If you are confused about how credit cards work, what is credit card debt, and how to deal with it, here is some useful information.


How do credit cards work?

First of all, it’s useful to understand what is a credit card and how it works. The concept of credit card ties to one of credit, which refers to your ability to obtain any good or service before payment. Simply put, your credit is based on your history of paying your bills on time. 

A credit card allows you to have a line of credit (the card’s credit limit). This limit is determined based on your credit score and is decided by the bank that issues your credit card. 

Every month you will have a limited amount of money that you can spend and repay in the future. At the end of the billing cycle, you can pay back the whole balance or a minimum amount which is set by the bank and you can find it on your billing statement.

What is a finance charge and how does it work?

When you don’t pay the whole balance but just the minimum monthly, you incur in a finance charge. These charges include the interest on the debt balance and any extra fee depending on the credit card institution. Simply put, this is the price you pay for obtaining the credit.

Another type of finance charge is the late payment fee that you need to pay whenever you don’t pay the minimum amount within the grace period. Each credit card issuer has a different grace period so it’s useful to check it in advance.

Every month that you don’t pay your credit card balance in full, you pay finance charges. As your balance increases, your finance charges will also increase. 

Finance charges are based on the current prime rate, a percentage that fluctuates based on market conditions. Each month your finance charge is calculated based on any market fluctuations. As of August 21, 2020, the prime rate for the US is 3.25%.

In addition to this, your finance charge can vary depending on your payment history and timeliness in paying your bills. 

How to avoid accumulating credit card debt

The best way to avoid accumulating credit card debt is to pay your balance in full each month. This will avoid you the finance charge as well as an increased balance each month.

Making the minimum monthly payment while you keep increasing your balance will only make the finance charge increase. Additionally, your minimum payment may also increase each month. That happens because the minimum fee is usually calculated as a percentage of your outstanding balance plus any other issuer fees.

Paying in full may not be possible each month but try to aim for it. Whenever that’s not possible, even paying more than your minimum payment will make things easier for the following month.