While the basic premise of a credit card is relatively simple, the process of selecting one can be quite complex. At their most fundamental level all credit cards offer you purchasing power without cash. After that, very little is the same. Annual fees, APR’s for cash purchases, APR’s for cash advances, credit card versus charge card, compounding interest charges, late fees, and a host of rewards programs vary greatly are just some of the factors you should consider when choosing your credit card.
The Difference between a Credit Card and a Charge Card
Although most people think a credit card and a charge card are the same thing, they have very different principles. With both a credit card and a charge card, a line of credit is extended to you for the purpose of loaning you money for purchases. The difference between the two cards, however, is in how you pay back the balance owed.
A credit card sets your account limit and then lets you charge as much as you want as often as you want up until you hit your limit. (Beware: some cards will allow you to charge over your limit but there are usually fees associated with this.) Every month you are required to make a minimum payment with the option of paying any amount over the minimum including the full amount. If you do not pay the full amount you will pay interest on the money owed until your debt is paid in full. Credit cards are great because they are flexible but they can also become very expensive if you are not attentive to your spending habits and finances.
A charge card will also establish a credit limit for your account, but with a charge card you are not given the option of paying back a portion of your balance; your full balance is due every month. There are no finance charges but there is usually a substantial annual fee for the privilege of the card. Since charge cards require discipline to spend only what you can afford to pay back every month, they are usually only given to applicants with good credit scores. Charge cards are useful in that you don’t need to have cash readily available to make purchases, but they can be expensive annually and they can also become a problem if you spend more than you can afford.
Credit cards and charge cards each have their advantages. If you have good credit, excellent spending control, and organized financial habits (no revolving debt), you may decide to apply for a charge card. Some charge cards have excellent rewards programs that make the annual fee worthwhile, and so selecting a charge card can be as simple as picking a card with a low annual fee and a rewards program that suits your lifestyle. Selecting a credit card, however, is a little trickier since there are more fees involved, as is explained in the next section below.
The Costs of Credit Cards
The first things to review when selecting a credit card are the rates and fees associated with the card. Be sure to read the fine print so there are no surprises after your purchases have already been made.
Annual Fee: Some credit cards still have annual fees although most of them no longer do. Typically these fees range from $10 to $25. Obviously, selecting a card without an annual fee is usually beneficial, but you need to consider what the card is offering in exchange for that fee since it may be something of value to you.
Annual Percentage Rate (APR): The APR in its most simple definition is the rate that calculates how much interest you are going to pay on all of your credit card balances. This is where you need to do your homework and read the fine print because every bank calculates the APR differently. An APR can be based on a fixed interest rate or a variable interest rate. Also, many banks charge different APRs for purchases than they do for cash advances.
Compounding Interest: Most credit cards work with compounding interest, which very basically means you pay interest on your interest charges. For example (note: payments are not being calculated to simplify the illustration), if you have an unpaid balance of $100 and a 10% APR, your new unpaid balance is $110. The following month, your $110 will be charged your 10% APR, so now you owe $121, and so forth. APRs are usually compounded daily and sometimes monthly.
Default Rate: The default rate is the rate assigned to your card in the event you should fail to make a payment on time, if you go over your credit limit, or any other host of possibilities. Once you trigger your default rate, which is very high, usually around 29%, it is hard to get it reversed.
Fixed Interest Rate: A fixed interest rate means your rate will not change from billing cycle to billing cycle. Your rate can change, but the bank is required to give you notice before that occurs.
Grace Period: The grace period is the time allotted to a cardholder in which no interest will accrue on the current balance. The grace period usually applies to paying your balance in full by the due date in order to avoid interest charges.
Late Fee: The late fee is a set dollar amount, such as $39, that will be added to your balance anytime you are late on a payment. If you do not pay the late fee, it will become part of your compounding interest and you will be charged interest on it every month until it is paid.
Promotional Interest Rate: Promotional interest rates are sometimes known as teaser rates because they tease or tempt a cardholder by offering rates as low as 0%. These rates are only offered for a limited time, which could be as little as ninety days or as grand as one year. After the promotional period is over the standard APR kicks in and that is usually substantially higher than a non promotional card rate. Also, if you are late on a payment it triggers the default rate and sometimes charges you interest all the way back to the cost of the original purchase no matter how much of it you may have already paid down.
Variable Interest Rate: Variable interest rates are based on the current interest rate and can change often and without notice. Typically this type of interest rate is based on the prime rate plus an additional three percent.
Every credit card has its fees and charges. By understanding what the different components are and how credit cards use them to calculate your charges, you will be better prepared to select a credit card that is truly the better choice. For example, the 8% variable rate card (which is really 11%) is not cheaper than the card with the 9.75% fixed interest rate. By looking at the bank fees and reading their disclosures you may be able to choose the card with the truly lowest rate.
Choosing a Rewards Program
Once you have narrowed down your credit card selection to the one that makes the most sense for your financial needs and habits, you can further select your card to suit your lifestyle. Many cards today offer rewards programs of sorts and although rewards credit cards usually have a higher APR, they also can offer some substantial benefits.
Rewards programs are usually based on three things: cash, merchandise, and mileage. Obviously if you vacation every year or you are a business person who flies frequently, you might want to consider a mileage rewards card. If you like the idea of accumulating points to trade for merchandise, there are lots of rewards programs that cater to this. Many of these programs also offer extra incentives for shopping in their merchant network. Of course cash is a favorite for many people, whether they let it grow over the year and request one check or apply the cash as credit to their statement account every month.
Whatever program suits your lifestyle is the right one to choose, however, remember there is a caveat to a rewards program. If you are unable to pay your balance in full every month you will probably spend more money on finance charges than you will earn in rewards, so if your habits are not disciplined enough you may be better off choosing a card that does not have a rewards program but instead has a substantially lower interest rate.
Selecting a credit card can be overwhelming, but if you break it down into three basic steps it’s pretty easy. Decide between a charge card and a credit card, narrow down cards with the most satisfactory finance offers, and then choose a rewards program for added value. Our free Credit Card Chaser Tool can help you find the right credit card by helping you compare different offers now for free. Get started selecting the best credit card today!