How Do Credit Cards Work?
Credit cards are best used as a tool to help you manage your cash flow. Using credit cards responsibly can help you build a good credit score, but it’s important to understand how they work before applying for one.
Credit cards are a modern convenience designed to make it easy to finance purchases quickly and safely… and maybe even rack up some nice rewards.
You can use them to manage cash flow and build a good credit history if you use credit cards responsibly, but they are complex financial tools that can easily leave you with a mountain of debt if you’re not careful.
If you’ve never had a credit card before, it’s important to understand how they work before you apply.
IN THIS ARTICLE
How Credit Cards Work
Credit cards are primarily meant to be used for making purchases – by accessing a revolving line of credit. Another way to think of a credit card is as a short-term loan.
When you open a credit card account, the card you’re issued has a credit limit, which is the total amount of money you’re allowed to borrow and make purchases against. (Your credit score and income are two factors credit card issuers consider when determining what your credit limit will be.)
By giving your credit card information to a merchant when you make a purchase, a transaction begins between the merchant and your credit card issuer that pays for your purchase and reduces your available credit limit. In other words, you’re using your credit card issuer’s money to make the purchase. You then repay the credit card company, typically with interest.
Rewards and miles
Some, though not all, credit cards offer rewards or miles as an additional part of the transaction.
These credit cards allow you to earn rewards on the purchases you make. So for example, you may have a credit card that pays you a percentage of your purchases back in cash rewards or earns miles that can help reduce expenses when you travel.
Those rewards can then be redeemed for things like:
- Statement credit
- Cash deposits into a linked bank account
- Gift cards
- Flights, hotels and other travel expenses
- Magazine or newspaper subscriptions
- Charitable donations
The amount of rewards you can earn with a credit card and what those rewards can be redeemed for varies greatly from one credit card issuer to the next. As a general rule, the more rewarding a credit card is the more likely you are to pay an annual fee for using it.
Credit Card vs. Debit Card: What’s the Difference?
Credit cards and debit cards may look identical physically, but there are several things that make them different from one another.
- Allow you to make purchases that you pay off later
- May carry interest charges for those purchases
- Have a set credit limit
- Typically involve more fees than a debit card, such as an annual fee or foreign transaction fees
- May allow you to earn rewards on purchases
- Are linked directly to your checking account
- Allow you to make purchases as well as withdraw cash from your account at ATMs
- Don’t create debt since you’re spending your own money
- Don’t require you to pay interest on the money you spend
- Usually don’t allow you to earn rewards on purchases (though there are some checking accounts that offer this)
A debit card can be used to pay bills, make purchases or tap into your cash at the ATM. But there are some scenarios where you may need a credit card handy.
Situations where you may want to use a credit card include:
- Booking travel arrangements
- Making large purchases that you need to pay off over time
- Making purchases at merchants that don’t accept other forms of payment
Having both a debit card and a credit card work to your advantage. You can use your debit card to pay for things you don’t need or want to charge while a credit card can be used to fill in the gaps and earn rewards.
|Feature||Credit Card||Debit Card|
|Carry A Balance||Yes||No|
|Can Earn Rewards||Often||Usually Not|
|Helps Build Credit||Yes||No|
What Are Secured Credit Cards?
Some credit cards are secured, meaning that you have to give the credit card issuer a cash deposit to open your account.
Secured credit cards are helpful for people who are either trying to build credit for the first time or are working on rebuilding their credit score.
With a secured credit card, you can start establishing a positive payment history. This can help boost your score if your account activity is reported to the credit bureaus.
Compared to unsecured credit cards, secured cards may have lower credit limits, higher annual fees and interest rates – but they’re less likely to offer rewards for purchases.
The CardName is an example of a secured credit card that can help you build credit by reporting payments directly to all three credit bureaus.
Other Ways To Use Credit Cards
Aside from using a credit card to make purchases, there are other types of transactions you can make. For example, you can use your card for a cash advance or balance transfer, though both of these will incur fees so be sure to read the fine print before making these types of transactions.
Credit card cash advances explained
A credit card cash advance allows you to withdraw cash from your available credit limit. This is something you may consider if you need cash quickly to cover an emergency expense.
The amount you can withdraw is determined by your credit card issuer. A credit card cash advance fee may apply, and you can also expect to pay interest on the advance.
Balance transfers explained
Balance transfers are a way to combine high-interest credit card balances onto a single card. Typically, a balance transfer would make sense if you were able to take advantage of low interest rates with a 0% introductory APR offer.
You open a new balance transfer credit card account, then tell the credit card issuer which balances you would like to transfer to the card. The credit card company completes the transfer, typically charging you a fee that is added to the balance. You then repay the new card’s balance over time.
The is an example of a balance transfer card and has one of the longer payback periods available with an intro 0% APR on balance transfers for 18 months (then, RegAPR).
About promotional APRs
Credit card companies can offer introductory interest rates for purchases and balance transfers. For example, you may pay 0% interest on purchases and balance transfers for the first 15 months after opening your credit card account. The catch, however, is that you need to pay off those balances before the promotional period ends. Otherwise, you would be charged interest for any remaining promotional period purchases or balance transfers.
How Credit Card Payments Work
Credit cards allow you to buy things now and pay for them later. But that doesn’t mean you can delay paying them off indefinitely.
Each month, your credit card issuer sends you an account statement. This statement shows:
- Purchases made during the previous billing cycle
- Minimum payment due
- Payment due date
- Your previous balance
- Any payments or credits applied to your account
- Fees charged
- Interest charged
- Your current balance
- Credit limit
- Current available credit
The time period between the end of your billing cycle and your payment due date is known as the grace period. If you pay your balance in full during this time, then you won’t pay any interest on new purchases made during the billing cycle.
On the other hand, if you don’t pay your credit card bill in full by the grace period, your existing balance and any new purchases are subject to your card’s regular variable annual percentage rate or APR. The APR on a credit card represents the annualized cost of carrying a balance on the card.
Credit card APRs can vary widely from card to card, and your credit score can influence what kind of APR you pay.
There’s more than one APR that can be applied as well. For instance, your credit card issuer may charge one APR for purchases, another for cash advances and still another for balance transfers.
A credit card interest calculator can give you an idea of how much different transactions may cost to pay off over time.
It’s also worth noting that with cash advances, there is typically no grace period; interest begins accruing on a cash advance immediately. The APR for cash advances and balance transfers can also be higher than the regular variable APR that applies to purchases.
How to Use Credit Cards Responsibly to Build Credit
Credit card account activity is reported to the credit bureaus, which can in turn affect your credit score. Things that have the most impact on your credit score include payment history and the percentage of your credit limit you’re using at any given time.
Using credit cards responsibly means developing habits that can help, not hurt, your credit score. That includes things like:
- Paying your credit card bill by the due date each month, if not earlier.
- Keeping your credit balance low in relation to your credit limit.
- Paying more than the minimum payment whenever possible or making credit card payments in full to avoid interest charges.
- Limiting how often you apply for new credit cards or lines of credit.
- Keeping older credit accounts open instead of closing them.
Together, these habits can help you get on the right path toward good credit.
Choosing the right credit card can also help with using cards responsibly. In terms of how cards work, the biggest areas they tend to differ in are rewards, fees, interest rates and card benefits.
When comparing options, look at what different credit cards offer to see how they fit your spending habits and lifestyle. If you mostly spend money at the grocery store and gas station, for example, a rewards credit card that pays you cash back would likely make more sense than a travel card that rewards you with miles.
Also take a look at things like the annual fee or whether a card has foreign transaction fees to get a sense of what it costs.
Most importantly, keep track of how you spend with your credit card. It can be easy to accumulate debt but not so easy to pay it off. Making sure you can make your credit card payments on time each month is key to using credit cards responsibly for good credit health.
fless likely to offer rewards for purchases.