In this article, we are going to learn about credit cards in details. You can expect to learn the following things today:
- What is a credit card?
- How does a credit card work?
- What is the difference between a credit card and a debit card?
- Why should you use a credit card (the benefits)?
- Precautions you should take while using a credit card (the disadvantages).
So, let us begin.
What is a credit card?
A credit card is a card (literally) that you can get from a bank or a financial company. What does this card do? It is a financial tool that allows you to borrow money from the bank or the financial organization that has issued the card to you. There are numerous benefits of credit cards but at the same, there are various problems as well.
Now you may naturally ask, ‘if I am borrowing money from a lender, isn’t it a loan?’
Yes, you are right. When you borrow money from a bank or any other financial organization, you are taking a loan. You need to repay the loan.
So, the next question that you may follow up with is, ‘if a credit card is a loan, then why should I get a credit card?’
It is a very smart question.
A credit card is definitely a loan. But a credit card differs from conventional loans in many ways despite the fact that they are structurally similar. Let us take a quick look at those similarities and differences.
|It is a form of credit that a bank or any other financial organization provides.||It is also a form of credit that you can get from a bank or a financial organization.|
|Credit cards are revolving borrowing1.||Loans have a set repayment time.|
|Credit cards have interest-free grace period2 for repaying.||There is no interest-free grace period for repaying a loan. Interest calculation starts right from the first month and continues until the loan is repaid in full.|
|Interest rates are higher compared to conventional loans.||Interest rates are lower compared to credit cards.|
|Credit cards are meant for small purchases.||Loans are usually meant for large one-off purchases.|
|Can be used for small debt consolidations.||Loans (in particular personal loans) are meant for large debt consolidations.|
|Offers a convenient and constant cash flow.||It is a one-time money you get from a creditor or a lender.|
Revolving Borrowing1: It is a type of borrowing in which you need to repay the money you borrow and once you repay, the money is immediately available for borrowing. In short, you can keep using the money as long as you keep repaying the money.
Grace Period2: A grace period is an interest-free period. You need not pay any interest during this period. You can repay just the amount you used.
Sounds a bit confusing right? Let us put the modus operandi of credit cards so that you can understand the whole concept easily.
How does a credit card work?
A credit card will always have a predefined credit limit. Simply put, there will be a limit on the amount of money you can spend.
You are free to spend the entire amount at one go or you can spend it parts. Whatever you spend, you need to pay back to the bank or the financial institution.
Now, when you spend using your credit card, you will have a grace period. If you pay back the amount you spent within this grace period, you will not have to pay any interest. You will pay only the principal amount you borrowed using the card.
However, if you fail to repay within the grace period, you will have to repay the principal amount plus some interest.
There is one interesting thing that you need to know about credit cards. You need not repay the entire amount you spent using your card. There is something called minimum amount due or minimum due.
You need to pay this minimum amount. The remaining amount (along with interest for the remaining amount) will be carried forward to the next month. Next month will again have the same option of minimum due or full payment.
You can again choose to pay the minimum due and let the remaining due roll over to the next month.
Here is the catch:
If you are paying only the minimum due each month, you will end up paying a lot of interest. This is definitely not a wise choice. It is always a prudent decision to fully pay the whole due and that too, within the grace period to completely avoid any interest payment.
Even if you are paying in full outside the grace period (that is, once the grace period is over), you will have to pay interest.
So, how does this grace period work?
The grace period is a very interesting concept. Grace period simply means an interest holiday period. During this period, the card-issuing organization will never charge any interest. You simply need to pay back the principal amount you spend.
The grace period is usually between 25 to 30 days.
Now the problem is that the grace period is calculated from the day you spend the money to the day of billing (the day on which the lender will generate the credit card bill).
Let us assume that the day of billing is 30th of every month. You spend using your credit card on 1st of April. The bill will be generated on the 30th of April. So, you will get a grace period of 29 days. On the 30th day, you the bill will be generated. When the bill is generated, the lender will add interest. However, if you pay within these 29 days, you will not have to pay a single penny as interest.
Consider this another scenario. The day of billing is 30th of every month. You spend using your card on 20th of April. The bill will be generated on the 30th of April. So, you will get a grace period of only 9 days. Similarly, if you spend on 29th of April and the bill is generated on the 30th of April, you will not get any grace period.
Bottom line is plain and simple. You need to be very meticulous about the date of spending using your credit card if you intend to repay within the interest-free grace period.
What happens when you pay in full or in parts?
Let us assume that your credit card has a limit of 1000 USD. You spend 500 USD to buy a phone.
The credit amount that remains in your card is 500 USD. You can use it again. Instead of using it, you decide to first repay the amount you spent.
Suppose your financial condition is not permitting you to pay 500 USD at once. You can pay only 200 USD and you pay the money within the grace period.
When you pay 200 USD, the amount gets added to your credit limit. So, the credit limit becomes 700 USD of the original 1000 USD. Now you can use up to 700 USD.
The remaining 300 USD is still due. Unfortunately, you cannot pay the amount this month. You decide to repay the remaining amount in the next month.
The company/bank will generate the bill as per the billing cycle. The company/bank will add interest to the 300 USD due.
Next month you need to pay 300 USD plus the interest accrued on 300 USD. Let us assume that you repay the whole amount (300 USD + interest) the next month. Then, 300 USD is added to your credit limit of 700 USD and the original credit limit of 1000 USD is restored. You can reuse the amount again.
The interest that you pay against 300 USD is the income of the bank. The bank will not add the interest amount to your overall credit limit.
The above example clearly tells that every time you repay, you can use the balance credit limit to purchase something or pay for a service. So, a credit card limit is always reusable. This is the reason why a credit card is called revolving borrowing or a revolving line of credit.
Now did you understand the concept of a credit card and how it works? We hope you understood the concept. In case you have queries, feel free to ask through the comments section.
Let us proceed further!
What is the difference between a credit card and a debit card?
The difference between a credit card and a debit card is very simple. Let us find out.
A credit card offers you credit or loan. The money you use is not your money. It is the money of the bank or a financial organization that allows you to use the money when you need. You are under the obligation of paying back the amount of money you use (through your credit card) to the card-issuing organization or bank.
You can use the credit card as long as you are not hitting the maximum credit limit allowed by the card. If you hit that limit, the only way you can reuse the card is only after you pay the entire due or at least a part of the due.
A debit card, on the other hand, gives you access to your own money that you save in your bank account. A debit card allows you to use your own money. You don’t have to repay anyone.
You can use your debit card as long as there is money in your bank account. Once your account balance becomes zero, you cannot use the debit card. However, if you put money back into your account, you can start using the debit card.
Why should you use a credit card (the benefits)?
Using a credit card comes with several benefits. Some of the benefits that you can enjoy include:
- It is a steady source of money when you need it urgently.
- You can use the balance transfer feature of your credit card for consolidating small debts.
- You get an interest-free grace period where you can literally pay only and only the principal amount you spend. You don’t have to pay any interest.
- Many credit cards come with special benefits like discounts on purchases made with a credit card.
- Most important of all, if you can use your credit card wisely and repay within the billing cycle, your credit score keeps increasing. The credit score plays a vital role in determining whether you are eligible for a bigger loan such as a housing loan.
Precautions you should take while using a credit card (the disadvantages)
Credit cards definitely have great advantages. However, there are a few dark sides of credit cards that you should be aware of. Let us take a look at the major disadvantages of using a credit card.
- Credit cards usually have greater interest rates compared to conventional loans like personal loans.
- Since it is a revolving line of credit, you get a temptation of spending again and again. If you cannot control the temptation, you can very easily step into a debt trap.
- Since credit cards have something called ‘minimum payment due or minimum due’, you will be tempted to use that feature. Using that feature will only mean interest accrual for an indefinite time frame. Always and always try to repay the entire amount that you spend.
- If you declare bankruptcy or you go for a settlement against your credit card dues, your credit score will take a hard hit. It will become difficult for you to go for other loans like housing loan, education loan, automobile loans, etc.
So, when you are using a credit card, you should always learn about terms and conditions and keep in mind the pros and cons of using a credit card. Never get tempted to unnecessarily spend simply because you have access to easy money. That money is nothing more than a loan that you have to repay. No one wants to get into a debt trap. Such a trap can ruin your life. Use your card wisely.