Investment Glossary – Credit Card

At this point in human history, it’s safe to say that most five-year-olds know what a credit card is – it’s how you pay for groceries, sneakers, video games, and candy. But unfortunately, the five-year-old view of what a credit card is can leave you in a whole heap of trouble if you carry that model forward into adulthood.

Credit cards aren’t magic pieces of plastic that help you buy different things – they are money loaned to you by a financial institution, with a written contract stating that you will pay the money back to them at a later date, and pay them interest if you don’t pay that money back within one billing cycle. Try explaining that to a five-year-old.

So let’s say that you have a credit card with Bank of High Interest Payments (BHIP). If you go down to the corner store and buy a couple cases of beer for $30, you did not make any payments to the corner store. That money came from BHIP’s account, and in turn, they make a note in your file that you now owe BHIP $30. That is credit that they’ve extended to you. And they’re going to want it back.

Now, BHIP is likely going to act as a relatively responsible lender, meaning they don’t want you to go and buy a $3 million house on your credit card. So they impose what is called a credit limit, or a maximum amount of credit they will extend to you on that line. For new borrowers, limits are typically low. However, as lenders get more comfortable with your behavior and you build a credit history, your credit limit typically increases.

So let’s continue with the above example – you’ve bought $30 of beer, and that’s the only purchase you made on your credit card for the month. Credit issuers typically use a one-month billing cycle, meaning they’ll let you run up charges for a month before requesting payment within a month to pay off the charges you accrued on your account. If you pay those charges off in that month, you don’t owe any interest. If there is still money you owe to BHIP after the month you’ve had to pay off the balance, then they are going to start charging interest on your account. And that means that your $30 purchase could end up costing you more. It’s a big incentive to be able to spend within your means and pay off as much of your balance as possible. Don’t just make the minimum payments.

Many credit cards also let you accumulate points, miles, or cash-back rewards as well. These rewards are meant to entice consumers to use the cards and buy things on them. Why? It’s not because BHIP wants you to take that trip you’ve always wanted to take. It’s because BHIP wants to collect interest and fees from you. So while credit card points offers can be enticing, it’s important to make sure you aren’t changing your behavior in negative ways to accumulate rewards, as the costs associated with interest and fees paid to an issuer can be greater than the rewards paid to you if you aren’t careful.

In short, credit cards are a way for you borrow money from a lender for day-to-day purchases using an easily accessible and widely-accepted form of payment.

The money spent on credit cards is borrowed from the credit card issuer, and has to be repaid at a later date. If it isn’t paid back promptly, interest starts to accrue, and that can make the overall cost higher for you if you end up paying significant amounts of interest on your account.

So yes, go buy some candy for your five-year-old. Use your credit card if you want to. But make sure you pay that balance off every month.