You might think of a credit card as simply a means to an end. On one hand, that’s true. It is simply another way to make a purchase, serving as an alternative to paying by cash or check. Yet, when used responsibly, a credit card can serve an even greater purpose, helping you build up a solid credit score and secure a loan down the road, pay a lower interest rate and even save on insurance. You can even rack up points that are redeemable for cash or other rewards.
With these benefits in mind, you might be itching to open your first credit card as soon as you are able to. Yet, before you sign on the dotted line, there are a few things you should know. Today, let’s take a look at five things to keep in mind before you take that next step.
1. Understand how a credit card works.
Unlike a debit card, which takes funds directly from your checking account whenever you make a purchase, a credit card applies those purchases toward what is essentially a short-term loan. At the end of the month, you’ll pay off that loan (or at least the minimum balance on it) to maintain your good credit standing.
Though you’ll usually have a short grace period window to send in the payment, most credit card billing cycles are around 30 days. Depending on your repayment timeline, you may or may not have tacked-on interest to pay as well.
2. Determine why you want a credit card.
Do you just want to be able to swipe a piece of plastic at the mall and buy anything you want? If so, you may not be quite ready to open a credit card. Sure, they are convenient tools that make it easy to buy goods, but that’s far from their only purpose. An ideal reason to open a credit card account is that you want to build up your credit. If you’re just starting out on your own, chances are you haven’t accrued much credit history yet. As such, if you go to take out a loan on a car or a new home, your lender might not approve you for a high amount, or will tack on a high interest rate, as there is no way to determine your repayment risk and responsibility.
On the other hand, if you can deliver statements that show you’ve paid your credit card bill on time every time, that establishes legitimacy and can get you a more favorable loan agreement. Similarly, your insurance premiums and even your cell phone plans can be obtained at a more cost-effective rate if you have a strong credit score.
Or, you might be interested in a credit card for the cashback or travel reward perks. Most major credit card companies apply between 1% and 2% of your purchase price toward these benefits. Before settling on a card, check to see what it offers and what you can expect to get back by using it.
3. Consider whether you need a secured or unsecured card.
Put simply, a secured credit card is one that is tied back to an original cash deposit. As such, the risk is lower and there is very little opportunity for nonpayment to occur. If you have yet to build a strong credit history, a secured card is often the way to go. Keep in mind that unlike a prepaid card, the balance a secured card doesn’t go down as you spend. Rather, the balance you first paid is acting as collateral, meaning that if you fail to pay your bill on time or you don’t pay your balance in full, you will still be required to pay interest.
Alternatively, an unsecured card isn’t linked to any form of collateral. Instead, your credit limit is determined based on your credit history and current income. That means if you haven’t built up those entities yet, your limit will likely be fairly low.
It’s often in your best interest to begin with a secured card and either cancel it down the road or make a transition to an unsecured card as you build up your credit and stabilize your career. Of course, if you are truly interested only in an unsecured card, you can always partner with a cosigner to obtain one.
4. Know the specifics of your grace period.
Before you choose a card, understand how its grace period is calculated. As a rule of thumb, a grace period is usually between 21 and 25 days, meaning you have that long to pay off the loan before you begin accumulating interest. Yet, be cognizant not to let that grace period sneak up on you. Any single day you go over that timeline, you’ll be paying interest and that can quickly add up if you’re not careful, which brings us to our last point.
5. Calculate how your interest payment is figured.
You might think that your credit card interest is calculated based on how much money you still have to pay off once the grace period comes and goes. While that is a common conception, it is an incorrect one. Rather, it’s your average daily balance that determines the interest rate and how much you’ll ultimately pay.
For instance, you may have a credit card limit of $1,000. Day 11 of your accrued interest timeline rolls around and you put $200 toward that balance. On Day 21, you pay $350. Your average daily balance, in this case, is $750. Knowing this, be sure to ask about the card’s Annual Percentage Rate, or APR. Once you have this number, divide it by 365 to get your periodic, or daily interest rate. To avoid paying this charge, be sure to pay your new credit card balance off as soon as you get it in the mail.
While this list of tips is far from exhaustive, it serves as a base point for anyone looking to navigate the new world of credit card ownership. When used responsibly, they can be excellent tools to help you learn how to save smartly, manage your finances correctly and plan ahead for the future.