EPT
What is a credit card?
Unlike a debit card a card card is not linked to your bank account or to your money. When you spend on a credit card the credit card company buys the product for you and then sends you a bill for it later on. You can choose to pay off that bill in full or to make installments on it paying interest. Different cards have different rates of interest and fees.
How do credit card companies make money?
A common misconception is that credit cards make their money from the fees that they apply to late and missed payments and the interest they charge on balances owed. However these are almost entirely negated by the money they lose in bad debt from the customers who use credit cards to spend more than they can afford.
Credit card companies charge the merchants processing fees which can be as high as 5%, in the case of Amex for example. They strongarm businesses, particularly small businesses, into accepting very unfavourable terms because they know that you as a consumer are likely to want to use a credit card and therefore the business has to accept them or their customers. What this means is that when you buy something that costs $1000 on your Amex the business only gets $950 after the fee is taken out. But then one month later Amex sends you a bill for $1000 which you promptly pay.
5% return on investment monthly compounded across a year is around an 80% return (1.05^12). The customers the credit card companies really, really like are not the ones who pay late, have interest and so forth. They really like the ones who use their credit card for their day to day spending in place of a debit card but always pay it off. They make 5% in the first month, if they can get their money back and then loan it out to someone else and make another 5% then that's way better than charging interest.
So why should I have a credit card?
Many credit cards give you a portion of the processing fees back as a thank you for using their card and generating them so many processing fees. If that sounds a little bit circular and dumb it's because it is, you use credit cards because the credit card company pays you to use them and the credit card company then tells businesses that you're unwilling to use anything but credit cards so the business better give the credit card company money.
Most businesses do not have fees at the checkout for using your credit card, even though credit cards incur additional costs for them. Instead they build the cost of the processing fees into the cost of the goods. When you buy something with cash or a debit card you are paying for the credit card fees unless you're at one of the very few places where you can negotiate a discount for cash. I recall Lidl (German supermarket) used to be cash or debit card only to make their prices more competitive, possibly because Germans don't typically use credit cards the way Americans do.
So if everyone is paying the inflated prices due to the credit card extortion but only credit card users are seeing a cut of the money then that means that a cash or debit card user is paying money into a scam they're not benefitting from. Their money indirectly becomes my money. You don't want that to be you.
The rewards can be quite significant. For example the Chase Freedom card (shameless plug, I have this card and like it) currently has 5 points per $ spent at gas stations and the points can be redeemed for more than a cent each. That kind of discount adds up over time.
Furthermore I think access to easy short term credit has a great role to play in increasing the stability of your investments. I do not have much of an emergency fund right now. I don't like to keep liquid cash lying around because of the opportunity cost of investing that cash. This won't fit everyone's situation but with a stable job, investments that could be liquidated within a month and health/car insurance I do not foresee a financial emergency that I couldn't handle in a month. This means that I can use ready access to credit to deal with large unplanned expenses and then pay them off one month later. This artificially increases the liquidity of my financial situation hugely. I can treat all resources that could be liquidated in one month or less as if they were cash without having to hold cash and eat inflation. That's pretty awesome.
Other common bonuses include extended warranties for products bought with the credit card, no foreign transaction fees, roadside assistance, free travel insurance and more other things than I can remember. Also, and this is a huge one, the credit card company will fight businesses who have been shitty to you on your behalf. You can dispute charges and the credit card company will just remove the charge until the business can verify that it the charge is legitimate and that your grievances are illegitimate. This gives you so much more protection, particularly with online purchases. You don't need to argue with the shitty customer service to get your money back because they haven't gotten your money yet, you can just cancel the charge.
Fraud protection is a huge bonus too, as R1CH pointed out in the comments causing this edit. Card skimming and online database breaches are growing problems and if a debit card is breached then the money is already gone leaving you with no recourse short of a lifetime of being Liam Neeson. If a credit card is breached, and you notice it and don't actually pay the charges, you're pretty much fine. The credit card company will refuse the charges and any merchant who provided goods or services to the fraudulent user is pretty much shit out of luck. As with the merchant fees businesses have accepted this as a cost of doing business and built it into the price of their goods which means that if you're using cash or debit you are subsidizing my fraud protection by overpaying.
What determines which cards you can get?
In the US you will have a credit score unless you have no credit history. When I came to the US I had no credit history and it caused some issues. Students, kids turning 18 soon and other similar groups will also struggle with the same issues. A credit score is a rough measure of creditworthiness, the degree to which you would be a good candidate for borrowing money. It doesn't perfectly match the things credit card companies are looking for and it is used for mortgages, car loans and even in job applications. It is calculated using the following system.
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There are 5 components of a credit score.
The first is payment history which makes up 35% of your total score, no more, no less. You could never make a payment on any debts and have them all go into collections and it would not impact the other 65% of your score (although obviously I wouldn't recommend this). Likewise you could always make every payment on time without fail but if you never addressed any of the other 65% your perfect payment history would not result in a good score. However borrowing money on a credit card is expensive so obviously we should plan on having a perfect payment history either way. It will only get you 35% but it's good for its own sake.
The second is amount owed, also known as credit utilization. This makes up another 30% of your credit score, no more, no less, in the same way as payment history. Utilization is simply how much of your available credit are you using. If your available credit was $20,000 and you had a $5,000 credit card balance your utilization would be 25%. The lower your utilization is, the better. However utilization has absolutely no memory. That means that if yesterday you owed $20,000 of a possible $20,000 and today you paid it all off the amount you owed yesterday would cease to matter. The credit score impact of utilization varies on a day to day basis as your utilization changes with no negative impact from previously high utilization and no positive impact from previously low utilization.
15% comes from the average age of account. This is calculated in a very simple way, the total age of every open account divided by the number of open accounts. At 15% of your total credit score it is far less important than utilization and payment history but is still nice to have. If an old account was closed it would lower your score from average age as would opening a new account. A closed account does not exist for the purpose of average age of accounts and at 15% it's a low impact area.
Another 10% comes from the types of credit in use such as mortgages, car loans, credit cards and lines of credit. This mitigates the high utilization impact of things like mortgages but does not penalize people who have only had credit cards. At 10% of your score it does not have a huge impact.
The final 10% comes from new credit in the form of credit pulls. When you apply for credit the financier can do either a soft pull or a hard pull (if you authorize them to do so, they cannot do them without your written permission). A hard pull will count against you on this final 10%. The credit score impact of a hard pull halves after 6 months and has no impact after 12 months. After 24 months it will disappear entirely from your credit report.
The first is payment history which makes up 35% of your total score, no more, no less. You could never make a payment on any debts and have them all go into collections and it would not impact the other 65% of your score (although obviously I wouldn't recommend this). Likewise you could always make every payment on time without fail but if you never addressed any of the other 65% your perfect payment history would not result in a good score. However borrowing money on a credit card is expensive so obviously we should plan on having a perfect payment history either way. It will only get you 35% but it's good for its own sake.
The second is amount owed, also known as credit utilization. This makes up another 30% of your credit score, no more, no less, in the same way as payment history. Utilization is simply how much of your available credit are you using. If your available credit was $20,000 and you had a $5,000 credit card balance your utilization would be 25%. The lower your utilization is, the better. However utilization has absolutely no memory. That means that if yesterday you owed $20,000 of a possible $20,000 and today you paid it all off the amount you owed yesterday would cease to matter. The credit score impact of utilization varies on a day to day basis as your utilization changes with no negative impact from previously high utilization and no positive impact from previously low utilization.
15% comes from the average age of account. This is calculated in a very simple way, the total age of every open account divided by the number of open accounts. At 15% of your total credit score it is far less important than utilization and payment history but is still nice to have. If an old account was closed it would lower your score from average age as would opening a new account. A closed account does not exist for the purpose of average age of accounts and at 15% it's a low impact area.
Another 10% comes from the types of credit in use such as mortgages, car loans, credit cards and lines of credit. This mitigates the high utilization impact of things like mortgages but does not penalize people who have only had credit cards. At 10% of your score it does not have a huge impact.
The final 10% comes from new credit in the form of credit pulls. When you apply for credit the financier can do either a soft pull or a hard pull (if you authorize them to do so, they cannot do them without your written permission). A hard pull will count against you on this final 10%. The credit score impact of a hard pull halves after 6 months and has no impact after 12 months. After 24 months it will disappear entirely from your credit report.
If you're an American teenager or young adult you should consider asking a financially responsible parent if you could be added as an authorized user on one of their cards. Do not actually get the card, when it arrives in the mail give it to the parent to cut it up. However their payment history, average age of account and utilization will start working in your favour and will be hugely useful when you buy your first car etc. An authorized user has no liability for any balances on the card, it's a no lose situation.
Signup bonuses, promotions and points
This is where it gets a little advanced and pretty fun. If you're one of the perfect candidates for a credit card, someone with a decent income, decent spending and who will always pay it off, in full, on time, credit card companies want you to be using their card. It comes back to the 80% annual return on investment mentioned at the start. They want you to be earning them that money, not one of their rivals, and they will get competitive in bidding for your business. A lot of cards come with pretty great incentives on top of the ones mentioned above, chiefly signup bonuses. It typically goes along the lines of "if you get this card, spend $X on it within Y months we will give you X bonus points".
Opening a new account purely for bonus points will hurt the 10% of your credit score that is determined by hard pulls on your credit. It'll also lower your average age of account. However the increased credit available to you will decrease your utilization and if you were to subsequently close the card after getting the bonus it'd disappear off of everything but the hard pulls. And it'd disappear off of that after a year.
The Chase Freedom I opened a few months ago offered me 25,000 points (worth $250 to $600 depending upon how I redeem them) if I spent $500 on the card within 3 months which was a pretty sweet deal imo. This practice is called churning and there is a subreddit devoted to it although for casual usage you don't really need to follow that. Just keep an eye out for high bonus cards and grab a new one every 3 months.
Other abuse
On September 15th one of my cards will give me 5% off all purchases on Amazon. Everything at Amazon including Amazon third parties and including gift cards which is exploitable as fuck.
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All purchases you make at Amazon.com, including digital downloads, Amazon.com Gift Cards, Amazon Fresh orders, Amazon Prime subscriptions, and items sold by third party merchants through Amazon.com’s marketplace are included.
Also this 5% off is in the form of points which are worth more than one cent each if redeemed creatively which means that the 5% off can translate to nearer 13% off.
The inclusion of gift cards is pretty awesome because it allows you to start bringing your credit card into areas which are not typically credit card friendly. I will be buying a few thousand dollars of Staples gift cards on Amazon, using those to buy a few thousand dollars of Target gift cards at Staples and then taking those to a Target and loading them onto a Target RED card (there is a Staples and a Target one mile from my house). You can pay rent/mortgage/utilities/student loans etc with a Target RED card using their online bill pay.
It's kinda crazy that it exists but it does so whatever, it should be about an hour of work for maybe $500 of savings thanks to the credit card company.
This is by no means a conclusive guide and explanation but it covers some of the basics and the role credit cards play in my financial life. I think they're an obscenely powerful tool and with good usage they could save/earn you several thousand dollars a year for a few hours of research and gaming the system. Never spend on credit more than you could afford were it not on credit. Don't use them as a fix for systemic financial difficulties. Take advantage of them as a tool.
