A credit card gives the cardholder access to a revolving account. The cardholder is usually obliged to make at least a minimum payment each month (determined by the balance amount), but is not obliged to pay off the entire debt each month. Nowadays, it is also common for credit card issuers to grant credit cardholders special grace periods, e.g. two months a year when you do not even have to make the minimum payment. There are plenty of great websites where you can compare the interest rates and costs of credit cards and you can also see what kind of bonuses you are offered.
When a cardholder elects to not pay off the balance in full, the credit card issuer will charge interest on the remaining debt. The interest charged will be added to the balance, which means that a credit card holder that does not pay off the balance in full each month will end up paying interest on interest (compound interest).
One of the main immediate benefits of having a credit card is convenience. Unlike cash, debit cards or checks, a credit card will give you access to a line of credit suitable for small short-term loans. With many check accounts and debit cards, even a small overdraft carries a big penalty – much more than what you would pay for using $100 of your credit card credit and paying it back when the monthly bill comes.
An alternative to credit cards is charge cards. A charge card will also give you access to credit, but you will be obliged to pay the monthly bill in full when it arrives. With a credit card, you do not have to pay the full amount – you can elect to pay only part of the bill and remain indebted to the credit card issuer. Of course, you will be charged interest on your debt.
Many people with credit cards use them as if they were charge cards, i.e. they pay the bill in full every month, but still prefer to have a credit card rather than a charge card since they want to have access to credit in case of emergency. In many situations, simply using your credit card in an emergency is easier than trying to rapidly get money out of a savings account that isn’t tied to a debit card.
Another advantage with credit cards is that they tend to come with extra perks, some of which can be highly valuable when you are in a pinch, e.g. travel insurance, enhanced produce warranty and roadside assistance. It should be noted however that there are charge cards that come with these perks as well.
For merchants, accepting credit card payments come with certain perks too, even though they have to pay fixed fees and commission to the credit card companies. Handling and transporting cash is far from cost-free, and having large amounts of cash also comes with an increased risk of robberies, theft and embezzlement. Accepting checks means assuming the risk of a check bouncing, in addition, to check processing costs.
Before credit cards become widespread, it was common for merchants to extend credit to their regular customers. Each merchant had to evaluate each customer’s credit worthiness and also the possible community ramifications of denying someone credit.
Before applying for a credit card, it is important to learn about the fees, interest rates and other possible costs associated with the card.
Here are a few examples of questions that should ideally be answered before one starts using a credit card:
- What is the annual fee?
- Is there a sign up fee?
- Are there any additional membership fees, e.g. fees for participating in a rewards program?
- What is the fee for getting an extra card linked to the same account?
- If my credit card is lost / damaged / stolen will I have to pay a fee to get a new one?
- What is the interest rate (provided that I’m never overdue)?
- What is the fee for being overdue?
- Is it possible to exceed the credit limit? What are the costs associated with exceeding the credit limit?
- Is there a returned cheque fee?
- Are there any payment processing fees?
- Are cash advances possible? What are the costs associated with a cash advance?
- Are there any special fees for transactions in a foreign currency?
- Is there an exchange rate loading fee?
In the United States, cardholders must be sent a notice at least 45 days in advance before certain fees are increased or changed. Examples of such fees are annual fees, late fees and cash advance fees. You can find out more in the Credit Card Accountability Responsibility and Disclosure Act of 2009 (also known as the Credit CARD Act of 2009).
- Acquiring bank: This is the financial institution that accepts payment for a product or service on behalf of the merchant.
- Authorization: Authorization (approval) is necessary for payment to take place using a credit card. The cardholder presents the credit card to the merchant, and the merchant submits the transaction to the acquiring bank. The acquiring bank will verify the credit card number, the transaction type and the amount with the card issuer. If everything is correct, the payment will be authorized and an approval code will be generated and stored with the transaction.
- Batching: Authorized transactions are stored in “batches” and sent to the acquiring bank. Usually, these batches are sent to the acquiring bank once a day.
- Issuer: This is the organization that issues the credit card to the cardholder. Credit cards are normally issued by banks or other financial institutions, e.g. Royal Bank of Canada, HSBC Bank USA or Wells Fargo.
- Merchant: This is the person or entity (e.g. a company or an organization) that accepts credit card payments for products or services.
- Offshore credit cards: When the credit card holder and the credit card issuer are based in two different countries, the credit card is known as an offshore credit card.
Using a credit card to withdraw cash from an ATM
Most (but not all) credit cards can be used to withdraw cash from an ATM. With most credit cards, a fee is charged for such transaction. This fee is known as a cash advance fee.
Interest on cash withdrawals is normally charged from the date of withdrawal, instead of waiting and only charging interest from the monthly billing date and onwards.
If you are not paying your credit card bill in full at the end of the month, be careful about doing cash withdrawals using your credit card. It is common for credit card companies to apply your monthly payment to every other charge before paying off the cash advance. So, if you owe $200 from ordinary charges and $100 from a cash withdrawal, and pay $150 at the end of the month, your entire payment will go towards paying part of your ordinary charges and $0 will go towards paying your cash withdrawal debt. This is not a good situation, because cash withdrawal debt usually has no grace period, incurs interest from the day of the withdrawal, tend to come with a higher interest rate than normal charges.
Cash withdrawals will, for most credit cards, not give you any reward points or similar.