How Do Credit Cards Work?

Credit cards are issues by banks, credit unions and a few publicly-traded corporations. When a person is given a credit card by one of these entities, that person is given a “line of credit”. The line of credit is essentially a credit limit or money limit. That person has credit with many (if not most) businesses which offers goods or services. This credit is a “cash advance”. Essentially, the person is able to get a loan for money for any good or service that can be purchased with the card.

Unlike a charge card, where the charge card balance must be paid off every month, a credit card allows someone to roll over this loan debt from one month to the next. The trade-off for being allowed to do this is that the person must be interest on this credit card debt. T

How Credit Limits Work

Let’s use an example to show how credit cards work and how credit limits work. Assume that a person has a credit limit of $5,000 on their credit card. Then assume that the person has a 7% interest rate on their credit.

The holder of this credit card can run up a credit card debt of $5,000. For any money that isn’t paid off every month, the person is charged 7% interest. If you charge $500 on your credit card in the first month, then you would be charged 7% interest if you did not pay off this amount. If you pay off only half the amount, you will be charged 7% interest on $250 instead. But if you pay off the entire debt, you aren’t charged any interest at all.

Running Up Debts on Your Credit Cards

As you can see, if you use your credit card within your means, you can use it for the sake of convenience. But if you get a higher line of credit and you consistently charge and then don’t pay off your credit card debt, you can get in over your head.

Avoid Maxing Out Your Credit Card

You should avoid maxing out your credit card in order to avoid more fees. Let’s go back to our credit card example. Imagine a person charges $500 every month on their credit card, but never pays off the debt. In 10 months, you will reach the limit of your line of credit. You will owe your creditors $5,000. You won’t be able to charge any more money on your credit card.

Also, you will be charged 7% interest on your credit card. The interest of 7% on your $5,000 credit card will be $350. Soon, an extra $350 will be charged to your credit card account. In this way, you’re credit card debt will spiral out of control.

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Then imagine that you have four credit cards with a $5,000 limit. If each has the same limits and interest, you can max out all four credit cards for $20,000 debt and an interest payment of $1,400 alone. This is when a credit card becomes a burden, because the average person is faced with a debt that’s too high to pay off.

Using Credit Cards Wisely

Of course, most Americans are using their credit cards wisely and never face bankruptcy. I wanted to show the dangers of credit cards, though, while covering the upside of credit cards. It’s important younger people just in the workforce get a credit card and pay off their debts, because this is a good way to get their credit rating up. A poor credit rating can affect their ability to get a job (some employers conduct credit checks as part of the application process) or qualify for business credit cards if they decide to open their own business instead. Once they start to buy cars and houses on their own, having a higher credit rating will mean thousands and tens of thousands of dollars in their pockets, instead of being paid in interest to credit and finance companies.

Other Credit Card Fees

Many credit cards have yearly transaction fees. These are meant to make a little money off the credit card customers who don’t run up huge debts on their credit cards.