- When a bank or credit-card company considers your application for credit, it will look at several factors to determine how much it should lend you and whether you will be able to pay back the money borrowed. Credit applications generally ask about your annual household income, nature and length of employment, and other major debt obligations (such as a mortgage). Creditors will also check your credit report and score to see how you have handled credit in the past and whether you are likely to be a risky borrower.
- Making purchases on credit is sort of like taking out a loan. The difference between an ordinary loan and credit is that if a bank were to lend you $5,000, it would give you all the money up-front and you would pay it back on a predetermined schedule for a predetermined amount of interest. On the other hand, when you purchase on credit, you might have the ability to make purchases up to $5,000, but you don't get the money up-front. Thus, if you don't need to use the whole $5,000, you don't have to pay interest on it. Furthermore, if you have previously paid your monthly credit-card bills in full and on time, you can take advantage of what is called a grace period. A grace period means that if you buy an item using your credit card on December 1, you won't have to pay for the item, nor will you have to pay interest on it, as long as you pay your credit-card bill in full by its due date. The due date might not be until December 30, meaning you essentially get an interest-free loan for a month. In this way, responsible consumers can use credit to their advantage. The only way credit-card companies make money on this type of consumer is through annual fees (though many cards have no annual fee) and the transaction fees the credit-card companies charge to merchants each time you use your credit card. These fees usually are in the 2-3% range.
- Responsible consumers who pay their bills in full and on time every month face no disadvantages from using a credit card, as long as the card does not have an annual fee. In fact, it may be more advantageous for them to purchase items with credit than with cash. This is because quite a few credit-card issuers offer rewards for using their cards. Some savvy cardholders even take advantage of 0% APR offers to get large cash advances, borrowing money for free and earning interest on it for several months and then repaying the balance in full before it is due.
- There are credit cards for any need: business, student, balance transfer, poor credit, no annual fee, low interest, and more. But for the responsible credit user, rewards cards are best. The most common credit-card rewards include frequent-flier miles, cash back, or points that can be redeemed for merchandise, gift cards, frequent-flier miles, plane tickets, hotel rooms, or cash. Certain credit cards will be more advantageous to consumers than others depending on their spending habits. Someone who drives a great deal would particularly benefit from having a card that offers 3% back on all gas-station purchases, for example, while someone who is doing a home renovation would benefit most from a card that offers 3% back on all purchases from home-improvement stores. Of course, someone who both drives a lot and is doing a home renovation should get both types of cards to maximize his or her rewards. Along the same lines, a business that frequently puts its employees on airplanes for work would do well to buy those plane tickets with a frequent-flier rewards credit card. Some brokerage firms also offer credit cards that reward cardholders with 1-2% cash back as long as that cash back is deposited directly into the cardholder's brokerage account. Another type of credit card is the store credit card, which generally offers special store privileges such as discounted shopping days, free shipping on online orders, special coupons, and a rewards system that provides discounts on future purchases.
- Consumers who do not use credit responsibly, however, can get into a great deal of financial trouble because of it. Consumers who use their credit cards to borrow money for longer than the grace period must pay interest, often at rates ranging from 10% to 30% annually, on both the existing card balance (until it is paid off) and any new purchases (from the moment the purchase is made). The interest rate is likely to be based on factors such as your credit score and what kind of rate the lender typically offers for the particular card you have. Consumers who make late payments or stop paying altogether because of forgetfulness, irresponsibility or financial hardship will face the highest interest rates. A card's rate will often increase automatically when the cardholder makes a late payment or pays less than the required monthly minimum. High interest can quickly cause what may have once been a reasonable credit-card balance to grow out of control to the point where the consumer can only make the minimum monthly payment each month and is essentially in a permanent state of consumer debt. The worst part is that since this is the type of consumer that credit-card companies make most of their money off of, these consumers will probably continue to be offered additional credit cards that they cannot really afford. Some people have such difficulty managing credit that they end up filing for bankruptcy. Finally, even consumers who pay off their balances in full and on time and use rewards cards may put themselves at a disadvantage by using credit because some people believe consumers spend more when they pay with plastic than when they pay with cash.
