What is a credit card and how do credit cards work?

Credit Cards are Revolving Debt

Credit cards are a type of revolving debt. Most credit card accounts have a credit limit. As long as you keep your balance under your credit limit, you can continually take on new debt by making purchases. You also consistently pay down that debt with your monthly payments. Unlike amortized debt (such as mortgages and car loans) where your payment plan consistently reduces the size of the debt, revolving debt allows your balance to continue to grow, often without you realizing.

Credit Cards are Unsecured Debt

Since there is no collateral tied to credit card debt, they are a form of unsecured debt. This means that if you fail to make your payments, the credit card company can not immediately seize property of yours that is tied to the debt. In a home mortgage, which is secured debt, the bank could repossess your house if you failed to make a payment. If you think this sounds great, think again. In exchange for the extra risk, lenders charge a far higher interest rate on unsecured debt. This is why you can get a 3-4% interest rate on your home loan, while a typical credit card interest rate is closer to 20%.

Don’t fall under the impression that because credit cards are unsecured debt, you can default on your credit card balances without consequences. Although the credit card company can not immediately repossess property, defaulting on your credit card will seriously impact your credit score and will send your bill to collections. If you continue to neglect your debt, creditors can bring a suit against you and potentially have your wages garnished.

What Does it Mean to Carry a Balance?

Although you are required to make a payment on your balance every month, you are not required to pay off your entire balance. When you pay less than your balance, the remainder is called a ‘carried balance’. Any new charges that you incur in the next month get added to this carried balance.

When Do You Owe Interest?

One common myth about credit cards is that you automatically pay interest on any and all purchases. This is NOT true! As long as you never carry a balance, you will never owe any interest! In other words, if you pay your balance in full each month, you will never owe any interest. Once you start carrying a balance, you start owing a 20% (annually) interest rate on that balance. Once you pay off your balance in full, the interest charges will stop.

One other way to avoid interest is with special offers where interest is waived for a specified time period. Be careful with these, however. First, using this offers develops the bad habit of carrying a balance. Second, the fine print of the deals often gets tricky. For example, many of these offers stipulate that the 0% offer is only valid if you pay off your balance in full within the time period. Otherwise you get nabbed with current interest and all the back interest from the promo period. I recommend staying away from these offers.

How People Get Buried in Credit Card Debt

I don’t think anyone opens a credit card account with the intention of burying themselves in debt. And yet it happens. There’s a reason so many ads on TV advertise credit card debt relief. It’s a serious pain point. According to NerdWallet, the average credit card debt balance was over $15,000 last year. $15,000 of credit card debt is extremely hard to pay off! That can easily be a quarter to half of your income. Furthermore, $15,000 means the first several hundred dollars of your monthly payment is just going towards interest! And remember, $15,000 is just average- there are people with far higher balances. So just how do people dig themselves this deep?