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Whether you've been using credit cards for years or you're in the process of getting your first one, they can be confusing. Credit cards can either be incredibly dangerous or immensely helpful, depending on how you use them. This guide will walk you step-by-step through everything you need to know about using a credit card wisely.
How to Use and Manage a Credit Card
You should always handle credit cards with extreme care. If you aren't careful, you can quickly end up in a lot of debt and find it difficult to get out. The number one thing you can do to manage your credit card wisely is to pay your bill on time and in full every single month. That strategy alone will help your finances tremendously. But if you'd like to learn other ways to maximize your credit card use, keep reading for the best practices for managing your credit card.
Pay your bill on time
To avoid interest, late fees, and poor credit scores, you should always pay your bill on time. One of the ways that people end up in credit card debt isn't only by charging excessive amounts to their cards. Simply missing a payment is another way that people get into trouble with credit cards.
By consistently missing payments, you could end up paying hundreds of dollars in late fees over the course of a year. In addition to that, your credit score will take a hit, which could cost you thousands of dollars in interest charges down the road. Paying your bill on time is one of the most important things you should be doing, and if you can't, it may be time to cut up your card.
Most credit card companies will allow you to schedule payments ahead of time or schedule reminders to pay your bill. Log into your online account and set up an automatic payment to your credit card every month. If you're not comfortable with an automated system, you should at least set up a reminder email five days before your payment is due so you'll never be late.
Understand the billing cycle
Each month your credit company will issue a statement with two dates: the closing date and payment date. The closing date is the last day you can make a charge for a single statement. After the closing date, any new transactions will go on next month's statement. The payment date tells you when the payment for a particular statement is due.
For example, you might have a closing date on the 31st of each month and a payment date on the 21st. In this case, your October statement would run from October 1st - October 31st with a payment due on November 21st. You have 21 days after your statement ends before you are required to make a payment. This 21-day timeframe is a grace period where you won't be charged any interest as long as you pay in full by the due date.
Keep in mind that all credit cards are different and each one has its own billing cycle, payment date, and grace period. Review the information for your specific credit card to understand how it works for your situation.
Pay your bill in full
Paying your bill in full is extremely important for using a credit card wisely because it allows you to both avoid interest and build a high credit score. Credit card companies calculate interest using your average daily balance. To figure out how much interest is charged per day, take your APR (Annual Percentage Rate) and divide it by 365.
The average daily balance calculation is one of the most misunderstood concepts when it comes to credit cards. Many people believe that credit card interest is calculated based only on the leftover balance after they make a payment. However, that's not the case and can lead to hundreds of dollars in extra interest payments.
For example, let's say you have a statement balance of $1,000 and make a payment of $500 on the due date. Most people believe they'll only be charged interest on the remaining $500, but this is not true. The grace period mentioned above only applies if you pay your balance in full. If you have any remaining balance on the card after the grace period, the credit card company will charge you interest based on the average daily balance, and you forfeit your grace period. Any transactions you charge will begin accruing interest immediately. It can often take up to two months of in-full payments to get your grace period back. If you only make the minimum payment, it can lead to years of debt, due to the interest calculation.
Keep your balances low
In addition to making on-time payments, it's essential to keep your balance low relative to your available credit limit. There are two main benefits to maintaining a small balance:
- Low balances help increase your credit score.
- You're more likely to pay off your balance in full and on time.
A significant portion (30%) of your credit score comes from your credit utilization, which is a ratio of what you owe to what is available to you. For a given card, if the credit limit is $1,000 and the card has $500 charged to it, the utilization ratio would be 50%. To maintain a high credit score, you should aim to keep your utilization below 20%, but closer to 10% is even better.
By aiming for a 20% or less utilization ratio, you will typically charge less than you can afford. By keeping a low balance, you minimize the chance that you'll spend more than you can pay off at the end of the month.
Monitor your monthly statement
Monitoring your statement helps you check for fraud, stay on a budget, and maintain a low balance. Even if you've set up an automatic payment, it's still wise to log in and check your statement every month to make sure everything looks like it should.
Most credit card companies have sophisticated systems that check for fraudulent charges, but they may not catch all fraud charges. At least once a month, you should check your statement and verify there aren't any purchases you don't recognize.
In addition to checking for fraudulent activity, monitoring your statement will help you stay on budget. There's no way to know if you're maintaining a low balance, keeping your spending in check, or blowing the budget unless you're regularly checking in.
Only charge what you can afford
Don't view your credit card as an extension of your budget. It's highly recommended that you never charge more to a credit card than what you can currently cover in your bank account. People don't end up with thousands of dollars in credit card debt on purpose. Instead, credit card debt tends to accumulate slowly over time.
By only charging what you can afford, you'll ensure that you won't pay any interest and always maintain a high credit score. It's tempting to spend ahead based on what you know you'll get paid, but it's a bad practice. If you lose your job or run into an emergency, you won't be able to cover those charges. That's how people start going into debt, and it slowly builds from there. It's recommended to never charge more than you currently have in cash.
How to Use a Credit Card to Build Your Credit
Credit cards tend to be at the core of a solid credit score strategy. They are the foundation and typically one of the first financial products you will use to build your credit. The best way to build your score using credit cards is to follow the recommendations listed above: pay on time, pay in full, and keep a low balance. Below, you will find out how credit scores are calculated and exactly how credit cards affect them.
How your credit score is calculated
The FICO score is the most commonly used credit score across the finance industry and is made up of five key components.
- Payment History (35%)
- Credit Utilization (30%)
- Length of Credit History (15%)
- New Credit (10%)
- Credit Mix (10%)
Payment history is based on how often you pay on time and how reliable you are as a borrower. Credit utilization is the ratio between the amount you borrow (balance) and how much is available to you (credit limit). The length of credit history is a simple score based on how long you've used credit: the longer, the better. New credit measures how often you apply for credit products or loans and what percentage of your credit is related to recently opened accounts. Lastly, credit mix is based on how many different types of credit you use. Generally, more is better.
Using credit cards to build your score
It's important to recognize that payment history and credit utilization make up 65% of your score. The best way to build your credit score with credit cards is to maintain a low balance and never miss a payment. If you're already doing those things, here are four more strategies to help you build your credit score:
- Never cancel your first credit card—unless it has an annual fee—because it will help your average account age.
- Call your credit card company and ask for a credit limit increase but don't increase your spending. This tactic will help your utilization score by decreasing your ratio.
- Open a new credit card and then set a recurring bill and automatic payment to that card. Setting up this small recurring payment will help both your overall utilization and your payment history.
- If you are applying for a loan soon, pay off all your credit cards a few days before each statement closes. Paying your cards off early will decrease your overall utilization and boost your credit score for a few days.
Credit cards are dangerous when used irresponsibly, but they are powerful tools to help your finances when used wisely. To maintain a high credit score, follow the best practices mentioned above: always pay on time, always pay in full, and keep a low balance on your card.
How to Use a Credit Card to Earn Cash Back & Rewards
To get rewards from a credit card, you should consider how you spend, then pick a card based on that information. Everyone's situation is different, and everyone has different spending habits. Some people travel a lot, and others tend to stay in the same city.
Analyze your spending to maximize rewards
Take a look at the past few months of your spending and categorize it as best you can. Ask yourself the following questions to figure out your spending: Do you spend a lot of money on gas and groceries? How often do you travel? Can you put work-related purchases on a credit card and then get reimbursed by your company?
Once you figure out what categories you're spending the most in, start researching different credit card options that fit your needs. You may find that, after analyzing your spending, you want to use two different cards to maximize rewards. However, while using multiple cards is a good strategy for rewards, don't get too distracted and end up spending more than you usually would.
Cash back vs. points
The second thing you should look at when maximizing rewards is how you prefer to redeem them. If you like to travel, it may make sense to consider hotel or airline-specific credit cards. If you prefer to redeem your rewards for cash, look at cash-back cards or general percentage cards.
Credit card rewards are confusing, and you should do your due diligence when researching redemption options. Most credit cards have particular rules about how you can redeem the rewards and sometimes they can be difficult to obtain. Consider how much time and effort you want to put in versus getting a simple card with straightforward options.