Card. Purchase credit cards often have a 0% interest period where you can pay for your shopping and avoid paying interest on what you owe, as long as you pay back in time.

If there are 2 things to think about before getting a credit card, let it be these:

  1. How you'll handle the temptation of having money (that isn’t yours) and not spending it. As credit cards will provide you with more money than you really have, the first step to consider is how you’ll handle any temptation when it comes to spending. Set some boundaries for when you’ll use your credit card.

  2. Can you realistically pay back your debt monthly? In your credit card agreement, you will often see any terms and conditions referring to how you pay your money back. If you’re planning to pay off your balance in full every month, make sure this is part of ‘paying yourself first’ and ensure this is the first thing you do when you get paid. Other factors to look at are the interest rate, is this manageable for you? Do you need to find a card which has a lower interest rate. Come up with a plan to keep you on track and help you pay off the bills on time.

Fempire Finance

*This article is not financial advice. Please do your own research before making financial decisions*

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