What is a Credit Card?
A credit card is a card that is issued by a financial institution, such as a bank or a credit union, that enables the cardholder to borrow funds from the institution, then pay the money back, with interest, based on the terms the institution stipulates. The funds can be accessed through purchases or cash advance.
A credit card may be used to make purchases or to get cash advances. It typically has a credit limit (maximum amount of funds that can be accessed for purchases) and a cash advance limit ((maximum amount of funds that can be accessed for cash). The cash advance limit is usually lower than the credit limit.
The interest rate on a credit card is fixed and usually ranges from 10% to 30%. The higher your credit score, the better interest rate you will likely get. Plus some financial institutions will lower your interest rate (when asked to) if you prove to be a worthy creditor over the years.
A credit card gives a grace period (zero interest period) on purchases from the date of purchase to the bill due date, provided your balance is paid in full each month. If you have a revolving balance on your credit card there is no grace period.
There is NO grace period on cash advances, interest is charged everyday on the advance until it is repaid.
There are typically 4 different types of credit cards:
- Standard Credit Cards: these extend credit to users for making purchases, balance transfers and taking cash advances.
- Rewards Credit Cards: these offer cash back, points to redeem for gift cards or other items, travel points and other benefits to customers
- Secured Credit Cards: these require an initial cash deposit that is held by the issuer as collateral.
- Charge Credit Cards: these have no preset limit – spending is unlimited – but unpaid balances cannot carry over from month to month (these are usually given to businesses).
What is a Line of Credit
A line of credit (LOC) is an open loan that is offered to customers by a financial institution that gives unlimited access to funds. However, there’s a limit to the amount of funds that can be accessed. Like credit cards, the money borrowed from a LOC must be repaid with interest, based on the terms of the lending institution.
Unlike a credit card, a LOC has no grace period, interest is charged the moment the money is borrowed and continues to accrue until the loan is repaid.
The interest rate on a LOC is not fixed. It’s tied to the prime interest rate so depending on the economic stability of the nation, you could see your interest rate change multiple times throughout a year.
There are 2 different types of lines of credit:
- Secured Lines of Credit: these are usually secured by a home and is called a HELOC (Home Equity Line of Credit)
- Unsecured Lines of Credit: these are not secured
The interest rate on a secured LOC is lower than that of an unsecured one because the risk is lower — the home is a collateral. Typically the interest rate on a HELOC is the prime interest rate, or the prime rate plus an amount between 0 and 1%. The interest rate on an unsecured LOC is usually the prime interest rate plus an amount between 2 and 10%.
The higher your credit score, the better interest rates you will receive on your lines of credit. Currently I have lines of credit with interest rates at prime, prime + 0.3% and prime + 0.5%.
Credit Cards vs Lines of Credit
Here’s a quick comparison between credit cards and lines of credit:
- Credit cards charge Compound Interest while lines of credit charge Simple Interest.
- The interest rates on credit cards are usually much higher than those on lines of credit.
- Credit cards offer low-interest promotional rates like a 0% introductory interest rate on initial purchases and balance transfers, and may even have a 0% balance transfer fee if the transfer is done within the first few months of getting the card.
I have never seen a LOC with a 0% introductory rate, but I do get low-interest promotional rates from time to time.
- Both have a minimum payment. For LOCs, the minimum payment is the interest, while for credit cards, the minimum payment is usually a percentage, such as 2% of your outstanding balance.
- Credit cards give you a grace period, usually of at least 21 days— from your purchase date to the bill due date — but there is no grace period with LOCs.
- If you pay your credit card balance in full, your interest charges will be 0. If you’re only making the minimum monthly payment however, the grace period doesn’t apply. Interest is charged for each day your balance is not paid up in full, even new purchases attract daily interest.
LOCs attract daily interest whether you pay the balance in ful or not.
- Credit cards tend to offer reward programs, while LOCs don’t. But some credit cards with reward programs may have an annual fee, while LOCs never have annual fees.
- Some credit cards charge fees for balance transfers (transferring other loans to a card) while LOCs have no balance transfer fees.
- Purchases made with your credit card may have some guarantee in the event the goods were damaged or a company goes out of business before the goods or services purchased were delivered.
So, the answer to the question: Should I use my Credit Card or My Line of Credit? is:
It depends on your financial situation.
Here are a few questions you should ask yourself to decide:
- Do I pay off my credit card in full each month?
- Is the interest on my LOC lower than that on my credit card?
- Do I need cash or am I making a purchase?
- Will I be able to pay my credit card in full by the due date if I make the purchase?
If you have a revolving balance on your credit card, all purchases accrue interest the day you make the purchase so if your LOC has a lower rate, it would be better to use your LOC to zero your credit card. This way you will get back your grace period, and the interest paid on your LOC will be lower for 2 reasons:
- The interest charge is lower
- Simple Interest is cheaper than compound interest
In situations where you have no revolving balance on your credit card but may not be able to pay a purchase in full, it’s better practice to make the purchase on your credit card to get the no interest grace period, then use the LOC to pay off the credit card on the due date. Using this strategy will reward you in different ways:
- The purchase will be interest-free from purchase-date to the bill-due-date
- You will receive the reward points on your credit card for the purchase
- You will still enjoy the no interest grace period on your credit card for future purchases.
The irresponsible use of credit cards can put you in debt very quickly. Plus subscribing to the minimum payment, and not knowing how the interest is calculated may see you paying for a purchase you made 2 years ago up to 10 or more years later.
Now that you know how to use them wisely, you have no excuse to become a victim of credit card debt.