A credit card can be an excellent way to fund a large purchase, build good credit history, or even get special rewards for items you probably purchase on a regular basis, like gas or groceries. However, there are several downsides to a credit card when compared against other financial instruments and you’ll want to carefully consider the pros and cons of a credit card before signing up for one.
Additionally, there are a variety of credit card options with different lending terms and reward structures, so you’ll also want to think about how you would most often use the credit card in order to find the best offer for you. Already know which kind of credit card you’re looking for?
How do Credit Cards Work?
Before looking at the different types of credit cards out there, let’s first explore what a credit card is and how it works. A credit card is a physical card, that gives you access to a line of credit with the financial institution that issued the card. When you pay for items using a credit card, money is subtracted from this line of credit and you are required to pay it back within a per-specified period of time. How much credit you are offered usually depends on your previous credit history and current level of income. If you have very little income and have never borrowed money before, a bank is not likely to give you a big line of credit because there’s no way for them to know if you are the type of person who will pay back the money that you borrow. On the other hand, if you have a good credit history and a sizeable income, a bank is more likely to extend you a much larger line of credit.
Regardless of how big or small your line of credit is, when you borrow money against this line of credit, the bank will eventually want this money back. In most cases, you will have a billing cycle of around 25- 30 days in which you will be expected to pay back the money you borrowed. If you choose not to pay back the full amount, the bank will require you to pay interest on the money that you owe.
How much interest you will be required to pay depends on two things: 1.) how much money you borrowed, and 2.) your interest rate. If you’re planning on using a credit card for a big purchase and don’t think you will be able to repay all the money you borrow within a single billing cycle, it would be a good idea to look closely at the interest rates of the credit cards you are considering before signing up.
Why does Interest Rate matter?
When comparing credit cards, one of the most important things to consider is the interest rate. A credit card with lots of rewards and a high credit limit might seem appealing at first, but if the interest rate is also high, you might end up paying significantly more in interest than you save with the rewards you earned. For example, a credit card offers you $20 cash back for every $1,000 you spend and you buy a new furniture set for $10,000, you will get $200 cash back. Sounds pretty good right? But what about the interest rate? Unless you are planning on paying back the entire $10,000 within the first billing cycle, you are going to have to pay interest on the money you owe. So let’s say you decide to pay off your new furniture set in 10 months, paying $1,000 every month, and you have an interest rate of 8%. After your first billing cycle, you will have made your first $1,000 payment and have $9,000 remaining. Since your interest rate is set at 8%, you are going to receive an interest charge of $720 for your first billing cycle alone. Your $200 in rewards is quickly spent on making this interest payment, and you still have an additional $520 in interest to pay.
Now let’s look at what would happen if you chose a card with fewer rewards but a lower interest. Let’s say that instead of signing up for the card that offers a cash back reward and an 8% interest, you choose a card with no rewards and a 2% interest rate. If you buy that same $10,000 furniture set, and make the same $1,000 payment, you will still owe $9,000 after your first billing cycle and, with this new card, you won’t receive any cash back. But since this card only has an interest rate of 2%, you will only have to pay 2% of $9000 which is just $180. So, for the card with rewards you ended up paying $520 in interest, and for the card without rewards you ended up paying $180.
While this example makes it seem like choosing a credit card with the lowest interest rate will always be the better choice, there are a few more things to consider before finding the card that’s right for you.
What about a “No-Interest” Credit Card?
One of the most popular types of credit card available is a “No Interest” credit card, which has an interest rate of 0%. Given our example above, this might sound like a fantastic option. However, often times these “no-interest” credit cards are only “no-interest” for a limited amount of time and after that period of time, the interest rate will change to something significantly higher. If you are considering a “No-Interest” credit card, make sure you understand exactly how long the interest rate will stay at 0%. While it might seem foolish to sign-up for a card that will eventually have a high interest rate, it can actually be an excellent choice in some cases. For example, let’s say you apply for a credit card with a 0% interest rate for 12 months and you buy that same $10,000 furniture set. If you make a $1,000 payment every month, you will have paid off the entire amount in only 10 months and paid $0 in interest. Ultimately, the best credit card for you will depend on how you want to use it.
How will you use your new credit card?
If you are planning to purchase an expensive item but know you will be able to pay it back in a short period of time, you might want to look for credit card offers that have the most favorable interest rates. However, if you are planning to use the credit card for smaller, everyday purchase and will completely pay off the credit card each billing cycle, you may want to look for offers that have the most favorable rewards. One final thing to consider before you begin your search are the extra fees and any limitations that may come with the card. For example, some credit cards will charge an annual fee, regardless of your balance. Meanwhile, some credit cards are not as widely accepted as others, making it difficult to use the card at your favorite places. So, if you find a credit card with a great interest rate and excellent rewards, be sure to also check for an annual fee and note whether the card itself is accepted by a majority of retailers.
Resources:
1. https://www.nerdwallet.com/blog/nerdscholar/credit-card/
2. https://www.nerdwallet.com/blog/credit-cards/how-to-pick-the-best-credit-card-for-you-4-easy-steps/
3. https://www.nerdwallet.com/blog/credit-cards/how-0-interest-credit-card-offers-work/
4. https://www.usbank.com/credit-cards/how-credit-cards-work.html
5. https://www.investopedia.com/terms/c/creditcard.asp
