Charge cards or Credit cards?

Charge cards vs. Credit cards: What’s the difference?

Most people know what a credit card is, because they either own one themselves or have friends and family that do.  However, when talking about charge cards, I often hear the following response: “Oh, a charge card and a credit card are the same thing, right?”

This is a common misconception, so to clear things up: no, a charge card is not a credit card.  Yes, they are both credit products, but there are two important differences to consider before deciding which would be beneficial to you.

Charge cards must be paid off

Revolving credit cards typically have a preset spending limit, which means you are assigned a ceiling on your spending that should not be exceeded.  As an optional feature, credit cards will allow a user to carry a balance month to month; the disadvantage to this is that interest will be charged on the outstanding balance. In this manner, credit cards offer payment and balance flexibility.

In general, charge cards do not have this kind of flexibility, though some products today allow a portion of your balance to be rolled over in certain circumstances.  The average charge card requires that you pay off your entire outstanding balance at the end of every billing cycle.  Many companies offering charge cards flaunt the fact that their products have no interest or finance charges; this makes sense, being that they won’t allow one to carry a balance over to the next billing cycle in the first place!  In a nutshell, charge cards are merely short term interest free loans that must be repaid monthly (or at the end of your billing cycle).  Failure to comply with these terms will usually inflict significant penalties upon the cardholder and termination of the account.

Charge cards are reported differently

Charge cards have no “pre set spending limit” and must be repaid at the end of every billing cycle (usually monthly).  The purchases you charge onto a charge card accumulates into a total balance that is reported to all three credit bureaus: Transunion, Equifax, and Experian.

The credit bureaus treat these open charge balances differently than revolving credit card balances, however.  Under the current FICO scoring model, charge card balances do not affect the utilization portion of your credit score.  This means that you can potentially run up a significant balance on your charge card and have it not hurt your FICO utilization, whereas doing the same on a revolving credit card could adversely affect your credit.*  Be warned, however.  Institutions who run your credit using older scoring models, such as TU-98, would receive a report that would indeed include charge cards in calculating utilization, which would be a bad thing.

Why use a charge card over a credit card?

I can see two reasons to use a charge card, rather than a traditional “revolver.”

Charge cards keep you “honest.”

For those that are still working on their credit management skills, charge cards can help to build good spending habits by forcing you to pay down your cards periodically rather than rolling over a balance and paying finance charges.  For myself, I use charge cards in every situation I’d use a debit card.

Charge cards can help your credit score more than a revolving credit card: sometimes.

If you have heavy expenses going on your cards and don’t pay them off before the end of your billing cycle, charge cards would alleviate the negative effects that this potential high utilization would have on your credit score.  Be sure that your lender reports your charge card as an “open” charge line instead of a “revolving” credit line, though.

What about “no preset limit” credit cards?

These are a tricky bunch.  “No preset limit” credit cards function as a hybrid of a traditional revolving credit card and an open charge card.  The cards have a stated credit limit, but if exceeded, the cards will allow you to make additional charges (all of which must be paid by the end of the billing cycle).  “No preset limit” credit cards can offer the enhanced spending ability of a charge card but also the ability to carry over a balance to the next billing cycle, like a traditional credit card.  These hybrid products’ balances are reported differently to the major bureaus; whether or not your lender decides to report your balances as generated from an open or revolving credit line is up to them.

Perks and benefits

Most charge card products offer cardusers cash back or points/miles based rewards, similar to their revolving credit cousins.  Responsible usage of a charge card can earn you various gifts, perks, travel, etc. just like your standard credit card.

Lastly….

Charge cards are not for everyone.  Since they often impose high fees and penalties for misuse and late payments, charge cards are a bad idea for those who often carry balances on their credit cards to the next month/cycle.  In addition, charge cards can also cause confusion when one is trying to figure out what their exact spending power is.  Most charge card issuers, including American Express, do not disclose what their internal “exposure” limit is to the cardholder.  If a charge card user accumulates a balance on their card that the issuer is uncomfortable with, they can freeze the account until the balance is paid down.  In my experience, this rarely happens unless you are trying to place huge purchases on the card that you normally wouldn’t.  A rather fun example would be purchasing a Maserati on your card (yes, people have charged cars to their cards before).  For larger purchases like this, you should call your lender and ask them to preauthorize the charge first in order to avoid any issues.

The charge card is a financial tool that can help your credit if used responsibly.  It adds to your overall credit mix (which helps your credit score) and makes for a great alternative to a debit card.  Charge cards don’t impose interest and penalties if you follow the terms of the card and pay it off in full at the end of every billing cycle.  Lastly, just like good credit card usage, charge cards can help to build or maintain your credit by showing a consistent on-time payment history.  If you don’t have a charge card yet, you may want to look into several of the newer products available today that have competitive annual fees and reward programs.  Do your due diligence and be sure to pick a charge card that fits your spending habits and lifestyle.  Happy responsible charging!

* FICO utilization is a component of your credit score.  Using your credit cards heavily up to their limits is construed as risky credit behavior, which then lowers your FICO score.  For example, if you own two $5,000.00 limit credit cards and charge them both up to $9,500.00 for the month, you are utilizing most of your available credit.  However, placing a small charge on one card for $1,000.00 would be good for your utilization, as it would be reporting at 10% ($1,000 used out of $10,000 available).  Taking this further, a strategy to curtail the reporting of high balances to the credit bureaus is to pay in full (PIF) your credit cards before the statement cuts at the end of your billing cycle.  Paying your cards off before the statement is released will show 0% utilization, suggesting a lower risk than the person who maxes out their credit cards every month.  Since charge cards do not report balances for utilization calculation purposes under the new FICO scoring model, heavy purchases placed on charge cards versus credit cards can potentially help your credit score.

Sources:

• http://www.myfico.com/crediteducation/questions/charge_cards.aspx

• Conversation with American Express customer service team, 8/2010

• http://articles.latimes.com/2010/aug/08/business/la-fi-0808-montalk-20100808

• http://ficoforums.myfico.com/t5/Credit-Cards/Charge-card-versus-credit-card/td-p/718026