5 min read
Debit Card vs. Credit Card: Which One Should You Choose?
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If you’re thinking about getting a credit card, you may be wondering “How does a credit card work?” Applying for credit cards can open up a world of possibilities for you by helping you build credit and maintain a respectable credit score.
Lesson Notes:
- A credit card gives you access to a revolving line of credit that you can borrow against, requiring you to pay back the money you borrowed plus interest.
- Having a good payment history and paying off your monthly balances can help you build credit and increase your credit score.
- It’s important to use a credit card responsibly by not overspending and paying off your balance every month; otherwise, you’ll have to pay more in interest and may go into debt.
LESSON CONTENTS
Using a Credit Card
When you use a credit card responsibly, you can establish a credit history that will help you later in life. Lenders assess how you handle credit when you apply for an auto or home loan and make decisions based on whether you have good credit or poor credit.
When you have a credit card, you enter into an agreement with the issuing financial institution. The card issuer agrees to extend credit to you up to the card’s limit, and in return, you commit to making a minimum payment every month. The minimum payment is calculated according to the interest rate agreed upon with the card issuer.
Each month, you are required to pay the accrued interest on the balance, along with a small principal payment intended for the balance itself. Unless you are in a special interest-free grace period, you’re being charged interest monthly if you have an outstanding balance. Paying the balance in full before receiving your monthly statement typically helps you avoid interest charges.
The key to using credit cards is to exercise responsibility and avoid overextending yourself. The best way to use your credit card wisely is to use the card only for the amounts you could easily cover in cash and to pay off your balance each month.
How Do Card Issuers Make Money?
It’s important to be aware of how credit card companies make their money, so you can avoid making mistakes that will cost you later.
Credit cards come with interest, which benefits the card issuer. You must stay current with your payment because lenders typically charge you a fee if you fall behind on your monthly credit card payment. Some lenders may increase the interest rate if you fall behind on one or multiple payments. Use direct deposit to automatically pay off your credit card debt every month.
Many credit cards have rewards or point systems that encourage you to buy things on credit. These points can help you save money, but you should avoid spending more than you can afford. As you continue making payments, you will free up additional credit that can go towards future purchases.
Some cards may also come with annual fees, foreign transaction fees, cash advance fees and other costs that can add up over time. Understanding your credit card agreement can help you avoid or negotiate away some of these fees.
If you have trouble paying off your credit card balance because of high interest rates, you can always transfer your unpaid balance to a balance transfer credit card with a lower interest rate to save money. The balance transfer card has a low introductory interest rate that will help you pay off the principal balance, so pay off as much debt as possible before the full interest rate applies. Note that you will incur balance transfer fees when choosing this option.
Credit Cards vs. Debit Cards
Debit cards often look like credit cards and work in the same payment systems as credit cards, such as Mastercard and Visa. However, they are connected to your checking account instead of being connected to a credit line. When you use a debit card, you spend money from your own account, not a line of credit. Your financial institution might allow you to exceed your available balance on your debit card with overdraft protection up to a certain limit.
If you need more money than what’s available in your account, some lenders may give the option of adding a line of credit to your debit card, which is usually much cheaper than paying overdraft fees.
When you use debit cards, you’re less likely to overspend since you can typically see your checking account balance in real time. You won’t build credit using debit cards, but you also won’t have to pay interest on your spending.
Unsecured vs. Secured Credit Cards
It can be hard to get a credit card if you don’t have a good credit score or have a limited credit history. However, you may be able to get a secured credit card.
While an unsecured card requires the card issuer to advance your credit on the assumption that you will pay it back, a secured credit card requires a security deposit, which is then used as collateral. The amount you deposit is your credit limit. For example, you may deposit $300 to obtain a credit line of $300. If you default, the card issuer can use the deposit to pay off your balance.
The secured amount is usually small because you are learning how to manage your credit wisely and how credit cards work. Your card issuer may slowly increase your credit limit over time by allowing you to make a larger deposit—if you demonstrate a history of paying your bills on time.
Eventually, if you develop a good payment history, they may offer you an unsecured line of credit much larger than your secured line. Secured credit cards can be an important part of learning how to handle credit and a great way to build your credit history to raise your credit score.
The Credit Card Transaction Process
So, how do credit union credit cards work physically? When you use a credit card at a store or give your credit card number for an online or over-the-phone transaction, the payment system asks for authorization from the credit card network to process the payment.
The network contacts your financial institution so your card issuer can verify your information. Your card issuer will either approve or decline the transaction. This process only takes a few seconds, thanks to the speed of electronic communication.
The payment is completed when your transaction is approved, and the appropriate amount is debited against your credit limit. At the end of the billing cycle, your card issuer sends you a statement. Your statement shows every transaction you made during the month, including all purchases and payments made on your account.
Your statement also shows your previous balance from the end of the last statement, your new balance, your minimum payment due, and your due date. If you carry the balance from month to month, you’ll see the interest rate and amount listed on your statement. Your credit remains in good standing as long as you pay by the due date. If you pay off your balance, you can avoid interest charges.
Credit Card Fraud
You need to keep your credit card details secure and secret. Keep your statements in a safe place. If your credit card is lost or stolen, call the number on your statement to report it so they can cancel the card.
If someone used your card to make unauthorized purchases, you usually have some protection if you report the loss as soon as possible. Most credit card issuers offer zero-liability fraud protection so you won’t be on the hook if someone steals your card and spends a lot of money with it.
Be smart with your credit card, especially if this is your first time buying things on credit. Use it for amounts you can cover in cash to get started and pay off your balance in full every month.
*PLEASE NOTE: This article is intended to be used for informational purposes and should not be considered financial advice. Consult a financial advisor, accountant or other financial professional to learn more about what strategies are appropriate for your situation.
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