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When you first start using a credit card, it’s a good idea to understand a few key terms. When you know how credit cards work, you can make better decisions about using your credit, and also which credit card is best for you. Here are the key terms to understand before you apply for a credit card.

Annual Fee

This is a fee that a credit card issuer might charge each year to use the card. Each year, on a specific date, you will be charged the fee. Some secured credit cards might charge a monthly fee instead. Pay attention to whether or not there is a fee associated with using the card, and how often it is charged.

APR (Annual Percentage Rate)

This represents the interest that you will be charged on an annual basis. For example, if a credit card has an APR of 19.99%, that’s how much you will pay on balances on your bill that you have every month.

However, credit card issuers don’t charge interest once a year. You might be charged different ways each month. Here are two of the methods that might be used when charging you interest:

A) Average Daily Balance

With this method, you are charged interest once a month, based on the average balance carried for the month. So, all of your balances each day will be added up and divided by the number of days in the billing cycle. That number will then be multiplied by your monthly interest, which is your APR divided by 12.

For example,

  • let’s say your average daily balance for the month is $1,000
  • Your APR is 19.99%.
  • You will be charged based on monthly interest of 1.6658% (19.99%/12 months)
  • so your interest charge = $16.66 for that month.

B) Daily Compounding.

In some cases, the credit card company will compound your interest daily. This means that, at the end of each day, interest is charged on your balance and added to the total. Your APR is divided by 365 days to determine your daily interest rate.

In our example

  • You have an average daily balance of $1000
  • your interest charge is 0.054767% each day. In other words, the charge for that day is about $0.55 cents.
  • That total ($0.55) is added to your balance ($1,000), and interest is charged on $1,000.55 the next day.

These aren’t the only two methods, but they are among the most popular. Regardless which method is used, if you carry a balance, your effective interest rate for the year will actually be higher than the listed APR. This is because of when the interest is charged each month, or each day, and then added to your balance.

With credit cards, you pay interest on your interest charges. The only way to avoid this is to pay off your credit card balance each month. Lesson: Pay off as much of your balance each month as possible!!!

Credit Limit

This is the amount that the credit issuer/ company is willing to let you borrow. On a credit card, how much you have available to you is based on how much of your credit limit you have available.

For example, if you have a $1,000 credit limit, that is how much you can have outstanding at any one time (the most that you can charge on your credit card).

If you charge $750 on your credit card, then you only end up with $250 left on your credit limit. You can only charge $250 more on purchases before reaching your credit limit of $1000. You have to make a payment to free up more room on your credit card.

Credit Utilization

Your credit balance is how much money you have borrowed so far. The closer that you are to your credit limit, the lower your credit score will be. This is because your credit utilization will be high. Your credit utilization is a reflects how much of your credit limit you have used.

For example,

  • if you have a balance of $750 on a $1,000 credit limit
  • your credit utilization = 75% ($750/$1000)

If you carry high balances, lenders see you as a risk, lowering your credit score. Again, pay your balances!

Credit Score

This is a number (three digits) that offers a summary of how well you have managed your credit and debt in the past. A higher number is more attractive. Your credit score is based on information in your credit report.

Your credit report lists all of your loan accounts, including credit cards. Credit issuers report your credit line (limits), your credit balance, and whether or not you pay on time. This information is then represented with numbers into systems produced by the 3 major credit agencies to produce your credit score.

If you have a good credit score, you will be approved for loans, insurance, and other other financial products at good rates. If you have a low credit score, you might have to pay higher interest to offset the risk that you represent to a lender. In some cases, you might be rejected for a loan, especially a home loan.

The two most important factors that determine your credit score models are your payment history (whether you pay on time and whether you pay at least the minimum balance required), and your credit utilization.

Other factors that influence your credit score include

  • How long you have had credit
  • The number of inquiries on your credit report
  • The types of credit accounts you have.

Many credit card issuers offer a grace period. This is the time during which you won’t be charged on your balance. Many credit card issuers won’t start charging interest on new purchases for at least 21 days. If you pay your credit card bill off each month, before the end of the grace period, you can avoid interest charges.

Not all credit cards have grace periods, though; in some cases you start owing interest as soon as you start spending. And you should realize that even on credit cards with grace periods, they don’t often apply to balance transfers and cash advances.

Minimum Monthly Payment

This is the lowest amount of money required by your credit issuer (company) each billing cycle. A credit card issuer typically charges 3%, 4%, or 5% of your balance as the minimum.

For example,

  • If you have a balance of $500 (including fees and interest) at the end of the month
  • Your minimum payment will be $15, $20, or $25, depending on the policy used.

It’s important to realize that how your interest is compounded (method A or B from earlier in the article) matters when it comes to how your balance is reduced.

Since a minimum payment typically includes your interest charges, your principal balance will only be reduced after the new interest is paid.

For example,

  • If your minimum payment is based on 3% of your balance
  • and your interest is $16.66 per month, your $30 minimum isn’t very effective.
  • After paying interest, only $13.34 goes toward reducing your principal balance. So your balance ends up being $486.66.

You can see how only making the minimum payment can mean years and years of debt – and thousands of dollars paid just in interest.

Your credit card statement/ bill that you receive each month that details your purchases and interest charges, should have a box that highlights the cost of paying only the monthly minimum, versus what you can save if you take three years to pay off your debt.

It’s best to charge only what you can truly afford, and pay off the balance each month. However, if you find yourself carrying a balance, you should always pay more than the minimum payment.

Have you been confused by any credit card terms? Let us know in comments and we’ll try to help.


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