When you’re young and still living with your mom and dad (literally no judgement), credit cards seem like magical passes to purchase whatever you want.
When you’re a bit older and realize just how massively it sucks to get that first bill and have to pay it off (on your own), they don’t seem as magical. However, they come with some great benefits you’re able to enjoy once you get the hang of annual fees, credit scores, interest rates, and other boring terms adults have to know.
Having a credit card in college or as a recent grad is different from understanding how credit cards work. Sure, they can open lots of doors for you, as long as you know how to use them all correctly. To understand how credit cards work, we’re going to give you a crash course in credit, then we’ll move on to figuring out how to get your first starter credit card so you can start building your financial future.
What is credit?
At its core, credit is basically trust. A company offering you a line of credit is trusting that you’re financially responsible enough to pay that money back as you spend it. How do they know you’re financially responsible? By looking at your credit report, which includes your credit score, employer information, and other things that say “Okay, yeah, you’re good to lend to this person.”
What’s a credit score?
If credit is trust between you and a lender (like a bank, mortgage company, etc.), then your credit score is how you’ll build that trust. What about terms like “FICO score?” That refers to the model that’s used to generate your credit score.
Different credit reporting agencies (there are three main ones) compile your information to generate your credit score. Most credit scoring models range from 300 to 850, and it’s generally accepted that to have “good” credit, you need a score above about 670.
Are there different types of credit?
Yep! There are three major ones you’ll need to know in order to begin setting up your financial life.
- Installment Credit: With this type of credit, you agree to borrow a set amount of money and pay it back in installments over time. Student loans are a great example of installment credit as you borrow, let’s say, $30,000 and agree to pay back $200 per month until you’ve paid off the loan and interest.
- Revolving Credit: Credit cards are the best example of revolving credit, which is when someone gives you a set line of credit ($1,000 for example) and that same amount is available to spend each month as long as you make payments on time.
- Open Credit: Open credit means you’re just free to spend whatever you want, right? Nah, unfortunately not. This refers to a situation where you use something such as gas or electricity and the company is essentially “lending” it to you on credit for the month and sending you a bill for it at the end of that month. The amount you owe each month varies depending on how much you use, but the account is an open credit account.
So, how do credit cards work?
Well, we’ve established that credit cards are a form of revolving credit, right? And to take out any line of credit you need a good credit score. So, to apply for a credit card, you’ll submit an application that includes your credit score. Most credit card companies and banks will let you know the minimum score before you apply.
If you’re approved, you’ll be approved for a specific line of credit, which is the highest amount of cash you can spend each month. Before receiving your shiny new card, though, you’ll need to digitally sign an agreement that includes the terms of your new credit card, including annual fees, interest rates, and other important information. For real, read this!
- Credit Limit: The amount of cash you can spend each month.
- APR: This stands for annual percentage rate, which is the interest you’re charged each year.
- Balance: Once you have the card and create your online account, you can access your balance, which is how much you’ve spent and owe back.
- Available Credit: Again, on your online account, you’ll see the available credit you have to spend that month.
- Billing Cycle: This is crucial (we repeat, crucial) to look at. If your payments are due on the 15th each month, go ahead and set up auto payment to ensure you don’t miss it.
- Foreign Transaction Fees: Studying abroad? Spending a gap year in Europe? Foreign transaction fees range from 1 to 3% of the charge amount every time you swipe with a foreign merchant overseas (or sometimes purchase goods online via a foreign shop).
As a young savvy spender like yourself, it’s likely that you’ll just use the card for small, simple purchases. Go ahead and link your bank account to the credit card so that you can set up auto payments. Each month, they’ll take the cash out of your bank account (checking or savings account, you decide), to pay your due balance on the credit card. Disclaimer about linking your bank account to your credit card for auto payments: you need to make sure you have enough money in your bank account to pay off the bill.
Most of the time, there’s a minimum payment you have to make. So, if your credit limit is $1,000 and you charge $250 worth of stuff to the card this month but only have to make a minimum payment of $25, you can do that. Keep in mind that the balance can accrue interest, though. If you’ve ever dealt with student loans at all, you know just how horrible interest is and how fast it can creep up on you.
Things you should have learned about finances in school
We could go on and on with this list, but it’s suffice to say that there’s no shortage of things you should have been taught in school but weren’t when it comes to finances. Learning how credit cards work is just one of them. Anything else you have questions about? Of course there is.
And, lucky for you, we’ve got lessons for that. Check out our easy-to-understand crash courses on things like healthcare, investing, and taxes here.