Credit card basics
E*TRADE Capital Management, LLC in collaboration with Morgan Stanley Wealth Management102/08/22
Summary: Learn about the differences between credit and debit cards, the various card types, and how to avoid destructive debt.
Thinking about getting a credit card? Make sure you know the basics so you can find a card that fits your needs.
Credit cards vs. debit cards
A credit card provides access to a line of credit you can use to make purchases.
Though credit and debit cards can be used in similar ways, there are important differences. Payments from your debit card are usually linked to either a bank or brokerage account. Money spent via a debit card is immediately deducted from your bank account and you will typically not be permitted to spend more than is in the linked account.
With a credit card, when you make a purchase, you are borrowing money from a bank or financial firm with the promise to repay the amount in the future. In order to get a credit card, you must apply to the card issuer. The issuer will check your credit history and other information to assess your creditworthiness—the likelihood that you will repay them. Your credit history and income are used to determine the amount of money you’re allowed to borrow and the interest rate that will be associated to the card.
The credit limit of your card is the maximum amount of money that you’re allowed to charge on that card. Credit cards typically allow you to not pay your bill off in full when it’s due and instead carry a balance. A minimum payment is generally required each month, however, and late fees may be assessed if you don’t pay the required 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 when you carry a balance. Your interest rate, also referred to as annual percentage rate (APR), will be the rate of interest you pay on that balance.
Types of credit cards
To attract borrowers, credit card companies offer a variety of cards with different benefits to the user. Below is a sampling of common cards.
Rewards credit cards: This type of credit card gives you something back when you make a purchase. These rewards can be in the form of cash or points.
- Cash-back rewards: A credit card that offers cash back, typically between 1% and 3% of how much you spent.
- Points: You can earn points based on the amount you spend 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 that are specially designed for their store. The retailer will likely provide discounts and rewards points to cardholders.
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 a control on how much they are able to charge every month.
Note that some credit cards, especially rewards credit cards, may charge you an annual fee.
How to avoid falling into destructive debt
Though credit cards can be a convenient option to make purchases while also accruing other benefits, it’s possible to fall into long-term, high-interest debt when using them. If left unchecked over time, this type of 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 help improve your credit score by showing that you pay your bills promptly, while avoiding potentially steep late fees. Not paying in full means your balance will incur interest expenses and could lead to a growing 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 more quickly than you might think.
When applying for or using a credit card make sure that 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 Securities and E*TRADE Capital Management, LLC audiences.
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