Credit is power. Your credit score opens doors to better banking products, lower repayment interest rates, home and car ownership, and in many places, getting a job or even renting your own place. Credit cards are not just amazing tools when used properly, but they are absolutely essential for most significant transactions in your life.
Misusing credit cards can result in a low credit score that will shut banks', employers', and car dealerships' doors on your dreams. On the flip side, while proper credit use will keep your credit score happy and stop you from accidentally overreaching your budget. Getting the most out of your credit card means using it responsibly every day.
To get started on your credit-building journey, here is our definitive basic instruction manual to using those magical money cards like a pro.
Welcome to Credit Cards 101.
Credit card vs. bank card
A bank card is connected to a checking and/or savings account that you deposit money into. This card is used to retrieve some of your existing money directly from your bank account, which is essentially a digital wallet. Even children are allowed to have bank accounts and bank cards in their name. Most people assume that your basic chequing account doesn't have much to do with your credit rating — but they would be wrong.
If you've never had a credit card before, then your basic chequing and savings bank account activity can get you in the door. If you don't have a credit history yet, then some banks (usually the one you're already banking with) will check to see what kind of banker you are by looking at your chequing and savings accounts. Having regular, predictable activity shows your bank that you are a reliable and consistent banker, even before they give you your first card. "Regular activity" means that you have a regular paycheque coming in every couple of weeks and maybe you pay a certain bill, like a phone bill, online through your account every month. Showing consistent movement of money into and out of your account indicates that you have income, you're reliable, and that you think about your money and where it's going. To give yourself a good start in credit, the first step is to start using your chequing and savings accounts regularly!
Unlike the bank card that you receive automatically to link to your chequing account, you must apply for a credit card. The "credit" on the card is money that does not come from your bank account. It's money that you're borrowing from the bank and that you have to pay back at the end of the month. If you buy some cool sneakers for $300 using your credit card, that means you just spent $300 of the bank's money. The reason why banks are careful who they give credit cards to is because credit works on a trust system: the bank trust that you will pay back the money you spend on your card. Having a consistent banking history can get you your first card because the bank can do the math and see if you make enough money to be able to pay them back regularly.
What happens if I can't pay off my entire credit card bill?
Here's the most important part of using credit right: don't spend more than you can pay off at the end of the month! This seems like a no-brainer, but this happens to everyone. All. The. Time.
When you're using a credit card to pay for things every day, you don’t have to think about how much money you're spending. Just swipe the card, sign, and walk away. Most people don’t have a clue what they spent until they see their bill halfway through the month, and then they realize they can't pay it all off. It doesn't seem like such a big deal if you buy something bigger, like a new laptop, because your old one crapped out on you and you genuinely need it.
But whenever you fail to pay off the entire bill, the money you owe carries over to next month's bill. And the bank charges you interest on the money you didn't pay them back yet. The problem is that many, many people consistently spend more than they can pay back at the end of the month and they figure that it's okay, they'll just foot the bill next month. Then they never do. They just keep spending a little every day, adding to their debt load.
The average American has $5,551 in credit card debt. And every day, every month, every year, each person pays their bank interest on the money they owe. This is how banks make their money: collecting interest from people who owe them money. Think how rich your bank is. A lot of this money came from regular people paying interest on their debt.
So, the first answer to the question that started off this rant is, if you don't pay off your credit card bill in full at the end of the month, you'll be charged extra money, i.e. interest. The extra money you pay depends on your exact credit card agreement with the bank, but the more debt you have, the more you'll be paying. Even if you're only $50 in debt to the bank at the end of the month, you'll be paying them back more than $50.
And the second answer to the question is, not paying off your credit card bill every month begins to affect your credit score negatively immediately. While using a credit card will lead to a temporary debt every, repaying this debt is essential to establishing a strong credit score.
Paying off your credit card bill each month helps you build a good credit score, which will put you on the path to approval for bigger loans (like a mortgage for a house) as your bank will learn to trust you. Not paying your bill off every month ruins your credit score because it shows your bank that you are not accountable to repaying your loans. The result of spending more than you can pay off is that your credit score, which is literally the most important financial information that exists about you, takes an immediate hit. The grim reality is, not paying your bill off at the end of every month can eventually ruin your life.
How to use credit cards properly
The point here is not to be terrified of getting a credit card. The point is that if you have one, watch how much money you spend! Don't wait until the end of the month to find out how much you spent in the past two weeks. Regularly check your online statement and make sure you’re within a reasonable amount for your income. You might realize that you've purchased $40 worth of coffee in the past two weeks (one $4 cup every morning from Monday to Friday). Or maybe you forgot that two weeks ago you had to pick up some new clothes for work and that as a result you definitely won’t be able to afford new shoes this month. It's not a problem—just wait until next month to get the shoes. Keep an eye on your spending and pay off your bill every month.
To make sure you don't spend more money than you can afford, figure out your budget. It's easy, I swear!
Look at how much money you make every month (your income), then subtract the amount that goes to fixed monthly expenses like rent, utilities, and your phone bill. Whatever is left over after subtracting these things from your income is how much money you actually have left over to spend on food, shopping, and entertainment. Assuming you don't want to put any money aside for savings, this money left over after paying your bills is your budget. The amount you spend on your credit card cannot go over your budget.
Ideally, you should monitor your spending using online banking, try to spend less than your budget, and then put the remaining money into a savings account.
Now, if your credit score has already suffered from a pattern of not paying off your bills on time, your life isn't over. You're not doomed to never own a home or car. You just need to figure out how much money you owe and to whom and start making regular monthly payments. If you have a lot of debt, it might be worth it to consolidate your loan or speak to a finance professional.
Cut back on your lifestyle spending and put as much money as possible toward paying off your debt, so it doesn't get any bigger due to added interest every month. Create a new habit of making regular payments and get your debt down, down, down, until it doesn't exist anymore. Then you know what to do next: get yourself down to one credit card (cut up the others), spend only as much as you can afford, and then pay off your bill every single month.
Here at MoneyWise we have lots of advice for how to spend less on everyday items, save money on big purchases, and avoid debt! Check out these awesome articles:
- 3 Tricks that Car Salesmen Use to Take Your Money
- How to Build Good Credit
- How to Think Through a Big Purchase
Having a good credit score — or improving your score if it's a bit battered — is essential for establishing a good relationship with lenders. Banks trust people who have high credit scores and they give these folks the lowest interest rates. A lower interest rate on a loan means you'll pay back less extra money over time, so you'll be getting better overall prices on your mortgage, car, and credit card bills. Using credit cards properly depends on remembering that a credit card is not a magical free money card. There are consequences to forgetting this simple fact — but if you don't enter the Nike store intending to spend like an NBA player, you'll probably be just fine!