HOW CREDIT CARDS WORK: >
A Guide to This Important Financial Tool
Many Americans carry credit cards with them, but might be wondering how credit cards work. From interest, balances, grace periods, and credit scores, there is an abundance of information to know about credit cards in order to be well-versed.
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Why We Wrote This Guide
A person’s credit history, credit score and credit card habits can impact their personal and professional lives in a number of ways. Not only may credit history be part of the criteria used to determine approval for auto, home or student loans, lines of credit or credit cards (and the fees, finance charges and terms and conditions associated with them), but also credit history may play a role in where a person can rent housing or work. Despite that, many people are never taught the basics of credit, including how credit cards work. At Discover, we put our customers first, and we demonstrate that commitment in our products and our services. We also understand that many people haven’t learned how credit cards work — or how they can be used the right way to make your financial life more convenient. Here, you’ll learn some important information we feel all customers deserve to know about credit cards, including: • The basics: simply, how credit cards work and what information do you need to know to use them well • The credit card terms cardholders should understand to find the right card for their needs • How your credit card use may impact your credit score and history (and why it matters) • How to make sense of the important information in your cardholder agreement, and on your credit card statement • How to avoid potential fees and finance charges related to various credit card transactions • How to take advantage of all the benefits credit cards can offer • How to help protect yourself from credit card-related fraud In short, we want you to feel confident that you are capable of using credit cards in a way that enhances your financial life.
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Why Having Good Credit Matters
If you have products that allow you to “buy now, pay later” (which may include your credit cards or accounts that designate you as an authorized user; a car lease or loan; student loans; or, in some cases, utility bills), then you probably have a credit report. Having good credit still matters, even if you have no intention of using credit cards to pay for purchases or applying for a mortgage in the near future. When you have good credit, you’re empowered: You can typically to be selective about the kinds of credit or loan products you use. Your credit history may also play a role in your ability to rent housing, land a job with certain employers, or find competitive insurance rates, according to an analysis by Consumer Reports.1
How to Find Your Credit Report Do you know whether your credit report is accurate? You can actually find out for yourself. By federal law, all consumers are entitled to view a free copy of their credit report once a year at AnnualCreditReport.com. Pull your annual credit report on a date that you’ll remember each year so you remember to stay on top of this important task. The Consumer Financial Protection Bureau (CFPB) reports that its top consumer complaints consistently involve issues with credit reports, and 79 percent of them involve inaccurate information on a credit report.2
Basic Information to Look for When You Check Your Credit Report Is your name, address history and Social Security number correct? Do you recognize all the accounts listed?
Do you recognize creditors who have requested a hard inquiry into your credit report? (This may happen when you apply for credit or a loan. If you don't recognize them, it could be a warning sign of potential identity theft.) Do you agree with the activity reported for each account, including account balances and payment history? If you do not agree with something in the report, you can submit a dispute in writing to each major credit bureau to investigate further.3
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Actions That May Contribute to a Good Credit History Once you've confirmed that the information in your credit report is accurate, take note of a few key pieces of information that may influence your credit score: • Your history of making on-time payments. The longer you allow a payment to become past due, the more impact it can have on your credit history. (We'll explore late payments in more detail in the next several pages.) • The amount of your balances compared to your credit limits. Using as little of your available credit line as possible may contribute to better credit. When you use a large percentage of your available credit limit(s), potential lenders may perceive you as a consumer who relies too much on credit to fund your lifestyle. This is known as your credit utilization rate. • How many credit accounts you have. There's no “magic number" of credit cards a person should have, but applying for several credit accounts in a short span of time, or very frequently, may temporarily hinder your credit score. The credit accounts you've had the longest may positively contribute to your credit history as long as you pay your bull in full and on time each month; which is why it's a good practice to keep your oldest credit card accounts active and open to continue lengthening your credit history. A good credit history essentially tells creditors you'll abide by credit or loan terms they may extend — based on the fact that you've held up your end of the borrowing agreement with other creditors in the past. When creditors feel confident that you'll repay money you borrow as agreed (as reflected by your payment history), they may be more likely to offer you competitive interest rates and loan terms. Likewise, a person who doesn't have good credit — perhaps due to a history of missed payments, unpaid loans, or credit balances that appear difficult for the customer to pay down — will usually require the lender to take on more risk if they offer credit to that customer. Although a customer who doesn't have good credit may be approved for some credit cards and loans, they may not be offered the most competitive rates and terms. If you don't have good credit, take heart: Credit activity is reported to credit bureaus regularly. Provided you're willing to commit to positive financial behaviors and be patient, you may be able to improve your credit history over time.
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If you don't have good credit, take heart: Credit activity is reported to credit bureaus regularly.
What’s APR (and Why Does it Matter to Credit Card Customers?)
We mentioned that people who have good credit may be offered more competitive loan or credit terms than a person with bad credit. That interest rate is often referred to as the APR. Because the APR refers to the annual percentage rate, credit card companies usually calculate finance charges using the daily periodic rate, which is based on the APR — card issuers typically divide the APR by 365 (sometimes 360) to calculate the daily periodic rate. When you use a credit card to buy an item, the creditor pays the merchant on your behalf. When your monthly credit card statement arrives, you’ll see the amount(s) you charged on your credit card account during the statement period, along with any remaining balance from the month(s) prior.
You have three options when it comes to making your monthly credit payment (provided it reaches your credit card issuer by the payment due date): • Pay the statement balance in full • Pay a portion of the balance (above the minimum payment due) • Pay the minimum payment due Of these three options, only the first one may mean you avoid finance charges on new purchases — regardless of your card’s APR — as long as you pay off the total balance on time each month. When you pay only a portion of your total credit card statement balance each month, charges that seemed insignificant (like a $10 lunch outing with coworkers, or a $3 cup of coffee) could end up costing more than the original “price tag” by the time you’ve paid them off — thanks to finance charges that are assessed on unpaid balances, based on your card’s APR. Because APRs can be costly to credit card customers who don’t understand how finance charges work, there are a few more important elements to explore. Let’s start with the basics of APRs, and explore what it means based on how you use your credit card.
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Who Determines the APR? Individual financial institutions and credit card issuers determine the APRs they will offer customers based on factors that may include: • The rates the Federal Reserve charges banks to borrow from one another and, potentially, an index like the U.S. prime rate (which may change weekly)4 • An additional percentage margin the credit card issuer wants to add to the base rate noted above • A customer’s credit history, credit score and other financial information
Why Your APR Could Change Most credit cards now use a variable APR, according to the CFPB.5 (It may be indicated by a “v” next to the interest rate on your credit card statement.) A variable APR means that the rate fluctuates and is not fixed. Here are just a few reasons your credit card APR could change: • • • • • •
If your card has different APRs for different types of transactions, the details will be clearly outlined in the card’s terms and conditions and on your credit card statement. Make sure you read your monthly statements so you’ll understand the potential charges related to your APR.
To reflect interest rate changes in the broader economy To reflect changes based on your credit use or your credit score6 You’ve missed a payment, or had a payment returned due to insufficient funds You didn’t pay at least the minimum amount due Why It’s Important to Know Your Card’s APR When you have good credit, you may have more options when it comes to finding/ owning credit cards with competitive APRs — but it’s important to understand the APR and terms that apply to any credit card you own, regardless of your credit.
Why It’s Important to Know Your Card’s APR When you have good credit, you may have more options when it comes to finding/owning credit cards with competitive APRs — but it’s important to understand the APR and terms that apply to any credit card you own, regardless of your credit. That’s because some credit cards may include different APRs based on the type of credit card transaction — such as purchases, balance transfers and cash advances. If you receive a credit card offer advertising low or 0% introductory APR on balance transfers for 12 months, for example, you will not be assessed finance charges on the balance you transfer during that time frame. But if you haven’t paid the balance in full by the time the introductory period ends, any remaining balance may be assessed finance charges. Even during the introductory APR period, a credit card may charge a different APR on new purchases or cash advances than the APR applied to the balance transfer. 6 | © Discover Financial Services
What You Need to Know to Use Your Card Wisely
When you understand the ins and outs of how credit works, you'll benefit from the conveniences (and potential rewards) credit cards may offer, while avoiding the fees and finance charges that make balances difficult to pay down. Almost half of all consumers carry multiple credit cards. In fact, the CFPB estimates that the average consumer has four of them.7 Credit cards are a tool that you can use to your advantage: Not only do many credit cards offer rewards or cash back simply for using the card, they may offer additional conveniences such as the ability to shop online, book travel and other features and benefits. It’s possible to reap all the benefits of credit cards and avoid fees and incurring interest — provided you pay your balances in full each month, and know a few other tips to ensure you use your card wisely.
Know Your Grace Period (and How to Leverage It) Discover cardholders’ payment due date is at least 25 days after the close of each billing period. This means you may be able to avoid finance charges on new purchases made during the grace period, provided you paid the entire balance on your previous billing statement by the payment due date and assuming the current balance due by the payment due date. Grace periods may not apply to cash advances and balances transfers: Interest may be charged starting on the transaction date, or the first day of the billing period during which the transaction is posted to your account. Daily interest charges may be calculated based on the daily balance for those transactions.
Understand the Fees Your cardholder agreement will state the fees associated with your card, which may include an annual fee and/or fees for specific transactions like balance transfers (usually assessed as a percentage of the transfer amount), cash advances, foreign transactions, late payments and returned payments. Read the terms and conditions before you apply for any credit card, so that you understand any potential costs associated with it. 7 | © Discover Financial Services
Pay More Than the Minimum Amount Due Credit card issuers vary in how they calculate the minimum amount owed on a credit card balance, but it’s often based on 1% to 3% of your card’s balance.8 You should check your credit card agreement to learn more about how the minimum payment is calculated. Although you’re technically required to pay only the minimum amount by your payment due date, limiting payments to that amount will make it difficult to pay down your balances. That’s because your remaining balances will carry over to your next month’s billing statement — plus finance charges (based on your APR), in addition to any new transactions you’ve made that month. Credit card statements typically now include a “minimum payment warning” that shows just how long it will take you to pay off a balance by paying only the minimum payment due.
Pay at least double the minimum amount owed; you’ll cut your repayment period in half.8
Know the Costs of a Cash Advance Some credit cards may include a cash advance feature that gives cardholders the ability to access a portion of their available credit line in the form of cash, by using convenience checks or an ATM withdrawal. Cash advances can be convenient when you need fast access to cash, but they may present additional fees (from your credit card issuer and the ATM operator). Many cash advance transactions offer no grace period, and may charge higher APRs on the balance for the advance.
Understand How Credit Cards May Impact Your Credit Score How you utilize your credit cards may impact your credit score. While your payment history usually accounts for the biggest portion of your credit score calculation, the amount of your credit line you use (sometimes called the debt utilization or credit utilization ratio), is typically the second most important piece. The lower you keep your credit card balances, the better it may be for your credit score.9 The length of your credit history, the frequency with which you apply for new credit and the different types of credit products you own contribute to your credit score, too. Because paying your credit card bills on time has such an impact on your credit score, it’s worth exploring the ins and outs of what happens if you miss a payment.
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What Happens When You Make a Payment (or Miss One)
If You Pay by the Payment Due Date Your credit card statement indicates the date your payment is due; the credit card issuer must receive your payment by that due date. Whether you use automatic bill payment online or snail mail, allow plenty of time for the payment to arrive by that date. Your credit card payments are indicated on your credit report each month. The longer your credit history reflects consistent on-time payments, the more it could benefit your credit score.
If You Miss Your Payment Due Date When your credit card issuer doesn’t receive your credit card payment by the payment due date, it’s considered late. If you miss a payment due date, contact your creditor as soon as you realize your error and pay what you owe (which may include fees for the late payment, depending on your cardholder agreement). Although some card issuers may raise the interest rate on your credit card as a result of the late payment and/or may increase the amount of your minimum payment due, do not let one mistake derail your credit. In fact, time is of the essence: A late payment may not necessarily be reported to the credit bureaus until it is at least 30 days past due. The amount of time the payment has gone unpaid, how recently the late payment event occurred, your history of late payments and your credit score all determine whether and how much your credit score will be affected.
If You Haven’t Paid Your Credit Card Bill in Several Months Even if it’s been months since you missed a payment, it’s still in your best interest to contact your credit card issuer and reach a solution — even if you’re facing financial hardship and don’t have the cash to pay your credit card bills. Not only will your late payment continue to be included on your credit report (including the amount of time it’s past due), your card’s balance may continue to grow due to late fees and finance charges. Don’t forget, your APR also may have increased as a result of the missed payment.
If You Pay More Than Your Balance If you pay more than you owe on your credit card, you’ll have a “credit balance” on your account. Your credit card issuer can handle your overpayment using one of these methods:10 • Credit the overpayment amount to your account. When you charge a purchase to the card in the future, that amount will be deducted from the credit balance. • Refund the overpayment to you within seven days of its receipt — provided you request the refund in writing. • Deposit the amount of the credit balance to your bank account if the account goes unused for six months.
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10 Tips for Using Your Credit Card If you have a chip-enabled credit card, insert the card chip-first, face-up at merchants who are equipped with EMV terminals when it’s time to pay. This technology offers greater protection when used at chip-enabled terminals or ATMs. Take advantage of online banking so you’re aware of your credit card activity, including your card balances and transaction amounts, and so you can manage your own use and spot any suspicious activity. Sign up for automatic payments in at least the minimum amount due for your credit cards to eliminate the possibility that you’ll ever miss a payment. Never send your credit card number (or any sensitive financial information) over unsecured email. Sign up for account alerts that you’ll find valuable, such as payment due date reminders and large purchase amounts. Use your credit card to reap the benefits it offers — but don’t charge more than you can afford to pay in cash. Keep on top of your credit score and check it as often as you can to know where you stand. Keep your oldest credit card accounts open and active — and don’t apply for too many credit cards in a short time period. Keep your issuer’s customer service number accessible in case you ever lose a credit card or have other questions. Always read the terms and conditions for any credit card you’re considering applying for, and review your monthly statements.
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Sources: 1. Consumer Reports, “How Your Credit Score Raises Your Premium" July 2015, http://www.consumerreports.org/cro/car-insurance/credit-scores-affect-auto-insurance-rates/index.htm 2. Consumer Financial Protection Bureau, “Consumer Response Annual Report" March 2016, pg. 20, Table 2, http://files.consumerfinance.gov/f/201604_cfpb_consumer-response-annual-report-2015.pdf 3. Consumer Financial Protection Bureau, “Disputing Errors on Credit Reports" https://www.consumer.ftc.gov/articles/0151-disputing-errors-credit-reports 4. Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/faqs/credit_12846.htm 5. Consumer Financial Protection Bureau, “Consumer Financial Protection Bureau—Consumer Credit Card Market Report" pg. 83, http://files.consumerfinance.gov/f/201512_cfpb_report-the-consumer-credit-card-market.pdf 6. Credit.com, “Do Credit Card Issuers Have to Tell You Before They Raise Your APR?" http://blog.credit.com/2016/01/do-credit-card-issuers-have-to-tell-you-before-they-raise-your-apr-134216/ 7. Consumer Financial Protection Bureau, “Consumer Financial Protection Bureau—Consumer Credit Card Market Report" pg. 40, http://files.consumerfinance.gov/f/201512_cfpb_report-the-consumer-credit-card-market.pdf 8. NerdWallet, “What Happens if I Make Only the Minimum Payment On my Card?" https://www.nerdwallet.com/blog/credit-cards/minimum-payment-credit-card/ 9. The Balance, "How Your Card Balance Affects Your Credit Score" https://www.thebalance.com/g00/balance-affects-credit-score-960446 10. Nasdaq, “Your rights if you overpay your card bill" http://www.nasdaq.com/article/your-rights-if-you-overpay-your-card-bill-cm517681
Legal Disclaimer: This site is for educational purposes and is not a substitute for professional advice. The material on this site is not intended to provide legal, investment, or financial advice and does not indicate the availability of any Discover product or service. It does not guarantee that Discover offers or endorses a product or service. For specific advice about your unique circumstances, you may wish to consult a qualified professional.
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