How credit cards work

Credit cards are an area of personal finance that can be fiercely debated.  In one camp, there are people who believe credit cards are evil.  Any purchase you plan on making should be made with cash on hand.  Otherwise you are just putting yourself into debt and debt is bad.  On the other side is the camp that believes you are wasting money if you don’t use a credit card.  There is no dispute about having cash on hand before you buy something.  They just believe that credit cards should be used as an intermediate step to take advantage of the rewards programs.

In order to take advantage of the rewards and protections a credit card has to offer though, you need to know how it works.  5% cash back on purchases doesn’t help you if you wind up paying 15% in interest on the balance.  When does a purchase become subject to interest?  In order to understand that, there are two specific dates you need to know: closing date and due date.

The first one to talk about is the closing date.  The closing date is the cutoff date that a credit card company uses to determine what the total is for the due date*.  Any charges posted on or before the closing date will be included in the monthly total.  Any charges that post after are carried over to next month’s bill.  You can find your closing date on your monthly statements.

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Let’s go through a quick example to show how the closing date works.  Let us say Wimpy looked at his October statement and saw the closing date was October 18th.  This lets him know that any charges that post before November 18th will show up in his December bill.  Now Wimpy goes and spends $15 on hamburgers each Tuesday on the 5th, the 12th and the 19th.  The charges on the 5th and the 12th are before the closing date and will show up in Wimpy’s December bill (which will be $30 total).  The burger he bought on the 19th was after the closing date so it won’t show up until he receives a bill for January.

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Once the closing date passes, the next (and much more important) date is the due date.  This is usually 20-25 days after the closing date and it is when you need to make a payment.  The amount due is calculated as a percentage from the total balance that is posted by the closing date.  That is the amount you will owe for the month unless the calculated amount is lower than the minimum payment threshold.  We will use some numbers to help illustrate this.

Let’s say your minimum will be 5% of the posted balance or $15 which ever is higher.  If your posted balance is $200, $200*.05 = $10.  $10 < $15 so your minimum payment would be $15.  If your balance was $500, $500 * .05 = $25.  $25 > $15 so your minimum payment would be $25.  You do not want to just make the minimum payment though.  If the amount posted by the closing date is not paid in full by the due date, you will incur interest on the remaining balance.  That interest is compounded daily and can add up quickly.

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We will use Wimpy one more time to demonstrate this.  Wimpy owes $30 for December and if we stick to 5%/$15 as the minimum, his minimum payment would be $15.  Let us say Wimpy only pays the minimum.  Now he would owe $30 in January plus interest.  If he had paid off the full $30, he would only owe $15.  No matter what, always make sure you can pay off your closing day balance by the due date.  If you can’t, don’t buy it because it’s going to cost you more.

Now that you understand the basic mechanics of how a credit card works, you can decide if they are right for you.  Do you happen to know the closing date of your cards?  Or do you not care and simply pay the full balance (posted plus unposted) by the due date?  I personally tend to do the latter.

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*The closing date is also the date that credit card companies share totals with credit agencies.  As long as you have some balance by the closing date you will show up with a % credit utilization for your credit score even if you pay the bill in full every month.

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