The Ultimate Guide to Understanding Credit Cards

December 9, 2022
6 min read
Thomas Kopelman

Some people love credit cards while others think they are the worst financial tool out there. Personally, we think credit cards can be an awesome tool when used correctly.

Keyword - “correctly”

In this guide, we're going to walk through:

  • What credit cards are
  • Pros and cons
  • Types of credit cards
  • The terms you need to know
  • Best practices
  • Your credit score and how it is determined

What are Credit Cards?

A credit card allows you to borrow money from a bank where there is an agreement that you will pay them back at your bills due date. If you do not pay it off by then, you will receive interest rates known as annual percentage rate (APR).

This APR is where credit cards can become dangerous since most have a rate close to 25%. This means if you hold a $10,000 balance on a card for a year, on average, you would owe $2,500 of interest. That's a lot of wasted money.

Some credit cards (most) offer you sign on promotions/bonuses as well as rewards for how much you use them. Some come in points, others cash back, etc. all of which can be awesome!

The problem is, if you have any interest accumulating on your balance, that will be far worse than the benefits you receive in points.

The pros and cons are pretty self explanatory, but the one I want to talk about is safety.

Most people do not think about this, but when a debit card is hacked, it is your money lost. Let’s say you have $500 in your account and someone uses that debit card, they may drain all $500. This could result in your being short dollars wise while waiting for the money back. With a credit card, if you get hacked and $500 is spent, that is towards what you owe, not your own money gone. This is why I think they are safer!

This APR is where credit cards can become dangerous since most have a rate close to 25%. This means if you hold a $10,000 balance on a card for a year, on average, you would owe $2,500 of interest. That's a lot of wasted money.

Types of credit cards

There are many, many types of credit cards out there (some overlap), but we will walk through the most common for you to know.

Rewards Cards

These are probably the most common ones you know. They can be cash back, points or miles, etc. A good card offers at least 1% cashback/points or even up to 2%. Some of my favorite cards are: chase freedom unlimited, chase sapphire, Capital One SavorOne Cash Rewards Credit Card, etc. There are a ton of great ones for you to choose from!

Secured Cards

These are great for anyone with a low credit card score who is trying to open up a card for the first time or are trying to rebuild their credit. They work like an unsecured card but require you to make a deposit (around $200) to receive a line of credit. Some cards allow you to do it with less.

0% Cards

These are cards that offer interest free financing for a certain period of time. It may be 0% for 12, 18, or even 24 months. Be careful with these, eventually the interest will start and you will have to pay it off. Punting it down the line is not always the best move. If you have a big expenses like a new furnace being needed, you could put the whole bill on a 0% card and make sure you pay monthly payments to have it completely gone by the time the 0% ends. This can be a great tool when used correctly!

Business Cards

Anyone who is self-employed can get a business credit card. You can use it for regular business expenses and let those points add up so you can use them elsewhere. I have some clients with consumer products that get them over $50,000 cash back a year! This is a huge benefit you would not want to miss out on. Some of my favorite business cards are Capital One Spark Cash, Ink Business Unlimited® Credit Card, The Blue Business® Plus Credit Card from American Express.

Terms to Know

  • APR - This is the interest rate you have on your card. The higher the rate, the more you owe if you do not pay off your balance. A good rule of thumb is to never carry a balance on your card.
  • Credit Limit - This is how much you can spend on each card. It may be a $10,000 limit which means you cannot spend more than that. But be careful, you want to know your total credit limit because of how your utilization effects your credit score. IF you have 3 cards all with a $10k limit, you will want to make sure you do not have over $10,000 total between the 3. The goal is to have your utilization under 30%. So if total limit is $10,000 than 30% of that is roughly $10,000. Keep it under 30%.
  • Minimum Payment - This is the smallest amount you can pay each month to keep your account in good order. Most believe if you just pay that, eventually you will pay off your debt, but this is not true. You should aggressively be paying off your cards, not paying the minimum payment.
  • Billing cycle - It is the amount of time between the last statement closing date and the next. It's typically around 21 days.

Credit Card Best Practices

Always pay off your entire bill on time

Paying interest costs to your credit card company is the worst thing you can do. Have an emergency fund to ensure you are always able to do this.

Keep your credit utilization below 30%

If you have 3 cards all with a $10,000 limit, this means you have a total limit of $30,000. You at all times want to keep your total utilization below 30%. This means you want a total balance of $10,000 or lower at all times between each card. No reason to let your credit score get pushed down.

Note: You can pay off your balance more than monthly to help do this!

Monitor your monthly statement

It is easy to overlook this and not realize spending on your cards that came from someone else. Check your statements monthly to ensure you have not been hacked or incurred incorrect charges.

Maximize cards for points

Some cards give extra cash back or points in certain categories. Pay attention to these to ensure you're maximizing your total points.

Don't cancel old cards

Even if you're done with a card, you don't want to cancel it. Part of your credit score is the length of history you have and if you get rid of a card, especially the oldest, could result in your score going down.

Focus on doing all of these right and you'll be in a good spot!

Credit Score

No matter what Dave Ramsey says, your credit score matters for renting, the interest rates you get on cars, houses, etc. So let's walk through what it is, how the score is made up, etc.

Your credit score is how lending companies determine if you are a credible borrower or not. FICO is the most commonly used credit score for most lender. It's made up of 5 components:

  • Payment history (35%) - do you pay the balance on time?
  • Credit Utilization (30%) - is the ratio between how much you borrow and what your total limit is under 30%?
  • Length of credit history (15%) - how long have you used credit (the longer, the better)?
  • New credit (10%) - how often do you apply for new credit, loans, products, etc. and what amount of your credit comes from recently opened accounts?
  • Credit mix (10%) - how many different types of credit do you have?

Your FICO score can range from 300 to 850. The higher it is, the better. It can take time to build your credit score up, but it is something you want to do. And be careful, if you have a low score do not keep applying for new products after being denied - this will just hurt your score more.

Ways to build your credit score

  • Never cancel your first card
  • Ask for credit limit increases
  • Open a new card and set automatic payments
  • Pay off all cards ahead of statement closing date
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