Credit card. What is it?

If you have  read my first blog post, you may find it tempting to apply for a credit card if you do not already have one. And you should. But I’d like to give you an overview of what exactly you’re stepping into.

So what is a credit card?

A credit card is a plastic card that … Wrong! This is not the right approach. A credit card in the modern sense is no longer simply a piece of plastic that you swipe at the restaurant. It started out that way, but inasmuch as money is no longer just a piece of paper, the credit card has witnessed its own evolution with the help from technology and information transparency. Nowadays, a credit card is a financial account, whose information is shared between creditors under limitations set by the law. A credit card is a type of financial account, just like a checking account is. The main difference is that a credit card balance is the money you owe, while a check account balance is the money you own.

Some people confuse a credit card with a debit card. A debit card is connected to your checking or savings account. Every time you make a transaction, all a debit card does is withdraw money from your bank account directly to execute the transaction. It’s a door that connects your bank account to the financial transaction. From your perspective, swiping a debit card has the same effect as writing a check in the sense that money gets withdrawn directly from your bank account. As a result of this, it’s hard to dispute a transaction made on your debit card, since the money has already been withdrawn from your bank account and you’d have to fight to claim it back.

A credit card, on the other hand, is a loan that the creditor extends to you. When you make a transaction, the money gets withdrawn from the creditor’s assets. For the next couple days, the transaction will appear as pending. If you do not dispute the transaction, it will post on your credit card account, and until you pay your balance, you have not spent any money. If you dispute a transaction, that means you refuse to pay for it, and the bank will have to settle the issue with the merchant, otherwise they do not get any money. See how easier this is for you? Yes, that’s another reason you should have a credit card.

Also, very importantly, debit cards do not offer benefits such as rental car insurance and warranty extension as credit cards do.

More on a credit card being a loan. Say you have credit card with a $2,000 limit from Bank of America. This means that for a period of one month, from the closing of one statement to the next, the bank gives you a loan of $2,000 that you should pay back at the end of the period. You do not have to fully utilize this $2,000; this amount is the maximum amount you can spend from this loan. The unused portion will be automatically applied toward the re-payment of the loan. Suppose that you obtained such a card in October and made purchases totaling $500 on it. The unused $1,500 is automatically applied toward the loan re-payment, so you only have to pay back $500. In November, your credit card statement will show a balance of $500. You have a couple of weeks to pay this back. Now you don’t have to pay all of this back yet. The creditor will ask you to make a ‘minimum payment‘, which you absolutely have to make. The rest, if not paid within a couple of weeks, will accrue interest and will become more costly to pay back.

What does this mean to you? Every month, you absolutely have to make at least the minimum payment. I always pay the balance in full so I pay zero in interest. If you fail to make the minimum payment, your credit history will be severely impacted and will take years to recover. If you do not pay the balance in full, it will be more costly to pay it later, but your credit history will not be affected. If you always pay in full like I do, you’re golden.

When I was in college the thought of getting a credit card never crossed my mind. This was the result of an unfortunate economic event: the 2007 financial crisis, in which people fell into a financial abyss and blamed that on credit cards. I heard so many bad things about credit cards that I thought they were as evil as Hitler. This is about as true as the statement that ‘money is the root of all evil’. But the problem was that many people were using credit cards in a wrong way. Instead of using credit cards as a means of payment, they were using them to live beyond their means. Like I said, a credit card is a loan. If you use it for wrong purposes and are not able to pay it back, that is not the loan’s fault. If you make a big purchase on your credit card only because you have the ability to, without regards of whether you’ll be able to pay back the amount in the future, that’s using credit cards for the wrong purpose. If you are a reader of my blog, I hope you never make that mistake.

If you always pay in full, which I recommend, or always pay at least the minimum, you’ll be fine.
Moral of the story: a credit card is a loan. Do not spend it on unnecessary things.