Credit

Introduction#

After you've applied, hopefully you get approved! The credit card company will follow up with additional information like when your card will be mailed and how to activate it. If you get denied, you probably did not have a high enough credit score and should consider some of the options listed above on how to improve your credit score without a credit card.

What is a credit card?#

It's not just a piece of plastic with some numbers on it. Before we talk about what credit cards are, it might be useful to understand how debit cards work. Once you've signed up for a checking account at a bank, you'll receive a debit card, which looks almost identical to a credit card. Debit cards take money you already have to pay for things. If you have $100 in your checking account, you can't buy anything worth more than $100. This makes sense and seems pretty safe since you can only buy things you have the ability to pay for; it's basically a more convenient version of cash.

Credit cards are not taking money from any existing accounts you have. You're actually borrowing the money. So even if I pay for a $100 meal with my credit card, that money doesn't get drawn out from my checking account. It is actually coming from the credit card company. When you open a credit card account, the credit card company gives you a credit limit. So if I'm given a credit limit of $1000, then I can't borrow more than $1000 to pay for stuff.

How do credit cards work?#

Wow, why not just pay for everything like this and never use my actual money? First of all, it's not free money. You have to pay back what you borrowed. On top of that, you have to pay interest. Remember interest? Interest is the cost of borrowing money, and just like our bank account pays us interest to borrow our money, we pay interest to credit card companies to borrow their money if we don't pay them back in full. This interest rate is called the annual percentage rate (APR) just like the interest rate.

If you pay back the full amount your borrowed before the end of the month, you won't have to pay any interest. The amount of money you still have to pay back at the end of the month is called your balance. If you don't pay back this balance in full by the end of each month, you'll have to start paying interest on what you owe. There is generally a grace period in which you can pay your balance before getting charged interest.

Example#

Let's check out an example. If you're not a math person or don't really care to see how this stuff is calculated, feel free to skip the next few paragraphs and just read the TL;DR. However, it might be useful to at least go through an example to understand why you should avoid carrying a balance on your credit card, even if you're never going to actually calculate it yourself (no one really does).

Suppose you sign up for a credit card with an APR of 14% and start out with a $0 balance. You buy $3000 worth of stuff with your credit card at the beginning of March. You make a payment of $500 in the middle of the month. At the end of the month, you still owe $2500. The next month, you make another payment of $600 in the middle of the month and end the month with a $1900 balance. How much interest (extra money aside from the $1900) will you have to pay for the month of April?

Step 1#

Take your APR and divide it by 365 to get the daily interest rate. So 14% / 365 = 0.038%. Everyday you don't pay back the credit card company, you'll have to pay extra in interest!

Step 2#

Calculate the average daily balance in your account over the course of the month. So we started April with a $2500 balance, and we owed that for 15 days until we made a payment of $600. For the last 15 days of the month, we owed $1900. $2500 15 + $1900 15 = $66000. This is our sum of daily balances. To get the average daily balance, we take $66000 and divide it by the number of days in the month (30). So $66000 / 30 = $2200.

Step 3#

Calculate the interest owed for the month by taking the daily interest rate from step 1, multiplying it by the average daily balance from step 2, and multiplying it by the number of days in the month. For the month of April, we'll owe 0.038% $2200 30 = $25.08¹

TL;DR: Pay your balance in full every month on time. If you can't, you probably shouldn't be using a credit card.

Why should you use a credit card?#

You might ask, "didn't you just say I'd have to pay interest if I keep a balance? Why would I get one of these when I can just pay for things in cash or with my debit card?" Have you ever wanted to own a house or lease an apartment or lease a car? It may seem counterintuitive, but you need to borrow money to prove to banks and other lenders that you can be trusted to pay them back. Here's some reasons why you should be using a credit card.

Credit Score#

Credit score is one of those things you always hear about, but never really understand. This number plays a huge part in your financials and your ability to borrow money. We'll talk about what a credit score is, how it's calculated, and why you should care.

What is it?#

Your credit score is kind of like your grade for how trustworthy you are to lend money to.

The credit score model was created by the Fair Isaac Corporation (FICO), and the FICO score is the most commonly used credit score. FICO scores range from:

Excellent: 800 to 850
Very Good: 740 to 799
Good: 670 to 739
Fair: 580 to 669
Poor: 300 to 579

In the U.S., there are 3 major credit reporting agencies: Experian, Equifax, and Transunion. These agencies collect our financial data to generate a report detailing our credit history. A credit score is essentially a summary of our credit report.

Factors#

There are 5 major factors considered in calculating your FICO credit score. The percentages vary per person, but they are as follows:

Payment history (35%) Based on questions like: Have you been paying back the money you borrow? Have you had any overdue payments? How long has it been since your payment was overdue?
Amount you owe (30%). Based on questions like: How much do you owe total? Credit utilization or what percentage of your credit limit are you using?
Length of credit history (15%). Based on questions like: How long have your accounts been open? How old is your most recent account? How long has it been since you used your account?
New credit you opened (10%) Based on questions like: How many recent credit inquiries have you had? When did you last open an account?
Types of credit (10%) What types of accounts do you have, or in other words, how are you borrowing money (e.g. revolving accounts where your payment may vary each month like a credit card or installment accounts where you have a fixed payment each month until you pay off your balance like a student loan or mortgage)?

Looking at two largest factors, it's pretty obvious that you should be paying your balance in full every month and making sure not to borrow too much in relation to your credit limit.

Credit Inquiries#

Before lending money to you, companies check your credit to see how risky lending to you will be. Credit inquiries (also known as credit checks or credit pulls) can either be hard or soft. Hard inquiries can lower your credit score, but soft credit checks do not affect your credit score.

Hard credit checks are required before a lender decides to give you credit. These inquiries pull your full credit history from one or more of the credit reporting agencies. Hard credit checks will cause a small credit score decrease, and it lasts on your credit score for 2 years. If you have a lot of hard inquiries in a short amount of time, lenders will see you as riskier.

Soft credit checks may occur if a landlord performs a background check, if you request one yourself, preapprovals for loans, and other situations. These provide less information, and do not affect your credit score. They're still listed on your credit report.

How does it impact you?#

Would you rather lend money to someone who borrows small amounts and consistently pays it back or to someone who borrows tons of money and never pays you back? Obviously, the former. Banks and other financial institutions see it the same way. They want to lend to people who have a high probability of paying them back.

A lender takes on more risk when they give money to someone with a low credit score compared to someone with a high credit score. If a lender thinks you won't be able to pay them back, they're going to charge higher interest rates to help cover that risk of losing their money; to them, some money is better than no money. That means people with lower credit scores end up paying more money than those with higher credit scores. If your credit score isn't good enough, lenders might not even give you the option of borrowing from them.

How does this affect you? Suppose you have a bad credit score and you want to buy a house. You might have to pay higher interest rates on that borrowed money; if your score is really terrible, they might not even lend you the money at all. If you want to lease an apartment, the landlord may want to see your credit score to judge how likely you are to pay rent. Same with borrowing money to buy a car.

Basically, you want a good credit score, and you can only have a credit score if you borrow money. You just need to make sure your borrowing small amounts and paying it back consistently to maintain a good credit score.

Safety#

Credit cards offer greater safety measures than cash and debit cards. If you lose cash, that's it. You've lost it. Nothing you can do (assuming you weren't robbed at gunpoint or something). If your debit card is used by a thief, the money is immediately withdrawn from your account. You can report the fraud, but it may take a while for the money to be returned to your account. Because you're just borrowing money with a credit card, you don't actually lose any money if your credit card is fraudulently used. You just report the fraud and the credit card company will take care of it, generally without you having to pay a dime.

Perks#

Many credit cards offer perks which make them even nicer to use. Some offer cash back on a certain percentage or on certain purchases. You can earn money back for stuff you would have bought anyways! They might have reward points which can be exchanged for things like travel or gift cards. And others might also offer frequent-flyer miles which can be redeemed for flights.

Credit cards are not for everyone#

Even though everyone should probably eventually have a credit card, it may not always be the right time to get one. You might think twice or even consider avoiding a credit card if:

You cannot pay the balance in full on time
You think you may overspend or lack self-discipline
You have a lot of debt
You don't have a good understanding of how credit cards work (hopefully you have a good idea of how they work by the time you finish reading this)

There are ways to manage a credit card even if you fall into categories 2 (e.g. make a strict budget), 3 (e.g. pay for essentials that you need to buy regardless and have the cash to pay for), or 4 (e.g. do more research). If you are fall into category 1, you should probably avoid credit cards for now.

Choosing a credit card#

Before applying for a credit card, you should do some research to identify one that would be best for you. Some things for you to consider:

APR. If you're paying off your credit card balance every month, the APR isn't too important since you won't be paying any interest.
Fees. Be aware of any fees you might have to pay. You can usually avoid most fees by paying your balance on time and not exceeding your credit limit. Some companies might have an annual fee for using their card.
Perks. Look to see what perks are included with the card. Maybe you travel a lot so you want frequent-flyer miles. Maybe you're a student so you can get a bonus for getting good grades. Maybe you spend a lot on groceries and get cash back for grocery stores. Maybe you get a one-time bonus for signing up.

The bottom of the line is to make sure you know what you're signing up for and how it all works.

Applying for a credit card#

Now that we know what a credit card is, how it works, and why we should use one, let's talk about how we go about getting one.

First, it might be useful to check your credit score. Remember that applying for a new line of credit may cause a slight drop in your credit score because of a hard credit check, so you don't want to apply to a bunch and get denied. Also, credit card companies sometimes list what range your credit score should be in order to be approved for a particular card. It's a good idea to have a pulse on your credit score anyways. You can get a free FICO credit score through Discover even if you're not a Discover customer. Also, you can get one free credit report per year from annualcreditreport.com. If you don't have a credit history or have a low credit score, it may be useful to look into secured credit cards, retail store cards, getting a cosigner, or becoming an authorized user on someone else's credit card.

Once you've confirmed you have a decent credit score, you just have to fill out the credit card application on the company's website. They'll ask for personal information like name, date of birth, Social Security number, employment status, income, housing costs, contact information, etc.

If your credit card company compounds your interest daily rather than monthly, the charge will be slightly higher. The point is not the math though. The point is that you'll have to pay additional money if you keep a balance on your credit card.)↩