Is a credit card really a loan? Understanding how a credit card works can make it easier for you to use it as well as to pay your account summary. The following are some of the basics.
The short answer is that credit card and loan are extensions of your credit, but how that credit is obtained and returned is different in each case. There are substantial differences between these two types of financial options that you should consider in your financial plans.
How credit cards work
When you use a credit card to make a purchase, what you do is borrow funds to pay the merchant. The credit card issuer advances funds to pay the merchant for each purchase he makes, and then charges the credit card amount to the credit card account. Depending on the type of account you have, you may also be able to request cash advances or transfer balances with your account to pay other creditors.
The issuer has a record of all charges in your account and sends you a statement, usually on a monthly basis. Each statement shows you the total balance you owe on the account and the amount of your next payment. According to the issuer, your monthly payment may be the total balance or a small percentage of that balance.
The issuer assigns a credit limit to your card account. Once you reach that limit, you cannot use it for new transactions. If you try to make a purchase when your card has reached its maximum limit, you may be declined.
However, as you pay your account balance, you will have more available balance and can use it again, until you reach the available credit limit. Credit card and other accounts that allow you to use, return and reuse your credit are known as “renewable” credit.
Keep in mind that the fact that you can spend up to a certain amount does not mean you should do it. An important factor when calculating your credit score is your “credit utilization rate”, which reflects how much you actually use of your credit limit. For example, if your credit card limit is $10,000 and your balance is $2,000, your credit utilization rate is 20 percent. Experts recommend that your credit utilization rate be below 30 percent.
How a loan works
A loan is a bit different from a credit card. As it is not a renewable credit, it has no credit limit. Instead, the loan is delivered as a total lump sum. You must repay the loan over a specified period, usually through monthly installments.
Depending on the type of loan, the funds can be deposited into your bank account or directly applied to the payment of a purchase, such as a house or a car. If you need more money later, you must apply for another loan.
When interest rates apply
Generally, interest is charged on all types of credit granting. While credit card issuers may not charge interest on purchases if you pay the total balance every month, they generally charge interest on cash advances and balance transfers as of the date of the transaction.
It is very important that you read the agreement and other legal notices that come with the credit cards and loans you receive to understand when and how much interest you may be charged.
The cost of borrowing money is measured through an annual interest rate, or APR, that reflects the annual interest rate and, in the case of loans, other fees and charges that may be imposed when the loan is granted. When looking for credit cards and / or loans, compare the APR offered by different lenders.
Interest rates can be fixed, variable or adjustable. Generally, credit cards have variable APRs that fluctuate with changes in the main rate.
Loans, especially mortgage loans, can offer adjustable rate options, which change over the term of the loan. If your interest rate can be modified, find out with your lender how the rate is set and how it can be modified.
How to use your credit intelligently
Using your credit card wisely allows you to create a solid credit history. This credit history can benefit you later because it shows lenders that you have a good track record regarding your debts.
Having a good credit history helps you qualify for a loan and can also help you guarantee a good interest rate, saving you money.
Paying on time is the most important thing you can do to create a solid credit rating. Using your credit card to make some purchases every month and trying to pay all bills before the due date contributes to your credit rating .
Paying your entire balance every month also allows you to save money on interest.
The better you understand the terms of your credit card, the better you can use it to reach your financial goals.