Credit Card Basics
What is a Credit Card?
Simply, a credit card is an extension of credit given to somebody from a bank. To understand how a credit card functions, we must first understand what credit is. Credit is money borrowed by an individual from somebody else. The borrower agrees to pay back that money in regular installments over a specified period. For example, if you were to loan a friend $10 and ask for it back tomorrow, you would be crediting that person $10. In this example, you are the lender, and your friend would be the borrower.
A credit card works in the same fashion. A bank will give you a credit limit (the amount of money you are eligible to borrow) and allow you to pay off that credited money within the loan period. To incentivize using a credit card, the bank offers rewards on their cards, including air miles, points redeemable for specific products, and cashback. These rewards can vary by bank and card type, with some cards requiring annual membership fees to possess. Cards can also have minimum spend requirements, meaning extra incentives if a minimum monthly spend is achieved.
Typically, a credit card would be paid off once a month with the total “Statement Balance,” the total amount of money spent on the card between the dates of the previous statement. There is usually a 21-day grace period in which the previous statement balance must be paid off before financial penalties are imposed. These financial penalties are discussed in great length in this article’s Payment Options section. Assuming the balance is paid, your card balance is set to zero, and you are free to spend up to your credit limit for the next statement period. Over time, if you are paying your card balance in time, the bank will begin to offer you more credit, meaning a larger monthly limit. The amount the bank is willing to offer is directly correlated to your income and credit; a topic also explored later in Payment Options.
Credit Score
A credit score is a score you are given from 300 to 900, with 900 being the highest score possible. This is a no “default credit score,” so the only way to get rated is to have a credit history. A high credit score is incredibly useful, as it can help you qualify for lower loan rates. These rates can be used for a mortgage, car loan, or any other reason you may need to borrow money from the bank. In addition, a higher credit score shows the bank that you have a strong history of borrowing money and paying it back on time. In other words, it allows the bank to trust that you will pay them back.
To help visualize how a higher credit score can impact your ability to borrow money, let’s look at the loan rates for a $10,000 car. To simplify this example, we will assume a 20% down payment ($2,000) is required, and the other $8,000 will be financed over a 36-month term. This example assumes all else being equal (income, other loans, etc.), having a higher credit score can lead to a lower interest rate.
Although overly simplified, the above example shows why increasing your credit score can be so valuable. It allows you access to lower rates when loaning money for big purchases, giving you more financial freedom.
By activating and using a credit card, you are building credit. To help ensure your credit score is not impacted, ensure you avoid late payments and overspending (going over your credit limit).
Payment Options
When a statement period is over, you must pay the bill for the balance of the statement. It is important to remember that you do not have to pay the entire balance. There is a minimum payment which is usually $10 or 3% of the statement balance, depending on your bank. You can pay any amount between the minimum payment and the statement balance. Payment periods can vary by company and card type, but the mandated minimum grace period is 21 days. This “grace period” is the amount of time after the current statement ends that is available for the minimum payment, or any amount between the minimum and the statement balance to be paid. If the full payment is made before the period ends, no interest is applied to the total amount.
Your credit score will not be negatively impacted by paying the minimum payment, which is why you should always pay at least this amount. However, there will be interest on the amount you don’t pay. Credit card companies make their money from the public in this regard, as the interest they charge on the “loaned” money is much higher than most other types of loan. The interest rates on most Canadian credit cards range from 15%-24% annually, which is exceptionally high compared to other types of loans. For example, the average mortgage rate in Canada hovers around 3.09% interest. To understand just how high credit card interest rates are and how that interest compounds, let’s assume we spend $500 in one month.
Again, this example will be oversimplified, but to help make this more realistic, we will pretend you have just purchased a new phone. As shown in the chart below, just 12 months without making a payment on just one $500 phone can compound to cost significantly more.
Using this example, you can see how by just paying the minimum monthly payment, the compound interest can cause the cost of that item to skyrocket. A $500 purchase over $100 in interest in just 12 months.
Again, this is how most banks make money even while offering reward programs: the interest rates are far larger than the benefits provided, so it only takes one period of minimum or no payment to make up for dozens of periods of rewards.
Other cards such as America Express (AMEX) don’t allow you to pay part of the principal down and instead are structured to be paid off in full every month. Because these cards have membership fees, the structure of the card allows the bank from those rather than interest, so they prefer to have their dues paid in full monthly.
If you simply don’t pay on time, your credit score will decrease, and these interest rates will be applied regardless. When using a credit card, you must understand how much you are spending and plan how to pay off that amount.
Types of Credit Cards
As mentioned throughout this article, multiple cards offer different rewards. Here are the most common:
Cash Back Cards
A cashback rewards card usually gives a certain percentage of purchases made back in actual dollars. For example, TD's cashback card offers 0.5% on most normal purchases and 1% on eligible purchases within categories like groceries, regularly recurring bill payments, and gas purchases. These cards can vary in the amount they give depending on corporate agreements, sometimes allowing certain cards to benefit specific individuals. For example, Tangerine offers a card that enables users to pick two categories to earn 2% back on all purchases. Suppose your job requires you to drive often and uses a reimbursement structure to pay you back for purchasing gas. In this case, Tangerine's card could be leveraged to make 2% on all of your gas purchases.
Travel Rewards Cards
Travel rewards cards usually give a certain number of "Flyer Miles," or points that can be redeemed with specific airlines for flights in the future. Once you have enough "Flyer Miles" to go on a flight, you can redeem the miles you have collected such that you can fully pay for the flight. As a result, these cards traditionally offer a higher value compared to a cashback card, as there is a limited number of ways in which you can redeem these rewards.
Again, banks usually have corporate agreements with specific airlines or airline alliances, so these points may only be redeemable with certain flights.
Product Points Cards
A points card is similar to a rewards program at a retail store. As you spend money with a specific vendor, you are awarded points that can be used to purchase products later. This is very similar to a cashback card, except you gain points through use rather than actual money. Also, these points are only redeemable on specific products. Again, this card style is more limiting than cashback but has better rewards per dollar spent.