Money 101: How Do Credit Cards Work?

For young people beginning their financial journey, few topics hold as much mystique and stigma as credit cards. We’ve seen people at both unhealthy ends of a spectrum: those who accrue consumer debt, and those who avoid credit cards altogether. The truth is that credit cards are neither good nor bad. They are merely tools that can factor into a healthy relationship with money when you approach them in the right way.

When we meet with young people and their families for our Money 101 financial literacy sessions, we give guidance on debt, spending, saving, giving, taxes, and other topics important for lifelong health. Below are some frequent questions about credit cards that can give you, or a young person in your life, a better understanding of how credit cards work and how to make them work for you.

How Do Credit Cards Work?

Briefly, a credit card account allows the user to pay for purchases on credit, essentially borrowing the cost of the purchase and paying it back later with interest. Unlike other types of debt, there is no set end date to a credit card. As long as you continue to pay off the balance, you can continue to draw from that line of credit. For this reason, they are called “revolving credit” accounts.

Every credit card has an upper credit limit, an annual percentage rate (APR), and a monthly minimum payment. Some credit cards also offer rewards like cashback and airline miles. But at its most basic, a credit card is a revolving line of credit you can use to cover purchases instead of paying in cash or with a bank debit card.

Why Should I Get a Credit Card?

Credit cards contribute toward your credit score, which is a measure of a person’s creditworthiness. FICO credit scores range from 300 to 850. Individuals with a higher credit score are viewed as better candidates for lending. This translates to lower interest rates and a greater likelihood of approval for things like home and auto loans. You’ll need at least a 620 to get a traditional mortgage and a 600 for an auto loan. If you build your score into the 700-800 range, you will save thousands over time through lower interest rates.

Credit scores are also reviewed by potential employers, landlords, insurance companies, and others to measure a person’s fiscal responsibility and even personal character. For this reason, it’s a good idea to keep an eye on your credit score and make sure the reports are accurate. Everyone can request one free report per year from each of the major credit reporting agencies as a way to monitor their credit and dispute any mistakes.

How do you build your credit score? By demonstrating a history of using credit and paying your bill on time.

How Should I Use My Credit Card?

An important element in calculating your credit score is “credit utilization,” or how much of your available credit you’re using. You want to aim to carry no more than 30% of your maximum balance. In other words, if you have a card with a $100 limit, you would want to charge fewer than $30 to it. For a card with a $1,000 limit, you would want a balance below $300. And so forth.

With that in mind, the best way to build your credit is to use a small portion of it regularly, and then pay off that balance in full each month.

Here are some tips:

  • Keep your credit card balance lower than your bank account balance. In other words, don’t spend money that you don’t have. Ecclesiastes 5:5 reminds us, “It is better not to make a vow than to make one and not fulfill it.” That’s certainly true of credit cards. If you don’t have enough in your bank to cover the full cost of your credit purchase, it’s best not to swipe instead of carrying a balance forward.
  • Arrange to pay the full balance of your credit card each month several days before the bill is due. You can set this up as an automatic payment from your bank, ensuring you never forget to make a payment on time.
  • Start by charging just one bill or expense to your credit card. This makes it easier to keep your spending under control and prevents you from accidentally charging more than you can afford.

By using your credit card regularly and committing to paying off the balance each month, your credit score will grow without accruing debt. Once you’ve gotten comfortable with this process, you can begin using the same process to reap added rewards like airline miles or cashback. But in the beginning, simple is best.

What Should I Look for in a First Credit Card?

Because good credit is so important, it’s wise to start building it right away. You’ll need to be at least 18 to get your first credit card, but younger people can be added as authorized users to a parent’s account and begin building their credit that way.

When it comes to choosing your first credit card, you’ll want to keep things simple. Opt for a card without any annual fees, international transaction fees, and other costly extras. If possible, choose one with no-penalty interest that will waive the first late payment.

How Many Credit Cards Should I Have?

With so many types of credit cards offered by lenders, it can be overwhelming to pick the best option. We recommend making it simple for yourself and beginning with just one card. From there, you can slowly add more to increase your available credit and take advantage of rewards opportunities in the future.

Whatever you choose, avoid opening multiple cards at once. Having more credit available is good, but having too many open inquiries into your credit can negatively impact your score. Pace yourself and build your cards up slowly.

Used responsibly, credit cards are a powerful tool, but they’re just one piece of developing healthy financial habits. Reach out to our team of financial advisors at John Moore Associates to learn about our Money 101 program and the ways we help families learn the principles of good financial stewardship at any stage of life.