As many cardholders will tell you, credit cards can be a helpful tool when used responsibly, but how exactly do credit cards work? Understanding the nuances of how credit cards work is critical to ensure you use them wisely, without falling into debt.
Since everyone’s financial situation is different, there is no magic formula. You will need to see what applies to your long-term goals and aspirations.
This article will cover the credit card basics and equip you with the knowledge you need to make the best financial decisions.
How Does A Credit Card Work?
Credit cards are a line of credit offered to you by a financial institution known as credit card issuers. You can access the credit through a card that operates through a network like Visa or Mastercard.
There are also different types of credit cards, designed with varying consumers in mind.
Because credit cards are a form of credit, like a loan, there are strict qualification criteria and applicable fees. The rules that govern the credit card are set by the financial institution that issues them, colloquially known as the issuer.
Where can you get a credit card?
Most credit unions and banks offer credit cards to their customers. Today you can also find non-traditional banks that issue credit cards.
Remember, not all Visa and Mastercard cards are credit cards. Visa, Mastercard, and others are just the network. As such, you can have Visa and Mastercard debit cards (which are the opposite of a credit card) and prepaid cards.
Visa, Mastercard, American Express, and Discover are known as the major four credit card networks. Other lesser-known networks include:
- Visa ReadyLink
Glossary of Terms
The world of finance can be pretty complicated, and terms may sometimes blur into each other, especially if you’re new and still trying to find your feet.
Here’s a glossary of the most common terms worth knowing:
- Issuer: the financial institution that issues the card, usually a bank or credit union.
- Network: the network the card uses to communicate between the merchant and issuer.
- Credit limit: the amount of credit provided to you by the issuer.
- Minimum payment: the smallest amount you need to pay back every month to avoid late payment fees.
- Full payment: repaying the total amount you owe on your credit card (i.e., your credit card balance).
- Available credit: how much you still have to spend on your credit card.
- Billing cycle: the period of time between one bill and another (typically one month).
- APR: the credit card interest rate charged on credit owed.
- Outstanding balance: the total amount you owe and need to repay to the bank.
- Grace period: the period of time between when a billing cycle ends and the payment due date.
Credit Card Features
Credit cards come in different shapes and sizes, something we will discuss in more detail below. Still, there are standard features that most credit card issuers offer.
Understanding these features can give you a better idea of how a credit card works. It will also equip you with the knowledge you need to understand the terms and conditions that accompany all credit cards.
The credit limit is the limit of credit that you can borrow from your card.
The issuer determines this based on several factors such as your credit card score, income, history of payments, credit utilization, and other factors.
APR stands for Annual Percentage Rate. It allows you to measure how much interest you will have to pay on any credit used but not paid.
The APR is not static and can change. Typically, two factors contribute to the APR applied:
- Your creditworthiness. The higher your credit score, the lower the APR.
- Prime rate. The prime rate is the rate the bank charges its best customers. It is typically based on the target level of the federal funds rate.
You may also get a higher APR rate if you fail to make the minimum payment required.
This rate can be substantially higher than the standard maximum rate, and the bank may even apply it indefinitely.
Different APRs may also be applied to credit card features such as Cash Advances and Balance Transfers.
Fees are a staple mainstay of all credit cards. These fees are over and above the APR charged on outstanding balances.
Since it is quite a broad subject, refer to the fees section of the article to learn more about credit card fees.
Fraud protection is an important credit card feature and protects you from fraud and theft.
As a cardholder, you have certain responsibilities, including reporting fraudulent activity within a specific timeframe and taking reasonable precautions against theft.
Make sure you take the time to read the terms and conditions associated with any fraud protection that your card may offer to avoid issues down the line.
Types of Credit Cards
At the most basic level, all credit cards work the same – a line of credit for a fee with interest payable on funds used.
Financial institutions, however, realized more people would take out credit cards if they offer something different, perhaps more suited to the things and activities they like.
Following this, today, you’ll find credit cards in different forms, offering various features and perks. This section will go through some of the more common ones.
Cash Back Credit Cards
As the name implies, cash back credit cards offer cashback on purchases made using the credit card.
Typically, there are limits on how much cashback you can earn per month, although some cards do come with no limit. In most cases, cashback is limited to eligible purchases, as defined by the issuer.
While cash back credit cards can be advantageous, you will still need to pay the balance on time as fees and interest can quickly wipe out any cashback you earned (and then some).
Co-Branded Credit Cards
Co-branded credit cards are cards that the issuer co-brands with another business, usually retailers.
Co-branded cards may offer discounts, points, or cash back when purchasing from that particular store.
Some will even reward you for eligible purchases from elsewhere. Still, you’ll earn less when compared to the retailer the credit card has partnered with on the card.
While co-branded credit cards may seem like a no-brainer if you regularly shop from that retailer, you should check out their fees in advance.
These might come with higher interest rates or annual fees, which may offset any cashback or points you earn.
Bad Credit Credit Cards
Credit cards for bad credit, also known as secured credit cards, are designed specifically for those with a bad credit score. You can expect fees and interest rates to reflect the additional (even if perceived) risk that the issuer is taking.
Bad credit credit cards may also ask for a security deposit to be used if payments are not made. Used wisely, they can help you improve your credit score and increase your chances of getting a regular credit card.
Travel Credit Cards
Travel credit cards are credit cards that offer rewards aimed at travelers. Usually, these cards are co-branded with airlines or explicitly designed for those who travel. Instead of cashback or points, you’ll earn miles which you can then use with airlines that accept them.
You’ll find rewards credit cards that reward you with other things as well, including cashback, access to exclusive events, hotel stays, discounts on meals, and many others.
Student Credit Cards
While credit cards can’t be issued to those under 21 years of age, you may qualify for a student credit card if you can prove your income or have a co-signer.
Because they’re aimed specifically at college students, student credit cards often come with perks like free Amazon Prime or one-time late-payment forgiveness.
They’re a great way to build your credit score while earning rewards.
Balance Transfer Credit Cards
Balance transfer credit cards offer more favorable terms on balance transfers, typically allowing you to take advantage of lower interest rates.
Most balance transfer credit cards require a good credit score, so your credit history will be a deciding factor should you apply for one of these cards.
Low-Interest Credit Cards
Low-interest credit cards offer a lower APR than other cards, making them more cost-efficient to use over the long term. Low-interest rate is typically reserved for higher-tier cards and may require a perfect credit score as part of the qualification process.
Credit Card Fees
There is no such thing as free money, which couldn’t be more true for credit cards. While you should keep fees relatively low, a missed payment or interest owed can skyrocket fees.
When used wisely, credit cards can be very effective. That said, using them irresponsibly can easily lead to credit card debt.
The annual fee is payable yearly, just for having the card. Fees can vary a lot from one card to the next, and you can even find cards that have no annual fee at all. The more premium the card, the higher the annual fee will be.
Many credit card companies may also offer the first year free of charge as a welcome bonus to encourage you to sign up for their card instead of the competitors’.
Make sure you read the terms and conditions before signing so that you’ll know what to expect when the second year rolls around.
Credit Card Interest Rates
When you spend money on a credit card, the credit card company will charge interest on any outstanding balance. They’ll typically work out your interest rate in an APR – Annual Percentage Rate.
As such, the interest charges you will have to pay back will depend on the APR percentage and the amount of time it takes you to pay it off.
We mentioned earlier that the average household credit card debt is $7,000.00. APR rates can go very high, 25% or even more in some cases.
To put things into perspective, if you had $7,000 in credit card debt with an APR of 25%, if you made a monthly payment of $150, it would take you 13 years to pay it all off. By then, you would have paid the $7,000 principal amount and just over $16,000 in interest.
Conversely, if you decided to pay all of it in one year, you would need to pay $651 per month. You would have paid the original $7,000 plus $811 in interest at the end of the year.
Interest rates are why paying the minimum amount due is not recommended, as this can lead to a very high credit card bill.
Late Payment Fees
Late payment fees are fees charged for late payments, typically when you don’t make the minimum payment by the due date.
Late copayment fees may vary from one card to another, but you should be able to find them on the pricing information page or the terms and conditions.
Foreign Transaction Fees
Foreign transaction fees (also known as FX fees) are fees charged whenever you make a payment that is not in the domicile currency, in this case, US Dollars.
These fees are typically charged as a percentage of the transaction amount.
Of course, fees will vary from one card to another, with travel credit cards generally having lower transaction fees than their alternatives.
Balance Transfer Fees
A balance transfer is when outstanding debt is moved from one card to another. There are several reasons why this is done, including taking advantage of introductory offers that include a 0% APR and better benefits.
However, you may be charged a fee for doing so, which is what the balance transfer fee is all about. Balance transfer fees may be charged as a flat fee or a percentage of the amount transferred.
Cash Advance Fees
A credit card cash advance is when you use your credit card to withdraw money from an ATM. A separate fee may apply in such cases. This fee is called the cash advance fee.
Most issuers will charge a percentage fee with a minimum flat fee that is applied regardless of the amount.
How To Apply For A Credit Card
Applying for a credit card is easy and can be done entirely online in most cases.
The process may vary from one financial institution to another. For example, the process at Chase Bank might be slightly different than that at Citi, but the basics will be the same all around.
Once you have selected the credit card you would like to apply for, check for any introductory offers available at that time. Make sure you read the terms and conditions and pay particular attention to how you can redeem the offer and any qualification criteria that may be applicable.
You will need to supply your personal information during the application process, including your name and surname, address, and SSN (Social Security Number). The issuer may also ask you to declare your income.
The application will typically list all applicable fees and ask you to agree to the terms and conditions of the card.
Depending on the card you’re applying for, the issuer may run a credit check on you to determine eligibility as well as the terms applicable to you, including the interest rate and credit limit.
Once everything is approved, the issuer will mail you the card, along with instructions of any additional steps you may need to take.
Why Should You Get a Credit Card?
There are several good reasons you might want to get a credit card.
While each credit card application needs to be done thoughtfully, used wisely, and responsibly, credit cards can be a valuable financial tool in managing your finances. This section will look at the top three reasons you might want to consider getting a credit card.
Cash Sign-Up Bonus
As a new customer, you can earn a nice cash bonus. The amount varies by card and offer, with higher-tier cards typically having higher bonuses.
Here’s a list of the best credit card sign-up bonus offers available for new cardholders.
Cashback offers reward you for everyday purchases, effectively giving you a discount on the things you buy the most. To make sure you’re saving money, you will need to pay the balance in full. That’s because the interest rate will always be significantly higher than the cashback rate.
If you’re looking to improve your credit score, a credit card can be just what you need. Of course, you will need to make payments on time since these get reported to the credit bureaus.
Frequently Asked Questions
How do credit cards work in simple terms?
Credit cards offer a line of credit, providing you with funds that you can access through the credit card. The cards are issued by a financial institution such as a bank or credit union using a credit card network, which ensures the card is widely accepted.
How do beginners use credit cards?
Credit cards do not require any experience and work the same way debit cards and prepaid cards work. The main difference is that you must pay any payments through a credit card since you are using the issuer’s money rather than your own. Interest fees apply on any utilized credit.
How does a credit card work step by step?
Step 1: Choose a credit card
Different credit cards come with different terms and perks. You will need to find a card that fits your financial requirements and means.
Step 2: Apply for a credit card.
You can apply for most credit cards online. Since there is a line of credit, you will need to qualify since the issuer needs to make sure that you can pay the money back. Exceptions in the form of secured credit cards exist. The issuer may check your credit score.
Step 3: Receive the card
Once the application is successful, the issuer will mail you the card.
Step 4: Use the card
You can now use your credit card to make purchases. Keep in mind that you will have to pay the money back sooner or later, so don’t go crazy.
Step 5: Pay the money back.
The issuer will send you the bill at the end of the billing cycle. You can either pay the total amount back and be in the clear or make the minimum payment.
If you make just the minimum payment, and monies not paid will accrue interest, you will also need to pay. The best is to pay back the full balance on the card, especially if it’s your first credit card account.
What are two bad things about credit cards?
Credit cards can be an excellent personal finance tool that supports you in building your credit score, earn you travel rewards, and get you better interest rates from lenders in the future.
That said, if you’re not careful, spending on your credit card can quite easily get out of control, and you can end up getting trapped in debt, paying high-interest rates, and damaging your credit score.
Though there are several things about credit cards that can be bad, here are two I’d consider being most important to watch out for:
- Late payment fees. Late payment fees are charged when you fail to make the required payment by the due date. Late fees can be pretty substantial and can also harm your credit score.
- Interest rates. The issuer will charge you interest on outstanding balances when you don’t pay your balance in full each month. Interest rates vary but can be relatively high and can lead to what is known as credit card debt. That’s why it’s so important to make credit card payments in full every month, without exceptions.