Credit card basics

A credit card provides access to a line of credit you can use to make purchases or access cash. When used wisely a credit card can help in building credit, making convenient purchases, and earning rewards. However, when used irresponsibly, it can become a counterintuitive asset that may leave you burdened with debt. Understanding credit card basics may help you utilize credit and manage debt in meaningful, impactful ways that can help you meet important financial goals.

Credit cards are a line of credit issued by financial institutions such as banks or credit unions. When you apply for a credit card, the issuer reviews your credit history and other information to assess your creditworthiness, aka—the likelihood that you will repay them. Your creditworthiness may be the deciding factor if you’re offered a line of credit or not.

Once approved for a credit card, the issuer will determine your credit limit and interest rate based on a few factors, including your credit history and income. Your credit limit is the maximum amount of money you can borrow or charge on the card. The interest rate is essentially how much you’re being charged to borrow that money.

When you use a credit card, the card issuer pays the cost of your purchase upfront with the expectation that you’ll pay back the amount at a later date, preferably your payment due date. Typically, you’ll receive a statement – an itemized bill of all of the charged transactions- every 30 days or so. From there, you can decide to pay the money back in full or pay a portion of the debt. Should you choose to carry a balance, a minimum payment is generally required each month, and late fees may be assessed if you don’t pay the minimum amount by the due date. Note that, if you don’t pay your bill in full, you will have to pay interest on the amount borrowed.  

Making a misstep with a credit card can cost you money in both the short-term—in the form of interest—and in the long-term if you have to pay more to get loans in the future due to poor credit. Managing your credit cards responsibly can help you build your credit score and improve your credit history.

Though credit and debit cards can be used in similar ways, there are important differences. Normally, a debit card is linked to a cash available account like a checking or brokerage account. Money spent with your debit card is immediately deducted from the account balance, and typically you cannot spend more than the available balance of that account. In the event you do, you may be subject to fees such as insufficient funds or overdraft fees.

Additionally, debit cards:

• Do require a bank account
• Do not help build credit nor do they impact your credit score or history
• Do not accrue interest charges

To attract borrowers, credit card companies offer a variety of cards with different benefits to the user. Here are some common cards:

Rewards credit cards: This type of credit card offers rewards when you make a purchase. These rewards can be in the form of cash, miles, or points.

• Cash-back rewards: A credit card that offers cash back, typically up to 2% of spending, although some cards offer higher cash back rates for spending in certain categories.
• Points: You can earn points based on your spending. You can redeem those cards to redeem for a variety of rewards ranging from travel to gift cards.
• Frequent-flyer miles: Some credit cards have partnered with airlines to reward you with frequent flyer miles based on the amount you spend.

Store-branded credit cards: Retailers may offer credit cards for use in their store only. The retailer will likely provide discounts and rewards points to cardholders, but these cards typically have higher interest rates than other types of cards.

Charge cards: These cards require the balance to be paid off in full every month. They generally have no preset spending limit and are best for people who have the income to pay off the bill every month, or who are looking for control on how much they can charge every month. 

Note that some credit cards, especially rewards credit cards, may charge you an annual fee.

Though credit cards can be a convenient option to make purchases while also accruing other benefits, they carry higher interest rates than many other types of debt, so it’s important to use them responsibly. If left unchecked over time, credit card debt can be very damaging to your overall financial condition.

To avoid that, try to pay off your balance in full every month, and on time. This will not only improve your credit score by showing that you pay your bills promptly, but also avoid potentially steep late fees. Not paying in full means your balance will incur interest and could potentially lead to a large credit card balance you’re unable to pay over a period of months or even years. Note that the entire unpaid balance, including interest and fees, may bear interest. This may mean that you’re paying “interest on interest” in a way that can unfortunately compound a destructive debt cycle very quickly.

When applying for or using a credit card make sure you understand the terms of the card, including the interest rate charged and any late fees, as well as the card benefits. Understanding these terms can help you enjoy the convenience of credit without falling into unmanageable debt.

The views expressed in this article are from Morgan Stanley Wealth Management. The original content has been modified for E*TRADE from Morgan Stanley audiences.

CRC# 3767137 09/2024