New to credit cards? This is how they work

When you need money for an emergency, or you are unable to afford something that you really want or need, credit can help. However, credit isn’t free. They come with credit card fees like interest, service and initiation fees, and more.

 So, if you’re shopping for a new credit card, you first need to understand how they work and the different types of credit cards available. That way, you’re able to manage them well and improve your credit score too. The best place to start is with the basics, we explain them below.

What is a credit card?

A credit card allows you to access pre-approved credit offered by the bank that issued the card. This means that you will have money available to cover purchases on credit. You then have to pay that money back, either in full at the end of the month or over time through minimum monthly repayments.

How does it work?

You apply for a credit card as you would a loan or any type of credit. Before approval, your bank will check your credit record and affordability. This is to see whether you have a history of paying or not paying your creditors, and whether you can afford the minimum payments required.

When you’re approved for a credit card, the bank authorises a credit card limit. This is the maximum amount available on your credit card. Your credit limit will depend on factors such as your income, your other debts, payment history and how much available credit you have on other cards.

At the end of each month, you will have the option of paying a certain minimum amount or paying the whole balance in full. Paying just the minimum every month is ultimately the most expensive option because it will cost you the most in interest. When you pay in full each month, you get a grace period that allows you to avoid paying any interest on your purchases.

What happens if you don’t pay?

Should you fail to make your payments on time, your bank will report your non-payment to the credit bureaus. Your payment history counts for 35% of your credit score — a three-digit number that indicates how risky it would be to lend you money. You must pay at least the minimum by the due date every month to avoid late fees and potential damage to your credit score.

The cost of having a credit card

Credit cards come with credit card fees. Here are some of the fees and charges that you may see in your pre-agreement. We suggest that you make sure you understand and agree to them before signing. They include:

• Interest payments - Credit cards can have different interest rates for point-of-sale till points and ATM withdrawals. When you pay in full every month, your purchases don’t accrue interest.
• Initiation fee - This is a once-off fee that credit providers charge you to enter into a credit agreement. The credit provider must give you the option to pay this fee up front and with no interest.
• Service fee - This is a fee that a credit provider charges you for servicing, administering or maintaining the credit agreement. Credit providers can charge this on a monthly, annual or per transaction basis.

Tips for effective credit card use

The benefits of using a credit card responsibly outweighs the costs. Here are some good practices to adopt:

1. Never use credit to fund irresponsible spending - Do not live on the available balance on your credit card. Make sure to pay the outstanding balance on your credit card every month. Look into credit offers from banks that include long interest-free credit periods of up to 60 days. You can use the interest-free period for purchases and settle the balance in full every month, without paying interest.
2. Avoid using credit to pay off debt - Rather stop and reassess your financial situation. Speak to an advisor and see what your options are. It may mean some cutting back on expenses, but will be worth it when you reduce your debt.
3. Use your credit card’s interest rate to your advantage - From a credit perspective, credit card rates are relatively lower than interest rates on personal loans. According to the National Credit Regulator, the maximum interest rate on credit cards is 20.5%, while the maximum interest rate on personal loans is 27.5%. Interest rates offered are dependent on the individual’s risk profile. A credit card may come at a lower interest rate than a personal loan if you need to apply for credit.

Read more: How to use your credit card wisely