Credit cards can be confusing. Studies have shown that while most people have a credit card—the average American has several!—few actually know how credit cards work.
Credit Cards 101
There are two important parts of the words “credit card.” The first, credit, means a loan. When you use a credit card, you are borrowing money for each purchase.
The second word, card, describes the physical traits of a credit card. Unlike a home loan, where a borrower never receives a card to charge up a home’s selling cost, a credit card is a right to receive a loan for any purchase. Simply swipe your card at a store, or enter your number online, and you agree to charge the purchase to your account.
Interest and Charges
Banks that issue credit cards make money in two different ways. First, a bank makes money by charging fees and interest charges to the credit card user. Secondly, a bank makes money by collecting fees from stores and merchants for processing a credit card.
Credit card companies make a majority of their money from interest, late fees, and other finance charges. The swipe fees, also known as interchange fees or merchant account fees, make up a much smaller portion of a credit card company’s earnings.
Credit cards have much higher costs to the user than other loans. Whereas a mortgage loan might cost only 5% per year in interest, credit card companies charge users 18% or more (some states allow interest rates of 30% or more per year) to borrow money. You now know why credit card debt is a growing problem in the United States. If your debt grows by 30% per year, then it’s very hard to pay that debt off; the debt grows just about as fast as you can possibly pay it down!
Why People Use Credit Cards?
Later in this chapter we’ll break down the many reasons people use credit cards. For now, let’s highlight the many different benefits of having a credit card:
- Easy to use
- Provide protection against credit card fraud
- Credit cards make trips to the ATM obsolete
- Some companies—car rental businesses, hotels, etc.—only accept credit cards for payment.
These are just some of the reasons people use credit cards. Continue reading to learn about how interest rates on credit cards work, and what you can do about high interest charges.
