Credit Cards

How Credit Cards Work: The History of Credit Cards

On a scale of 1 to 10, how knowledgeable are you about credit cards? Do you know where and when use of credit cards began? Can you explain how credit cards actually work? More importantly, do you know how to use them as financial tools to improve your wealth instead of drain it?

Where and how did credit cards get started?

Americans owe $953.3 billion dollars in revolving debt and most of that amount is from credit cards (source). That did not just happen overnight. The use of credit cards evolved over time to become the financial norm instead of the oddity it once was.

As far back as the 1800s, stores were offering credit to their customers. While there were no cards involved in the early days, a general store owner often extended credit to his customers, with the understanding that when the harvest came in, the customer would settle up accounts. After a time, the practice spread from rural areas into cities, with department stores extending store credit to customers via a charge account paid off at the end of the month.

The problem with this, of course, was that consumers had to keep up with numerous cards to purchase from different merchants. That problem disappeared in 1950, with the introduction of the Diners Club card. This card was different from the department store cards because many different merchants accepted it. The precursor to the credit card as we know it, the Diners Club card was wildly popular.

Throughout the 1950s, banks began to offer credit cards to their clients. In 1958, Bank of America, which was a California bank at the time, offered the BankAmericard. Over time, the BankAmericard grew into the company now known as Visa. In the 1970s, Visa, Mastercard, and American Express® became household names as consumers began to more fully succumb to the seduction of using plastic for convenient payments.

In 1989, Citibank offered the first rewards card and a new era of credit card use began, with consumers flocking to use cards to take advantage of rewards like discounted air travel and cash back. The credit card industry continues to evolve even today, with new combinations of reward types continually introduced in the highly competitive industry.

Are charge cards and credit cards the same thing?

Some people use the terms “charge cards” and “credit cards” interchangeably, but they are actually two distinct card types. If you have a credit card, you can choose either to pay your balance in full every month, or you can carry a balance and make a payment less than the entire amount due. As long as you pay at least the minimum payment, your credit will remain in good standing.

On the other hand, if you have a charge card, you must pay the balance on the card in full every month by the due date specified. If you fail to pay on time and in full, you are in default of your charge card agreement and your credit score will likely take a hit.

Another difference between charge cards and credit cards is the limit on the cards. Credit cards have a pre-set credit limit. Charge cards typically do not have a set limit, since you must pay the full amount each month anyway.

Credit cards are much more prevalent than charge cards. Additionally, it is rare to find a charge card that does not charge an annual fee, whereas there are many credit cards with no annual fees.

What types of credit cards are there and how do they work?

The main types of credit cards are:

  • Standard, unsecured credit cards.
  • Balance transfer credit cards.
  • Rewards credit cards.
  • Student credit cards.
  • Secured credit cards.
  • Retail cards and gas cards.
  • Prepaid cards.

Here is a quick rundown of how each type of card works:

Standard, unsecured card:
This one is the plain Jane of the credit card industry. It has a set credit limit. When you make purchases, you receive a monthly bill which lists the purchases, any interest charges, your current credit card balance, and a minimum payment amount. You do not earn rewards with these cards, but the interest rates are often quite good and you may be able to find several options that do not charge an annual fee. If all you want is a convenient way to pay for things while building your credit, these cards are a good choice.

Balance transfer cards:
Balance transfer cards offer a low introductory interest rate on balance transfers for a specified amount of time. Consumers use balance transfer cards to save money on interest. For instance, suppose you are carrying a balance on your credit card of $3,000 and your interest rate is 12 percent. If you pay $200 per month on that credit card, it will take you 17 months to pay off your balance. Now, suppose you find a balance transfer card that offers an introductory rate of 0 percent for 18 months. If you pay the same $200 per month, it will take you only 15 months to pay off your balance.

There is one word of caution, however. Balance transfer cards often charge a fee of 1 to 3 percent of your transferred balance up front to complete the balance transfer.

Rewards Cards:
Rewards cards offer rewards on credit card purchases in the form of cash back, points, or travel. Cashback rewards cards allow you to earn money back for specified purchases you make on your credit card. Some card companies return the money to you by issuing a credit to your credit card account. Others send you a check periodically. Still others send you gift cards from one of their merchant partners.

Points rewards cards
On the other hand, award points based on the dollars you spend. You redeem points by choosing merchandise offered as part of a catalog of items in the rewards program of the card issuer.

Travel rewards cards :
Travel rewards cards give you a certain number of miles which you can redeem for airline tickets or, in some cases, for rental cars. The number of miles you earn varies from credit card to credit card, so you need to read the cardholder agreement carefully to take full advantage of your rewards.

Student credit cards:
Student credit cards are for college students with little or no credit history. Student cards generally have lower credit limits, and some of them have high interest rates. However, responsible college students may find student cards to be useful in building a credit history.

Secured credit cards:
Secured credit cards are a good choice for those with poor credit. With a secured card, you put down a deposit to secure the card. Then, you use the card as you would use any other credit card. If you default in your payments, the card issuer may choose to close your card and keep the deposit you put down to apply to your outstanding balance. If you pay your credit card bill on time every time, however, a secured credit card can help you rebuild your credit. In time, your card issuer may choose to convert your secured card into an unsecured card, at which time you will receive your deposit back.

Retail cards and gas cards:
These cards come from a particular store or gas company. You can only use the cards with the issuing merchant. However, using these cards responsibly may help you to build a better credit score if you do not currently have credit or if your credit is poor.

Prepaid cards:
Prepaid cards look like credit cards and work like credit cards from the perspective of merchants. However, they are not actually credit cards. With prepaid cards, you load your card with a certain amount of money and use it as a credit card until the money is completely used. At that point, the card has no value.

Prepaid cards are a good option for people who cannot get credit cards otherwise, but still want the convenience of paying with a card. There is a note of caution, however. Many prepaid cards carry hefty fees, so before you choose this option, read all the fine print.

How do credit card companies make money?

Credit card companies make money in two main ways, through fees and interest. If you carry a balance on your credit card and do not pay it in full every month, the card company will charge interest based on your average daily balance, your adjusted daily balance, or your ending balance. You can read your cardholder agreement to discover which of these methods your credit card issuer uses to arrive at your interest charge.

Credit card companies may also assess the following fees:

  • Annual fees.
  • Cash advance fees.
  • Balance transfer fees.
  • Foreign transaction fees.
  • Late fees.

What are annual fees?

Some credit cards charge an extra fee every year to offset the administrative costs and perks of maintaining a card. These fees are independent of interest rates or other fees, such as balance transfer fees, cash advance fees, and late fees. You pay them whether or not you use the card.

Most annual fees range from $59 (Capital One’s Venture Rewards) to $95 (Chase’s Sapphire Preferred), although some high-end cards have annual fees of $450 or more (Citi Prestige Card).

The annual fees allow credit card companies to pay for valuable perks, such as signup bonuses, free FICO scores, rental car insurance coverage, trip cancellation, emergency travel assistance, and membership in rewards programs.

However, many credit cards don’t charge annual fees and still provide perks. Check whether the benefits are worth the annual fee before applying. The cards with the best rewards and benefits have annual fees. However, many of them waive the fee the first year, which gives you a chance to test drive them and decide whether they are worth the money.

It doesn’t take much to justify a $59 or $95 annual fee. Just using the rental car insurance coverage of a credit card once a year can cover the annual cost of a card.

Tip: Sometimes credit card companies will waive the annual fee for customers that request it, particularly in the case of big spenders. Call the number on the back of your card and ask the customer service rep. It’s worth a try.

What are interest rates and how do they work?

The interest rate of a  is the cost of borrowing money expressed as a percentage of the loan’s balance. In the case of credit cards, interest rates is expressed as an annual percentage rate or APR. The APR of a card tells you what percentage of your debt you will have to pay in interest over a year.

For example, if you have a debt balance of $10,000 and an APR of 16%, you will pay $1,600 ($10,000 x 0.16) a year in interest. This example assumes your balance remains the same throughout the year.

Credit cards companies work out your interest rate by adding a percentage to the going prime rate, which varies with the market. Prime rate is the average overnight rate at which large banks lend money to each other. Lenders typically base their prime rate on the one published daily in the Wall Street Journal. For example, prime rate was 3.50% on September, 6, 2015. A typical card may add 12.74% to 19.74% to prime rate depending on the cardholder’s credit, which would bring the total to 16.24% to 23.24% APR.

Minimum payment

Your credit card minimum payment is the amount you have to pay to avoid late fees and getting a negative item on your credit report. There isn’t a standard way to calculate minimum payments but credit card companies typically require a minimum dollar amount, such as $25, or 1% to 4% of your card balance, whichever is greater. Check the pricing and terms of your credit card for instructions on how to calculate your minimum payment.

Chase, for instance, charges Sapphire Preferred cardholders the sum of 1% of the balance, monthly interest charges, and late fees for the statement the minimum payment is calculated.

For example, if you owe $8,000 and your minimum payment is 4%, your minimum monthly payment will be $320, assuming a 16% APR.

Try to pay your monthly card balance in full to avoid interest payments. Repaying a credit card debt with minimum payments alone gets expensive fast. In the previous example, repaying the $8,000 with minimum payments (of 4%) would take 143 months and a total of $11,897.

Late payment fees

Credit card companies charge you a fee if your payment is late or if your method of payment is returned. Fees vary from $15 to $37. However, the Credit Act of 2010 put some restrictions on the fees credit cards can charge. For instance, late payment fees cannot exceed the monthly minimum payment of a credit card. The Federal Reserve Board also sets benchmark fees for the first ($25) and second ($35) late payment within six months.

How to keep your good credit?

Having good credit can save you thousands of dollars a year. According to a survey published by the University of Syracuse, someone with bad credit pays an average of $4,975 more a year in minimum credit card payments than consumers who have a low-rate card with the average balance. (Source)

Here’s what you can do to protect your good credit:

  • Pay your bills on time
  • Keep your debt-to-credit ratio low
  • Consider paying your bill several times a month
  • Don’t open more accounts than you need (every inquiry will ding your credit)
  • Avoid closing accounts (having an older average account age is good for your credit)
  • Check your credit report for false or inaccurate items
  • How can you use credit cards to increase your spending power without damaging your credit?

Hands down, the best way to handle credit cards is to charge only what you can pay within the grace period each month. Carrying a balance means that you will pay interest.

If you are already carrying a balance and you have excellent credit, a balance transfer card with a 0 percent introductory rate may help you eliminate interest fees. You will likely have to pay a small balance transfer fee, but if you think that you can pay your entire balance within the introductory period, a balance transfer option is cost-effective.

Using credit cards responsibly helps you build your credit. This is important, because a good credit score affects your life dramatically. With an excellent credit score, you can get favorable terms and rates for large purchases like your home or your automobile. Good credit also improves your job prospects if your employer runs credit checks as part of the hiring process.

Where can you find the best credit card for you?

To find the right credit card for you, you can check with your local bank or search online. With either option, it makes sense to comparison shop, since there are literally thousands of credit cards from which to choose.

Fortunately, help is available. SuperMoney enables you to easily compare multiple credit card offers and provides hundreds of real-life customer reviews to help you narrow down your choices. Take advantage of our research.