How Do Credit Cards Work?

Have you ever read one of the cardholder agreements
for one of your credit cards? If you're like most people the answer is no. And I don't blame you. Those agreements are written in legalese and squeezed together in tiny little print that is barely legible.

The truth is that credit card companies don't really want you to read it. They'd rather you remain ignorant. But it is extremely important that you understand the key terms of the agreement that explain how your balance is calculated and what triggers fees or interest rate increases.

Understanding the terms of your credit card agreement will help you to compare cards, to know when you should switch to a new card, and to save money by working the system.

To get you started, here is a list of key terms used in credit card agreements and what they mean:

Preapproved - How many times have you received an offer in the mail stating that you have been 'preapproved' for a credit card?

This is a somewhat deceptive practice as you have by no means been preapproved for anything. All it means is that you met some initial criteria for creditworthiness. There is no guarantee you will be approved for the card if you choose to apply.

Annual Fee - Many credit cards charge an annual membership fee to their cardholders. Typically, the charge ranges from around $25 to $75, but some premium cards charge as much as several hundred dollars.

Transaction Fee - Credit card issuers usually charge a fee for transactions other than purchases, such as cash advances and balance transfers, though they sometimes waive these fees for new cardholders as part of their introductory offer. The fee amount is usually calculated as a percentage of the transaction, though a minimum fee applies. Some issuers cap the fee at a certain dollar amount, but
those are now few and far between.

Grace Period - Taking advantage of a credit card's grace period will let you avoid paying finance charges by paying your balance in full before the due date.

If there is no grace period, interest will begin accruing the day you use the card. But if the card has a grace period of say 21 days, interest will not begin accruing for 3 weeks as long as you paid your balance in full the previous month.

Smart consumers use the grace period to avoid paying finance charges on their purchases while still having the convenience of using a credit card instead of cash.

Easy To Get Credit Cards

The most important and powerful factor in determining the true cost of your credit card is the Annual Percentage Rate (APR). This is the amount of interest charged on the card's balance expressed as an yearly rate. In order to calculate your monthly finance charge, the APR is divided into a periodic rate, usually daily.

In order to calculate the daily interest rate, simply divide the annual rate by 365.

Example: 14.99% / 365 = .04106849315%

Your credit card's interest rate can be either variable or fixed. A variable rate is linked to an economic indicator such as the Prime Rate and it fluctuates with the economy. A fixed rate does not fluctuate with the economy, but is instead set by the credit card issuer. But don't let the name fool you. The rate is anything but fixed. The issuer can increase your rate whenever they want as long as they give you advance notice.

Another way your interest rate can increase is if you miss a payment or send one in late. The credit card company can use this as an excuse to jack up your rate to obscene levels.

Balance Computation Methods

Credit card companies use different methods for calculating your balance. Whichever method they use, it must be clearly indicated on your statement and in the cardholder agreement. The majority of credit card companies use one of the following three methods:

1. Average Daily Balance. This is the most common calculation method. The issuer simply takes your balance from each day in the billing period, adds them all up, and then divides by the number of days in the billing period. Any credits to your account for the month are deducted, but purchases are usually not included.

2. Adjusted Balance. This is the most consumer-friendly calculation method. The issuer simply takes your outstanding balance at the beginning of the billing cycle and subtracts and payments or credits. For example, if your beginning balance was $1,000 and you made a payment of $125, interest would only be charged on the remaining $875. Purchases are always excluded when using the Adjusted Balance method.

3. Two-Cycle Balance. This is the least advantageous calculation method for consumers. It works just like the Average Daily Balance Method but it uses the prior two billing cycles instead of just the most recent.

Apply Visa Card