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Learn How Credit Cards Work and Describe the Costs Involved

Companies issue credit cards to earn money. Annual fees can be anywhere from $0 (no fee) to $300 a year. Interest rates are high: some are as high as 25 percent before compounding! Balance transfer fees can also be very high—they can start at 3 percent and increase with each transfer. Cash advance fees usually start at 4 percent and can go higher. Often, these fees can’t be paid back until the original, less costly debt is paid back; this results in even higher costs to you. Penalty rates sometimes exceed 25 percent, and late fees are also high. All of these charges are added on top of a 1.5 to 5 percent charge to merchants. What a business—and it’s a cash business as well. This is why credit card companies mail out billions of credit solicitations each year.

How Credit Cards Work

A credit card is one type of open credit. Open credit is an agreement you make with a financial institution (in this case, a credit card company) that allows you to borrow money up to a specific limit; it is expected that you will pay back the loan at a specific interest rate and pay other attached fees as well. Many factors determine how much open credit will cost you annually: the balance owed, the interest rate, the balance calculation method, the cash advance costs, the annual fee, and the additional penalty fees.

By understanding how open credit works, you can avoid the pitfalls that this type of credit can present. There are several key factors that you should understand about open credit before you apply for this type of loan:

  • Interest rate: Credit card companies state the interest rate as an annual percentage rate, or APR. This is the true, simple, interest rate that is charged over the life of the loan. However, the APR does not take into account compounding periods or the time-value of money (see Section 9–Time Value of Money on this Web site). You should also watch out for teaser rates. Teaser rates are introductory rates used to attract new customers—some are as low as 2.9 percent—but these rates change after a specified period of time. Don’t be fooled—read the fine print.
  • Compounding period: The compounding period is how often interest is charged to your account. Most credit card companies compound interest daily. It’s interesting to note that when you save money, interest is compounded monthly, but when you borrow money interest is compounded daily. Any time you borrow money, remember that you are paying interest, not earning it.
  • Balance calculation methods: You should understand that credit card companies use three main balance calculation methods: average daily balance, previous balance, and adjusted balance. The most commonly used method of calculating your balance is the average daily balance. This method adds up your average daily balances for each day during the month, divides the total by the number of days in the month, and multiplies the result by your monthly interest rate (your APR divided by twelve). The previous balance method is the most expensive method. This method takes your previous balance that you owed last month and multiplies it by your monthly interest rate. The last method, the adjusted balance method, is the least expensive. This method takes your previous balance, subtracts your payments, and multiplies the total by your monthly interest rate.
  • Cash advances: Avoid using cash advances. Cash advances are an extremely expensive way to borrow money. Interest begins to accrue as soon as you get a cash advance, because cash advances are not considered normal credit card charges. Generally, the interest rate charged on cash advances is higher than the interest rate charged on purchases. In addition, there is usually a cash advance fee of between 2 and 4 percent of the cash amount advanced. Moreover, some cards require you to pay the purchase balance before you can pay the cash advance balance so that the credit card company earns the higher interest rate for a longer period of time.
  • Grace period: A grace period, or period over which you do not pay interest on new purchases, normally lasts from twenty to twenty-five days. The grace period excludes cash advances and often doesn’t apply if you carry over a balance from a previous month. If you do not owe a balance for the previous month, a grace period means that you could avoid paying for a purchase for nearly two months. However, you need to watch out because not all credit cards offer a grace period.
  • Credit card philosophy: Before you apply for open credit, you should decide your personal credit card philosophy. What kind of credit card user will you be? There are three main types of credit card users: credit users, convenience users, and combined convenience and credit users. If you use your credit card to borrow money that you don’t have, you are a credit user. Credit cards are one of the most expensive ways to borrow. Credit users typically carry a balance from month to month. If you are a credit user (it is not a good idea to be a credit user), look for a card with a low APR.

If you use your credit card only because it’s convenient, you are a convenience user. Convenience users generally pay off their credit card balance each month. If you are a convenience user, look for credit cards that offer low annual fees, long interest-free grace periods, and free benefits.

If you use your credit card for both credit and convenience, you are a combined convenience and credit user. This type of credit card user needs to balance the interest rate and the annual fee to obtain the lowest overall cost for the card. Find the card that matches your needs the best.


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