Credit cards have become a standard part of our financial lives. Indeed, credit cards are usually required for all sorts of transactions, from getting an airline ticket to signing a cell phone agreement. Understanding how a credit card works can help you avoid falling into the easy temptation of abusing it.
A credit card is known as a revolving line of credit. Here is how that works. A lender, usually a bank, approves you for a credit limit, which is the maximum amount the bank will let you borrow. The bank decides what that limit will be by examining your income, assets, and credit history. This lets the lender know how much you can afford in debt. The lender then issues you a credit card.
Once you have the credit card, you are able to use it to borrow up to your limit. For example, if your credit card has a $5,000 credit limit, that is how much debt you are able to put on that card, including any financial charges and interest. As you use the credit card to make purchases, that amount is subtracted from the credit limit.
As you repay the debt on the credit card, that amount becomes available for you to borrow again. For example, if you charge a $500 purchase on your credit card and repay $100 the first month, you can borrow back the $100 amount. As you put money into paying off the credit card, you can immediately borrow that amount again. That makes the credit card a revolving line of credit. It has no end date; it is a continual source of a loan as long as you make your minimum monthly payments.
Credit cards are very convenient, but therein lies the problem. It can be too tempting to use a credit card to make a purchase when you cannot actually afford it. Also, since only a minimum monthly payment is usually required, it can be too easy to take your time paying off the credit card. The problem with that is that your interest will be building up. You pay interest on the outstanding balance, but since credit cards usually don't have very low interest rates, delaying paying off a balance can really add up in wasted interest payments. Also, if you maintain a large balance on credit cards, it can be very detrimental to your credit scores.
It is almost impossible to get away from credit cards in our economic lives. However, as long as they are used with discipline, credit cards can be a useful tool.