Mar
17
2023
Bull Markets, Explained

Bull Markets, Explained

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Bull Markets, Explained

A bull market occurs when a broad market index rises at least 20% over two months or more. Bull markets signal higher levels of investor confidence and optimism about the future of the market. They are generally a sign of a strong, healthy economy.

The opposite scenario, in which stock prices fall by 20% over an extended period, is known as a bear market.

If you’re investing in the stock market, it’s important to know the nature of bull markets and their potential impact on your returns.

What Is a Bull Market?

When asset prices generally rise over time, the upward trend is known as a bull market. The traditional benchmark for identifying a bull market is an increase of 20% or more in a market index over a two-month period. For example, stock experts might look closely at the Dow Jones Industrial Average (DJIA) or the S&P 500 to determine whether a bull market exists.

Bull markets can imply that the economy is in good shape, with unemployment low and new jobs being created. Investors tend to view a bull market favorably because it suggests that stock prices may continue to rise over the long term. People who buy stocks early in a bull market may benefit later from the investments’ significant price appreciation.

Why Is It Called a Bull Market?

Although there’s no single explanation for how bull and bear markets got their names, people often suggest that the descriptive names are meant to reflect the nature of each animal.

Bulls, for instance, have a reputation for charging or attacking. In a bull market, eager investors may rush in to buy stocks in the hope of capitalizing on future price increases.

Bears, on the other hand, are often seen as being defensive animals that only attack when threatened. In a bear market, it’s common to see investors pull back out of caution and sell off stocks they own or avoid buying new ones. Those behaviors are often driven by fear and uncertainty about the market trending down.

Characteristics of a Bull Market

Identifying when a bull market begins or ends is sometimes challenging, given the nature of stock prices and how rapidly they can move up or down. Generally, there are three indicators that stock experts use to determine whether a bull market exists.

•   Stock prices, or prices for a broad market index, have increased by 20% or more over a set period of time, typically two months or longer.

•   Investor confidence is high and those buying into the market have an optimistic outlook toward the future.

•   Overall economic conditions are largely positive, with low unemployment rates and, ideally, low inflation rates as well.

These three signs usually indicate that the market is on a sustained upswing. Other indications of a bull market can include strong earnings reports and marked increases in investors’ dividends.

What Causes a Bull Market?

Bull markets are usually driven by changing undercurrents in the economy. They tend to reflect the business cycle.

The business cycle experiences periods of expansion, followed by periods of contraction. Real gross domestic product is a commonly used metric for determining which of four phases the economy is in.

•   Expansion. During the expansion period, the economy is growing and domestic production is up. There may be a bull market for stocks during this period.

•   Peak. A peak occurs when the economy exhausts its ability to grow. At this stage, the bull market typically hits its highest levels before entering the next phase.

•   Contraction. During the contraction period, the economy shrinks. Companies may cut back on spending or hiring to save money and stocks may enter bear market territory.

•   Trough. The trough is the lowest point in the business cycle. It’s followed by the beginning of the next expansion phase, which can open the door to a new bull market.

The business cycle also influences when bear markets occur. In addition, there are times when a bull or bear market is triggered by something other than the business cycle. For example, in early 2020 there was a short-lived bear market caused by uncertainty over the emerging COVID-19 pandemic.

Example of a Bull Market

The bull market that began in 2009 following the shock of the financial crisis is the longest on record, lasting until the bear market that occurred in early 2020.

Several factors contributed to the sustained length of the bull market, including strategic moves to manage monetary policy on the part of the Federal Reserve, and tax breaks delivered by the 2017 Tax Cuts and Jobs Act.

Many stockholders benefited from steady dividend payouts, and the real estate market also delivered a strong performance during that time.

Bull Market vs Bear Market

Bull markets and bear markets are opposites in terms of how participants behave and what the outcomes can mean for investors. Bull markets typically involve upward movement of stock prices while bear markets indicate a downturn.

In a bull market, investors tend to take a positive view of the market. Bear markets, on the other hand, can trigger pessimism, fear, or other negative feelings among investors.

Bull markets are usually marked by thriving economies and high levels of corporate growth. Bear markets point toward a slowing economy and limited growth. In extreme cases, a bear market could suggest that a recession may be on the horizon (although a recession can offer certain opportunities as well).

Investing Tips During a Bull Market

Investing in a bull market isn’t one-size-fits-all, so your personal approach may be different from other investors’. There are, however, a few overall strategies that could help you to maximize gains while taking on a level of risk you’re comfortable with.

Keep Your Goals In Sight

It’s easy to be tempted to follow the crowd when investing in a bull market or a bear market, but it’s important to stay focused on your individual goals, especially if you’re a beginning investor. If you already have a financial plan in place, that plan can act as a guide for how to choose the right asset allocation during a bull market.

Diversify Your Portfolio

Diversification is an important tool for managing risk in a portfolio. When you’re diversified across different asset classes or industries, it helps to limit your exposure to certain kinds of investment risk. If one investment begins to decline in value, your other investments can help to bolster your portfolio.

A higher allocation to stocks may be optimal if stock prices are rising, but you may want to balance those out with less risky investments, like bonds.

If you’re investing in mutual funds or exchange-traded funds (ETFs), consider what assets each one holds to avoid becoming overweighted in one particular industry or sector.

Go Long in Your Positions

Going long simply means adopting a buy-and-hold approach when investing in a bull market. The end goal is to buy stocks at a low price, then sell them later for a higher price to maximize returns. The key is knowing how to identify the impending end of a bull market so that you can sell before prices drop.

The Takeaway

Bull markets, in which asset prices rise and investors feel optimistic, are a natural part of the market cycle. A bull market begins when a market index rises 20% or more over a two-month period, and it can last months or years. Generally, during a bull market, maintaining a diverse portfolio and a clear idea of your goals can help you manage your investments prudently.

If you’re not investing yet, it’s never been easier to get started. With SoFi, you can open an online investment account and start building a portfolio. You can choose between self-directed trading or automated trading as you begin your journey to growing wealth. SoFi doesn’t charge management fees, and investors can choose between stocks, ETFs, and more.

Invest with as little as $5 with a SoFi Active Investing account.

FAQ

Is a bull market a good market?

A bull market usually signifies that the market is strong. A market where stock prices are generally increasing can offer an opportunity to buy and hold stocks — if you can purchase them before prices rise too high.

How long can a bull market last?

Bull markets have no set duration; they can last months or even years. When a bull market occurs, it typically sticks around for a longer period of time than bear markets do.

Should you sell stocks in a bull market?

Selling stocks in a bull market could make sense if you’re able to sell them for substantially more than you paid for them. Essentially, it all comes down to timing and what makes sense for your individual goals and tolerance for risk.

Photo credit: iStock/GOCMEN

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.


Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

Exchange Traded Funds (ETFs): Investors should carefully consider the information contained in the prospectus, which contains the Fund’s investment objectives, risks, charges, expenses, and other relevant information. You may obtain a prospectus from the Fund company’s website or by email customer service at https://sofi.app.link/investchat. Please read the prospectus carefully prior to investing.
Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.
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Mar
17
2023
What Is Broker Call, or Call Money Rate?

What Is Broker Call, or Call Money Rate?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Broker Call, or Call Money Rate?

The broker’s call — also called “call money rate” or “call loan rate” — refers to the interest rate that brokerage firms pay to banks when they borrow money.

Brokerage firms borrow money from banks in the form of call loans in order to offer loans to traders and investors with margin accounts. As such, the interest rate that brokerages pay banks is what’s referred to as the broker’s call, or call money rate.

Banks can call those loans back from brokerages at any time (hence the name “call loans”), which may cause brokerages to call the money they lent to traders or investors (in the form of margin). That’s one example of what’s referred to as a “margin call.”

Broker Call Rate Definition

The broker call rate is the interest rate that brokerage firms pay banks for borrowing money that they, in turn, loan to traders and investors to pursue margin trades. Since many brokerage firms allow investors to trade “on margin,” the brokerages need to have access to a pool of money that they can borrow from.

In effect, banks lend money to brokerages, and the brokerages lend money to investors — each loan carries a different rate. The broker call rate, again, is the interest rate that the brokerages pay to the banks.

Investors and traders that are using margin to trade will be on the hook for interest payments to the brokerages, and the applicable interest rate for those traders are called margin rates.

But, in terms of a broker call rate, that is only referring to the interest rates that brokerages pay to banks, not the margin rates traders pay to brokerages for their margin accounts.

In addition, although the broker call rate is quoted as an annual rate, these loans are typically for much shorter periods of time. As such, the fees are assessed daily. If the annual rate is 5%, the overnight rate is 5% divided by 365 days or roughly 0.014% per day.

Margin rates, or the rates charged to traders, would be higher.

Recommended: What is Margin Trading and How Does it Work?

Explaining Call Money Rate

Although the terms sound quite different, the broker call rate and the call money rate are essentially the same thing: it’s the interest rate that brokers pay to banks for borrowing money. That typically comprises short-term loans that the brokers then turn around and lend to traders or investors for use in margin accounts.

Brokerages will typically include a service charge, expressed as a percentage, on top of the call money rate to get their margin rates. So, in effect, traders or investors using margin accounts pay a premium, plus interest, to trade with margin loans.

As an investor is deemed capable of borrowing more money, the gap between the broker call rate and the margin rate narrows.

Brokerages drive extra revenue by exploiting the difference in interest rates, just as investors do the same via interest rate options.

The Use of the Term ‘Call’

A quick side note: You may have noticed that the term “call” is a common financial term with various meanings, including:

1.    A brokerage issuing a “margin call” requiring a borrower to increase the cash in their account or sell assets to raise cash for their account.

2.    A lender “calling a loan” on a borrower, requiring them to repay their debt.

3.    Yield to call is another example of the word that in this phrase refers to bonds.

What Is a Call in Options Trading?

A “call” is also a common type of option (the two main types of options are puts and calls), but the sense of the word here is quite different. A call option is a derivative contract that gives investors the right, but not the obligation, to buy a certain number of shares of an underlying asset.

While options trading and margin trading are similar in that they use leverage, margin trading specifically involves borrowed funds. A margin account is not required for options trading.

How Is the Broker Call Rate Calculated?

The broker call rate in the U.S. fluctuates continuously, but generally increases along with interest rates across the board due to the Federal Reserve lifting benchmark rates. Conversely, as the Federal Reserve cuts rates, the broker call rate falls as well.

The broker call rate and the Federal Reserve funds rates are tightly linked, but they are not required to be the same.

It’s also important to know that the broker call rate fluctuates on a daily basis, much like other interest rates. With that in mind, the broker call rate’s calculation is less of a calculation, and more based on a benchmark, such as the London InterBank Offered Rate, or LIBOR rate.

LIBOR serves as a benchmark interest rate that lenders around the world use when they lend to another financial institution on a short-term basis. As such, it makes sense that it would serve as the benchmark for the broker call rate.

But LIBOR is being phased out as of the beginning of 2022, and is being replaced in most instances by the Secured Overnight Financing Rate (SOFR). The transition won’t fully replace LIBOR until 2023, however.

How Does It Affect Margin Traders?

Margin traders utilize leverage to attempt to supercharge their returns. That is, they’re borrowing more money than they actually have in order to make bigger trades. This increases their investing risk, but can also increase their gains.

And, as discussed, it’s pretty obvious how the broker call rate can affect margin traders. Since brokerages need to borrow money from banks, and pay the associated costs for doing so (in the form of interest), they need to turn a profit through their own lending activities. Lending to margin traders, by charging interest plus a service fee or other related cost, helps them cover those costs.

So, the higher the broker call rate, the more interest brokerages need to pay banks in interest charges. That gets passed down to margin traders, who, in turn, end up paying more in interest charges to brokerages when they use margin. This is one of the drawbacks when using a cash account versus a margin account — there are additional costs to consider for using margin, which can eat into returns.

Broker Call Rate Example

Here’s an example of how the broker’s call rate may come into play in the real world:

Brokerage X needs to offer margin funds for its clients with margin accounts, but doesn’t have the money to cover its needs. So, it borrows the money from Bank Y at a predetermined broker call rate. Bank Y decides that the rate will be the current LIBOR rate, plus 0.1%. So, if the LIBOR rate is 3%, for example, the broker call rate is 3.1%.

Brokerage X then uses the borrowed funds to offer margin funds to its clients, for which it charges a margin rate of 4%, plus a $10 service fee. By doing so, Brokerage X drives a little extra revenue through its lending activities, and when the traders pay the margin funds back, it can return them to Bank Y, paying the 3.1% broker call rate for the privilege of borrowing.

Current Call Money Rate

The current call money rate is published daily by the Wall Street Journal, and others. As it fluctuates often, margin traders, or others who may be subject to those fluctuations, can or should make a habit of looking at the current rate in the event that it changes their strategy.

Due to the Federal Reserve raising benchmark rates in an effort to blunt high inflation, the call money rate has seen rapid increases throughout 2022. As recently as June 2021, for instance, the call money rate was only 2%.

Margin Trading With SoFi

The broker call rate is the interest rate that brokerage firms pay banks for borrowing money that they, in turn, loan to traders. Since many brokerage firms allow investors to trade “on margin,” the brokerages need to have access to a pool of money that they can borrow from.

Brokerages typically charge a fee, expressed as a percentage, on top of the call money rate to get their margin rates. So, in effect, investors using margin accounts pay interest to trade stocks with margin loans — plus a little extra.

Leveraged trades are complicated and can be risky. While using borrowed money lets traders place bigger bets, and possibly see bigger gains, they also risk steep losses.

If you’re interested in opening a margin account, you can start by opening a new investing account with SoFi. From there you can apply for a margin loan and start trading. SoFi doesn’t charge commission, and SoFi members have access to complimentary financial advice from professionals.

Get one of the most competitive margin loan rates with SoFi, 12%*

FAQ

Who decides the call rate for margin trading?

A brokerage ultimately decides the costs associated with margin trading for investors. But as far as what determines the broker call rate, it goes back to the rate as determined by the prevailing benchmark interest rate, such as LIBOR, or the Secured Overnight Financing Rate (SOFR), which is taking precedence as LIBOR is phased out.

What is the overnight call rate?

The overnight call rate refers to the interest rate that banks use when lending or borrowing overnight. Again, since the call money rate is constantly fluctuating, the overnight call rate may or may not be different from the call money rate during normal trading hours.

Photo credit: iStock/YakobchukOlena

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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Mar
17
2023
Guide to Speculative Investments

Guide to Speculative Investments

By | Growing Wealth, invest, Investing | Comments Off on Guide to Speculative Investments

A speculative investment is when an investor hopes to profit from a rapid change in the value of an asset, often one that’s considered non-productive.

Many speculative investments are short-term, and they can be made in markets such as foreign currencies, collectives, fine art, and margin trading of stocks.

Typically, speculative investments are high-risk positions in assets with frequent price fluctuations, providing both the opportunity to profit and the risk of loss.

What Are Speculative Investments?

In general, if an investor is investing in an asset with the belief that its value will increase within a short amount of time, and they will be able to sell it for more than they bought it for, that is a speculative investment.

The types of investments that fall into the speculative investing category are often referred to as non-productive assets, because they don’t produce any income while they are held by an investor, such as dividends or rental income.

The way investors make money on them is by speculating that someone else will buy the asset for more than they did at some point in the future. There is some underlying agreement in the markets that an asset has value despite its lack of production. For instance, gold and precious metals are considered valuable, and investors buy them predicting that their value will increase.

Conversely, non-speculative investments tend to be part of long-term investment strategies. These are assets that may increase in value over a longer period of time, and may also provide income while the investor owns them.

Examples of non-speculative investments can include real estate and owning part of a business, but even real estate and stock investments can be considered speculative in certain cases.

How Does Speculation Work?

As noted above, speculation is when investors anticipate that their purchase will go up in value and they will be able to sell it for a profit. Investors would be unlikely to take part in speculative investments unless there was a significant chance that they might see a significant gain, despite the risk exposure.

Investors typically consider many factors, such as a news event, election cycle, interest rate changes, or a new regulation. Any of these could spark a price change in a speculative asset.

If an investor has several speculative assets in a portfolio, they might hope that just one or two of them earn a huge profit, making up for any losses in other areas. Speculative investing poses a high risk for novice investors.

Speculation looks different depending on the market. For instance, speculation in the real estate market might look like an investor buying multiple properties with small down payments with a plan to quickly resell them for a profit.

Speculation can also look like betting against the market trend through short selling, a strategy where investors to bet that a particular stock’s future price will be lower than its current price. It’s the opposite of going long a stock, where an investor buys shares with the expectation that the stock price will increase.

4 Examples of Speculative Investments

Below are four examples of common speculative investments.

1. Foreign Currencies

One type of speculative investment is foreign currencies (forex). The forex market is the largest in the world. Around $6.6 trillion is transacted each day in the global foreign currency markets.

Forex trading involves buying and selling currency pairs such as EUR/USD. As the value of one currency goes down, the other goes up. Traders speculate on which way the relationship will go and hope to profit off the change in value.

Forex markets are open 24 hours a day, and investors can execute trades as quickly as seconds or minutes, making it a popular forum for speculation.

2. Precious Metals

Precious metals such as gold, silver, copper, and others are traded as hard commodities (versus soft commodities, like agricultural products). These are speculative investments that fluctuate in price constantly based on a variety of factors, including inflation, supply and demand for products that require these metals, and other trends.

Thus, investing in precious metals can be risky because they’re susceptible to volatility based on factors that can be hard to anticipate. Even a relatively stable commodity such as gold can be affected by rising or falling interest rates, or changes in the value of the U.S. dollar.

In the case of any commodity, it’s important to remember that you’re often dealing with tangible, raw materials that typically don’t behave the way other investments or markets tend to.

3. Cryptocurrencies

Cryptocurrencies are considered speculative since they fluctuate widely in price and come with high risk and potential high returns. Because the crypto markets are barely 14 years old, there isn’t a lot of history to the market to use for predictions, and no way of knowing whether a crypto like Bitcoin (or Ethereum, Litecoin, Dogecoin) will go to $100K or to $1K within the next year.

4. Bond Market

Asset prices in the bond market fluctuate widely depending on interest rate changes and political and economic conditions. The prices in the U.S. Treasuries market are often strongly influenced by speculation.

Bonds are rated by agencies such as Moody’s and Standard and Poor’s. Highly rated bonds are not considered speculative and are referred to as “investment grade,” while lower-rated bonds are considered speculative and referred to as “junk bonds.” Since junk bonds are riskier, they pay out higher interest rates to investors.

Pros and Cons of Speculative Investment

Speculative investments come with both upsides and downsides. The choice of whether to make speculative investments depends on an investor’s risk tolerance, knowledge about markets, and short- and long-term investment goals.

Pros

Some of the pros of speculative investments include:

•   Potential for high returns

Cons

Downsides of speculative investments include:

•   Don’t provide income while they are held. (With some exceptions, such as cryptocurrencies that earn interest through staking)

•   Risk of losing one’s entire investment

•   Requires active trading and time commitment

Speculative Investments vs Traditional Investments

Below are some of the key differences between speculative investing and traditional investing:

Speculative Investments

 Traditional Investments
Usually short-term Long-term
High risk and active Low- to medium-risk and generally more passive
Includes alternative and niche assets such as art, forex, and crypto Generally includes traditional assets like stocks, bonds, and index funds

Recommended: What Are Alternative Investments?

Speculative Investments vs Gambling

The difference between speculation and gambling is that speculation involves taking a calculated risk on investing in an asset with an uncertain outcome but an expected return from the asset increasing in value. Gambling involves betting money with an uncertain outcome and the hope of winning more money.

Gamblers could be said to possess a more risk neutral outlook, in that they might disregard even high levels of risk for a potential reward. Speculative investors calculate the risk vs. the reward.

Other Risky Investments

In addition to the speculative investments highlighted above, the following are higher-risk types of investments that can be considered speculative.

Margin Trading

Margin trading involves an investor borrowing money from a broker in order to make a trade rather than using a cash account to buy securities. Usually investors can only borrow up to 50% of the purchase amount of securities they want to buy. For example, if an investor with $3,000 in their account, can borrow $3,000, allowing them to purchase $6,000 worth of securities.

Typically, less experienced, risk-averse investors choose cash accounts vs. margin accounts because of the risks involved with leveraged positions. By using margin, the investor can place bigger bets. But if the trade doesn’t go in their favor they could lose both their own capital and the money they borrowed.

Margin accounts also charge interest, so any securities purchased need to increase above the interest amount for the investor to see a profit. Different brokers charge different interest rates, so it’s a good idea for investors to compare before choosing an account.

Options Trading

With options trading, investors purchase an option that gives them the ability to buy a stock in the future at a particular price if they choose to. In other words, options give holders the right, but not the obligation, to buy or sell an asset like shares of a company stock.

Options holders can buy or sell by a certain date at a set price, while sellers have to deliver the underlying asset. Investors can use options if they think an asset’s price will go up or down, or to offset risk elsewhere in their portfolio.

Options are considered financial derivatives because they’re tied to an underlying asset.

Penny Stocks

Penny stocks are high-risk stocks that have a low dollar value. Investors can buy several shares of them since they are so inexpensive, with the hope that they increase a lot in value over a short period of time. An event such as a big news story could trigger a change in stock value and provide the chance for a trader to cash out.

The Takeaway

Speculative investments are risky, but can provide significant returns and can be a good way to diversify one’s portfolio. They are generally best for active traders looking for short-term investment opportunities, who can tolerate higher levels of volatility and risk.

Speculative investments are often considered non-productive assets, such as foreign and cryptocurrencies or commodities like gold or silver. But some stocks and bonds can be speculative too. Speculation is mainly the opportunity to profit from short-term price movements.

If you’re looking to start trading, consider margin investing with SoFi Invest. SoFi’s online investing app is streamlined and secure, so you can research, track, buy and sell on margin right from your phone or laptop. You can borrow money against your current investments to buy stocks and ETFs.

Get one of the most competitive margin loan rates with SoFi, 12%*

FAQ

What are some examples of some speculative investments?

Examples of speculative investments include penny stocks, crypto, precious metals, and forex. Many speculative investments fall into the category of non-productive assets, and they’re usually susceptible to volatility, giving investors the opportunity to profit from short-term price movements.

Is speculative investing the same as gambling?

No, gambling involves betting money with the hope that you will win more money, while speculative investing involves buying an asset with the expectation that you will be able to sell it for a profit.

Is Bitcoin considered a speculative investment?

Bitcoin and cryptocurrencies are considered speculative investments because their prices fluctuate widely and are difficult to predict. They are risky and come with the potential for significant gains or losses.

Photo credit: iStock/Delmaine Donson

*Borrow at 12%. Utilizing a margin loan is generally considered more appropriate for experienced investors as there are additional costs and risks associated. It is possible to lose more than your initial investment when using margin. Please see SoFi.com/wealth/assets/documents/brokerage-margin-disclosure-statement.pdf for detailed disclosure information.
SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

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Mar
17
2023
Guide to Protective Collars in Options Trading

Guide to Protective Collars in Options Trading

By | Growing Wealth, invest, Investing | Comments Off on Guide to Protective Collars in Options Trading

As an investor in a volatile market, it can be stressful worrying about gains turning into losses from day to day. One strategy to protect your gains is through protective collar options.

Protective collars provide inexpensive near-term downside risk protection on a long stock position, but the strategy also limits your upside.

What Is a Protective Collar?

A protective collar is a three-part strategy:

  1. A long position in a previously purchased underlying asset that has seen a large price increase you wish to protect.

  2. A long put option, also known as a protective put, that provides downside protection to your asset gains.

  3. A call option with the same expiration date as the long put written on the underlying asset, also known as a covered call. Writing this call offsets the cost of purchasing the long put option, but it will also limit the future potential gains on the underlying asset.

As with other options strategies, when you reduce risk, you must give up something in return. In the case of a protective collar option strategy, you limit your upside since you are short calls. Additionally, the sale of calls helps reduce the overall cost of the transaction. It might even be possible to construct a protective collar that generates income when initiated.

Collars in options trading help address price risks. The term “collar” refers to the strike prices of the two options being above and below the price of the underlying asset. The put strike is typically below the current share price while the short call strike is above the price of the underlying asset. Profits are capped at the short call strike price and losses are capped at the long put strike price.

How Do Protective Collars Work?

Protective collars work to hedge against the risk of a near-term drop on your long stock holding without having to sell shares. It’s one of many strategies for options trading to manage risk. If you have a sizable gain on your shares, you might not want to trigger a taxable event by liquidating the position.

Protective collars have many beneficial features:

•   Protective collars allow you to initiate the trade cheaply. A protective collar option can be done at a net debit, net credit, or even without cost, known as a “zero-cost collar”.

•   Protective collars provide downside risk protection at a level you determine. You will be purchasing a long put. By choosing a put that’s at the money, you will protect the most loss, but at the highest cost.

   Conversely by choosing a long put that is out of the money, you pay less up front, but the accepted potential loss will be higher.

•   Protective collars allow you to participate in further asset increases, again at a level you determine. By writing a call that’s at the money, you earn the highest premium but limit upside participation and increase the likelihood your shares will be assigned and sold.

•   By choosing to write calls that are far out of the money, you will earn lower premiums that can offset the cost of the purchased put option but allow continued participation in any future asset increases. Additionally, the likelihood that the call will be exercised and assigned is lower.

Recommended: Guide to Leverage in Options Trading

Maximum Profit

The maximum profit on a protective collar options position happens at the short call strike. The highest profit is limited to the high strike minus the net debit paid or plus the net credit received when executing the options trade.

   Maximum Profit = Short Call Strike Price – Purchase Price of Stock – Net Debit Paid

   OR

   Maximum Profit = Short Call Strike Price – Purchase Price of Stock + Net Credit Received

Maximum Loss

The maximum loss on protective collar options is limited to the stock price minus the put strike minus the net debit or plus the net credit received.

   Maximum Loss = Long Put Strike Price – Purchase Price of Stock – Net Debit Paid

   OR

   Maximum Loss = Long Put Strike Price – Purchase Price of Stock + Net Credit Received

Break Even

Theoretically, there are a pair of break-even prices depending on how the initial trade was constructed. If it was a net debit protective collar, then the break even is the stock price at trade initiation plus the net debit paid. If the options trade was executed at a net credit, then the break even is the stock price at trade initiation minus the net credit.

   Break Even = Stock Price at Trade Initiation + Net Debit Paid

   OR

   Break Even = Stock Price at Trade Initiation – Net Credit Received

However, for an asset that has seen significant appreciation, the concept of break even is almost irrelevant.

Constructing Protective Collars

Putting on a protective collar strategy might seem daunting, but it is actually quite straightforward. You simply buy a low strike put option and simultaneously sell an upside call option. Of course, you must already own shares of the underlying stock.

The protective put hedges downside risk while the covered call caps gains but helps finance the overall trade. Both options are usually out of the money.

Pros and Cons of Protective Collars

Pros

 Cons
Limits losses from a declining stock price while still retaining ownership of the shares Upside gains are capped at the call strike
There remains some upside exposure Losses can still be experienced down to the long put strike
Protective collars are cheaper than purchasing puts only Slightly more complicated than a basic long put trade

Recommended: Margin vs. Options Trading: Similarities and Differences

When Can It Make Sense to Use Protective Collars?

You might consider implementing a protective collar options position when concerned about near-term or medium-term declines in an equity holding. At the same time, you do not want to sell your shares due to a large taxable gain. For that reason, protective collar options might be more likely to be used in taxable accounts rather than tax-sheltered accounts like an IRA.

With the downside risk hedge also comes the risk that your shares get “called away” if the stock price rises above the short-call strike.

A protective collar can work well during situations in which the market or your individual equity positions lack upside momentum. A sideways to even down market is sometimes the best scenario for protective collar options. During strong bull markets, the play is not ideal since you might see your shares vanish when the underlying stock price gets above the short call strike.

Finally, user-friendly options trading is here.*

Trade options with SoFi Invest on an easy-to-use, intuitively designed online platform.

*Check out the OCC Options Disclosure Document.

Protective Collar Example

You own 100 shares of XYZ company that you paid $50 for, and the stock is currently trading at $100. You’re concerned there might be a move lower on your equity stake, but you do not want to trigger a taxable event by selling.

A protective put is an ideal way to address the risk and satisfy your objectives. You decide to sell the $110 strike call for $5 and buy a $90 strike put for $6. The total cost or net debit is $1 per share or $100 per option, each option represents 100 shares.

If the price rises above the short call strike price of $110 to $115:

   Unrealized Profit on Stock Position = Current Price – Purchase Price

   Unrealized Profit on Stock Position = $11,500 – $5,000 = $6,500

   Maximum Profit = Short Call Strike Price – Purchase Price – Net Debit Paid

   Maximum Profit = $11,000 – $5,000 – $100 = $5,900

You have given up $600 of potential profit to protect your downside risk.

If the stock trades anywhere between $90 and $110, For example $105:

   Unrealized Profit on Stock Position = Current Price – Purchase Price

   Unrealized Profit on Stock Position = $10,500 – $5,000 = $5,500

   Profit = Current Price – Purchase Price – Net Debit Paid

   Profit = $10,500 – $5,000 – $100 = $5,400

You have paid $100 to protect your downside risk. It may also have been possible to choose options that would have allowed you to profit on the protective collar.

If the price drops below the long put strike price of $90 to $85:

   Unrealized Profit on Stock Position = Current Price – Purchase Price

   Unrealized Profit on Stock Position = $8,500 – $5,000 = $3,500

   Maximum Loss = Long Put Strike Price – Purchase Price of Stock – Net Debit Paid

   Maximum Profit = $9,000 – $5,000 – $100 = $4,000

You have avoided additional losses of $500 by purchasing the protective collar.

Collars and Taxes

Nobody likes paying unnecessary capital gains taxes. Protective collar options can be used to avoid that scenario. The strategy offers downside risk control while allowing you to keep your shares.

You still might be required to sell your stock to the holder of the calls you wrote, though. If you decide to sell your shares to the put owner, that too will trigger a taxable sale. The potential taxes can’t be avoided using this strategy, but they can be deferred, let’s say into next year, and this can be valuable in itself.

The Takeaway

Protective collar options are used to guard against near-term losses on a long stock position. The combination of a protective put with a covered call offers a low-cost way to help control risk. It can also be a tax-savvy move to protect an unrealized gain without triggering a taxable event as you would when selling shares.

If you’re ready to try your hand at options trading, SoFi can help. You can trade options from the SoFi mobile app or through the web platform. And if you have any questions, SoFi offers educational resources about options to learn more.

With SoFi, user-friendly options trading is finally here.

FAQ

Are protective puts worthwhile? When does it make sense to buy protective puts?

Protective puts can make sense if you are concerned about bearish price action on your underlying stock position. They are worthwhile if you have a strategy with respect to timing, direction, and price of the trade.

What does protective, covered, and naked mean in options?

“Protective” in options trading refers to having downside risk protection should a stock position drop in price. A protective put, for example, rises in value when shares fall.

“Covered” in options parlance means that you are writing call options against an asset you currently own.

“Naked” is when you are writing call options that you do not currently own.

What are the benefits of collar trades?

Protective collar options trades are used when you are bullish on a stock but are concerned about near-term downside risk. A major benefit is that the strategy helps to cushion losses if the underlying stock drops. Since the strategy assumes you own shares of the underlying asset, a combination of a protective put and a covered call help to keep costs low on the trade. That is a major benefit to traders looking to protect a long stock position.

Photo credit: iStock/Prostock-Studio

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SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
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Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

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Mar
16
2023
How Do Credit Cards Work? Beginner’s Guide

How Does a Credit Card Work: In-Depth Explanation

By | Credit, credit card | Comments Off on How Does a Credit Card Work: In-Depth Explanation

There are millions of credit card accounts in the United States alone, and it’s estimated that 84% of adults in the U.S. have at least one credit card. Yet, many people don’t have a firm grasp on the basics of what a credit card is and how credit cards work.

If you have a credit card account, or plan on ever using one, it’s important to understand the fundamentals of credit cards. This ranges from what a credit card is to how credit card interest works to how credit cards relate to credit scores.

Recommended: Tips for Using a Credit Card Responsibly

What Is a Credit Card?

A credit card is a type of payment card that is used to access a revolving line of credit.

Credit cards differ from other types of loans in that they offer a physical payment card that is used to make purchases. Traditionally, credit cards are made of plastic, but an increasing number of credit card issuers now offer metal cards, usually for their premium accounts that offer travel rewards.

But a credit card account is much more than a plastic or metal payment card. A credit card account is a powerful financial tool that can serve many purposes. For starters, it can be a secure and convenient method of payment anywhere that accepts credit card payments. It also can be used to borrow money in a cash advance or to complete a balance transfer.

Additionally, credit cards can offer valuable rewards, such as cash back and travel rewards like points or miles. Cardholder benefits can also include purchase protection and travel insurance policies.

If used responsibly, a credit card can help you to build your credit score and history, which can open up new borrowing opportunities. Of course, credit cards can also damage your credit when used irresponsibly. If you rack up debt on your credit card, it can be hard to get it paid off and back in the clear (here, for instance, is what happens to credit card debt when you die).

Recommended: Does Applying For a Credit Card Hurt Your Credit Score?

How Do Credit Cards Work?

Credit cards offer a line of credit that you can use for a variety of purposes, including making purchases, completing balance transfers, and taking out cash advances. You can borrow up to your credit limit, and you’ll owe at least the minimum payment each month.

You can apply for a credit card from any one of hundreds of credit card issuers in the U.S. Card issuers include national, regional, and local banks, as well as credit unions of all sizes. Card issuers will approve an application based on the credit history and credit score of the applicant, among other factors.

There are credit cards designed for people with nearly every credit profile, from those who have excellent credit to those with no credit history or serious credit problems. As with any loan, those with the highest credit score will receive the most competitive terms and benefits.

Once approved, you’ll likely receive a credit limit that represents the most you can borrow using the card. Whether your limit is above or below average credit card limit depends on a variety of factors, including your payment history and income.

The credit card is then mailed to the account holder and must be activated before use. You can activate a credit card online or over the phone. So long as your account remains in good standing, it will be valid until the credit card expiration date.

Once activated, the card can be used to make purchases from any one of the millions of merchants that accept credit cards. Each card is part of a payment network, with the most popular payment networks being Visa, Mastercard, American Express, and Discover. When you make a payment, the payment network authenticates the transaction using your card’s account number and other security features, such as the CVV number on a credit card.

Every month, you’ll receive a statement from the card issuer at the end of each billing cycle. The statement will show the charges and credits that have been made to your account, along with any fees and interest changes being assessed.

Your credit card statement will also show your balance, minimum payment due, and payment due date. It’s your choice whether to pay your minimum balance, your entire statement balance, or any amount in between. Keep in mind that you will owe interest on any balance that’s not paid back.

If you don’t make a payment of at least the minimum balance on or before the due date, then you’ll usually incur a late fee. And if you pay more than your balance, you’ll have a negative balance on your credit card.

Credit Card Fees

There are a number of potential fees that credit card holders may run into. For example, some credit cards charge an annual fee, and there are other fees that some card issuers can impose, such as foreign transaction fees, balance transfer fees, and cash advance fees. Cardholders may also incur a late fee if they don’t pay at least the minimum due by their statement due date.

Often, however, you can take steps to curb credit card fees, such as not taking out a cash advance or making your payments on-time. For a charge like an annual fee, cardholders will need to assess whether a card’s benefits outweigh that cost.

3 Common Types of Credit Cards

There are a number of different kinds of credit cards out there to choose from. Here’s a look at some of the more popular types.

Rewards Credit Cards

As the name suggests, rewards credit cards offer rewards for spending in the form of miles, cash back, or points — a rewards guide for credit cards can give you the full rundown of options. Cardholders may earn a flat amount of cash back across all purchases, or they may earn varying amounts in different categories like gas or groceries.

The downside of these perks is that rewards credit cards tend to have higher annual percentage rates (APRs), so you’ll want to make sure to pay off your full balance each month.

Balance Transfer Credit Cards

Balance transfer cards allow you to move over your existing debt to the card. Ideally, this new card will have a lower interest rate, and often they’ll offer a lower promotional rate that can be as low as 0% APR. However, keep in mind that this promo rate only lasts for a certain period of time — after that, the card’s standard APR will kick back in.

Secured Credit Cards

If you’re new to credit or trying to rebuild, a secured credit card can be a good option. Generally, when we talk about credit cards, the default is an unsecured credit card, meaning no collateral is involved. With a secured credit card, you’ll need to make a deposit. This amount will generally serve as the card’s credit limit.

This deposit gives the credit card issuer something to fall back on if the cardholder fails to pay the amount they owe. But if you’re responsible and get upgraded to a secured credit card, or if you simply close your account in good standing, you’ll get the deposit back.

How Does Credit Card Interest Work?

The charges you make to your credit card are a loan, and just like a car loan or a home loan, you can expect to pay interest on your outstanding credit card balance.

That being said, nearly all credit cards offer an interest-free grace period. This is the time between the end of your billing period and the credit card payment due date, typically 21 or 25 days after the statement closing date. If you pay your entire statement balance before the payment due date, then the credit card company or issuer will waive your interest charges for that billing period.

If you choose not to pay your entire statement balance in full, then you’ll be charged interest based on your account’s average daily balance. The amount of interest you’re charged depends on your APR, or annual percentage rate. The card issuer will divide this number by 365 (the number of days in the year) to come to a daily percentage rate that’s then applied to your account each day.

As an example, if you had an APR of 15.99%, your daily interest rate that the card issuer would apply to your account each day would be around 0.04%.

Recommended: Average Credit Card Interest Rates

Credit Cards vs Debit Cards

Although they look almost identical, much differs between debit cards vs. credit cards. Really, the only thing that debit cards and credit cards truly have in common is that they’re both payment cards. They both belong to a payment network, and you can use them to make purchases.

With a debit card, however, you can only spend the funds you’ve already deposited in the checking account associated with the card. Any spending done using your debit card is drawn directly from the linked account. Because debit cards aren’t a loan, your use of a debit card won’t have any effect on your credit, positive or negative.

But since it isn’t a loan, you also won’t be charged interest with a debit card, nor will you need to make a minimum monthly payment. You will, however, need to make sure you have sufficient funds in your linked account before using your debit card.

Another key difference between credit cards vs. debit cards is that credit card users are protected by the Fair Credit Billing Act of 1974. This offers robust protections to prevent cardholders from being held responsible for fraud or billing errors. Debit card transactions are subject to less powerful government protections.

Lastly, debit cards rarely offer rewards for spending. They also don’t usually feature any of the travel insurance or purchase protection policies often found on credit cards. You likely won’t be on the hook for an annual fee with a debit card, which is a fee that some credit card issuers do charge, though you could face overdraft fees if you spend more than what’s in your account.

To recap, here’s an overview of the differences between credit cards and debit cards:

Credit cards

 Debit cards
Can be used to make purchases Yes Yes
Can be used to borrow money Yes No
Must deposit money before you can make a purchase No Yes
Must make a minimum monthly payment Yes No
Can provide purchase protection and travel insurance benefits Often Rarely
Can offer rewards for purchases Often Rarely
Can help or hurt your credit Yes No
Can use to withdraw money Yes, with a cash advance Yes

Pros and Cons of Using Credit Cards

Beyond knowing what a credit card is, it’s important to familiarize yourself with the pros and cons of credit cards. That way, you can better determine if using one is right for your financial situation.

To start, notable upsides of using credit cards include:

•   Easy and convenient to use

•   Robust consumer protections

•   Possible access to rewards and other benefits

•   Ability to avoid interest by paying off monthly balance in full

•   Potential to build credit through responsible usage

However, also keep these drawbacks of using credit cards in mind:

•   Higher interest rates than other types of debt

•   Temptation to overspend

•   Easy to rack up debt

•   Various fees may apply

•   Possible to harm credit through irresponsible usage

How to Compare Credit Cards

Since there are hundreds of credit card issuers, and each issuer can offer numerous individual credit card products, it can be a challenge to compare credit cards and choose the one that’s right for your needs. But just like purchasing a car or a pair of shoes, you can quickly narrow down your choices by excluding the options that you aren’t eligible for or that clearly aren’t right for you.

Start by considering your credit history and score, and focus only on the cards that seem like they align with your credit profile. You can then narrow it down to cards that have the features and benefits you value the most. This can include having a low interest rate, offering rewards, or providing valuable cardholder benefits. You may also value a card that has low fees or that’s offered by a bank or credit union that you already have a relationship with.

Once you’ve narrowed down your options to a few cards, compare their interest rates and fees, as well as their rewards and benefits. You can find credit card reviews online in addition to user feedback that can help you make your final decision.

Important Credit Card Terms

One of the challenges to understanding how credit cards and credit card payments work is understanding all of the jargon. Here’s a small glossary of important credit card terms to help you to get started:

•   Annual fee: Some credit cards charge an annual fee that users must pay to have an account. However, there are many credit cards that don’t have an annual fee, though these cards typically offer fewer rewards and benefits than those that do.

•   APR: This stands for annual percentage rate. The APR on a credit card measures its interest rate and fees calculated on an annualized basis. A lower rate is better for credit card users than a higher rate.

•   Balance transfer: Most credit cards offer the option to transfer a balance from another credit card. The card issuer pays off the existing balance and creates a new balance on your account, nearly always imposing a balance transfer fee.

•   Card issuer: This is the bank or credit union that issues the card to the cardholder. The card issuer the company that issues statements and that you make payments to.

•   Cash advance: When you use your credit card to receive cash from an ATM, it’s considered a cash advance. Credit card cash advances are usually subject to a much higher interest rate and additional fees.

•   Chargeback: When you’ve been billed for goods or services you never received or that weren’t delivered as described, you have the right to dispute a credit card charge, which is called a credit card chargeback. When you do so, you’ll receive a temporary credit that will become permanent if the card issuer decides the dispute in your favor.

•   Due date: This is the date you must make at least the credit card minimum payment. By law, the due date must be on the same day of the month, every month. Most credit cards have a due date that’s 21 or 25 days after the statement closing date.

•   Payment network: Every credit card participates in a payment network that facilitates each transaction between the merchant and the card issuer. The most common payment networks are Visa, Mastercard, American Express, and Discover. Some store charge cards don’t belong to a payment network, so they can only be used to make purchases from that store.

•   Penalty interest rate: This is a separate, higher interest that can apply to a credit card account when the account holder fails to make their minimum payment on time.

•   Statement closing date: This is the last day of a credit card account’s monthly billing cycle. At the end of this day, the statement is generated either on paper or electronically, or both. This is the day on which all the purchases, payments, fees, and interest are calculated.

Credit Cards and Credit Scores

There’s a lot of interplay between credit cards and your credit score.

For starters, when you apply for a new credit card, that will affect your score. This is because the application results in a hard inquiry to your credit file. This will temporarily ding your score, and it will remain on your credit report for two years, though the effects on your credit don’t last as long.

Further, how you use your credit card can impact your credit score — either positively or negatively. Having a credit card could increase your credit mix, for instance. Or, closing a longstanding credit card account may shorten the age of your accounts, resulting in a negative impact to your score.

Making timely payments is key to maintaining a healthy credit score, as is keeping a low credit utilization rate (the amount of your overall available credit you’re currently using). If you max out your credit card or miss payments, that won’t bode well for your credit score. Conversely, staying on top of payments can be a great step toward building your credit.

The Takeaway

Credit cards work by giving the account holder access to a line of credit. You can borrow against it up to your credit limit, whether for purchases and cash advances. You’ll then need to pay back the amount you borrowed, plus interest, which is typically considered to be a high rate vs. other forms of credit. For this reason, it’s important to spend responsibly with a credit card.

Whether you're looking to build credit, apply for a new credit card, or save money with the cards you have, it's important to understand the options that are best for you. Learn more about credit cards by exploring this credit card guide.

FAQ

How does a person shop for a credit card?

To shop for a credit card, start by looking at your credit score to determine what cards you may be able to qualify for. Then, decide what kind of card is best for your needs, such as a card that has a low interest rate, one that will allow you to build credit, or a card that offers rewards. Finally, compare similar products from competing card issuers to assess which is the most competitive offer available to you.

Can I use my credit card abroad?

Yes, most credit card payment networks are available in most countries. As long as you visit a merchant that accepts cards from the same payment network that your card belongs to, then you’ll be able to make a purchase.

How do you use a credit card as a beginner?

If you’re new to credit and working to build your score, you’ll want to make sure you’re as responsible with your card as possible. Pay your bill on time, and aim to pay in full if you can to avoid interest charges. Use very little of your credit limit — ideally no more than 30%. And make sure to regularly review your credit card statements and your credit report. But don’t let any of that scare you away from using your card either — it’s important to regularly use your card for small purchases to get your credit profile built up.

How do credit cards work in simple terms?

Credit cards offer access to a line of credit. You can borrow against that, up to your credit limit, for a variety of purposes, including purchases and cash advances. You’ll then need to pay back the amount you borrowed.

How do payments on a credit card work?

At the end of each billing cycle, you’ll receive a credit card statement letting you know your credit card balance, minimum payment due, and the statement due date. You’ll then need to make at least the minimum payment by the statement due date to avoid late fees and other consequences. If you pay off your full balance, however, you’ll avoid incurring interest charges. Otherwise, interest will start to accrue on the balance you carry over.

Photo credit: iStock/Katya_Havok

Third-Party Brand Mentions: No brands, products, or companies mentioned are affiliated with SoFi, nor do they endorse or sponsor this article. Third-party trademarks referenced herein are property of their respective owners.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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