How Do Credit Cards Work?
Credit cards can help you build a good credit history quickly, can help with unexpected expenses, and can earn you rewards. It’s important, however, that you understand how credit cards work and how to use them in a responsible way.
In today’s economy, a credit card is an important financial tool that is often necessary to build credit, set up accounts and make certain purchases. In the United States, approximately 192 million people have at least one credit card — yet many do not understand how credit cards really work.
Knowing the fundamentals of how credit cards work can help you use them wisely. That can make all the difference; understanding how they work can help you build your financial health and a strong credit profile. Using them without that understanding, however, can lead to all sorts of negative effects — including potential financial ruin.
On this page:
- What is a Credit Card?
- The Benefits of Using a Credit Card
- Common Credit Card Fees
- How Credit Cards Affect Credit Scores
- Choosing the Card That’s Right for You
What is a Credit Card?
Before we can answer the question, how do credit cards work, it’s important to actually define them. The short version is that a credit card is a financial product that allows you to borrow money for purchases, to pay bills, or even to get extra cash.
You can use your credit card just like you would a debit card, except the money you’re using doesn’t come from your checking account. Instead, it’s borrowed from the card issuer, almost like a short-term loan.
Your Credit Card Balance
If you pay off the balance that you borrowed within a set amount of time, generally 25 to 30 days, then you owe nothing else to the card issuer. If, however, you decide to only pay back part of what you’ve borrowed when your due date arrives, then you’ll have a balance that carries over into the next month and you will be charged interest.
Credit Card Interest
Credit card interest rates are charged on outstanding balances, so if you do not pay back the full amount, you will owe the bank interest on top of what you borrowed.
Each month, interest capitalizes and is added to the balance, which earns interest on itself again the next month. The longer it takes you to pay off your balance, the more it will cost you over time.
You can determine how much interest you will actually be charged in a given month by looking at your credit card statement. It will list your Daily Periodic Rate (DPR), which is your annual percentage rate (APR) divided by the number of days in the year used by your credit card issuer. For example, if your APR was 15% and your card issuer uses a 365-day year, then your DPR is 0.00041%.
Next, find your average daily balance that is subject to interest; this is the amount that is unpaid from the previous month. This number should also be listed on your account statement.
Finally, multiply your DPR by your average daily balance and the number of days in your billing cycle. If you had a $1,000 balance from the previous month, a 30-day billing cycle and a DPR of .00041%, you will pay an interest charge of $12.30 for that month. This amount will be added to your balance, so even if you do not make a single purchase on your credit card, your balance will continue to grow if you are not making your monthly payments in full.
How Credit Card Interest Leads to Debt
It is extremely important to be careful about your credit card spending.
Ideally, you would pay off your credit card balances in full each month so no interest accrues. If you don’t you will be charged the interest which will increase your total credit card debt.
>> Read More: How to Pay Off Credit Card Debt Early?
If you spend more than you can afford on your credit cards, and cannot afford your payments, you may enter a cycle of debt that is hard to escape.
Credit Card APR
Simply expressed, the APR is your interest rate averaged out over the course of the year. It’s meant to express the true cost of using your card, identified in your statement as finance charges.
>> Read More: APR vs. Interest Rate: What is the Difference?
Credit Card Payments
You’ll receive statements from your credit card companies each month that outline not only how much you borrowed on the account, but how much of it you’ve paid back and how much interest will be charged on any remaining balance. The credit card bill will tell you an amount that you must pay, called a minimum payment, to keep the account in good standing. You can also choose to pay any amount over that, up to and including the full balance.
Now that we’ve gone over what a credit card is and how it works, let’s take a look at the benefits and costs of using one.
The Benefits of Using a Credit Card
There are a number of ways that owning a credit card can help you if you use it responsibly.
Convenient, Inexpensive Loans
There’s no denying it’s very convenient to have a credit card on hand, especially for those little emergencies that can pop up and deplete your bank account. Unexpected car repairs, medical bills, and other things can all be paid for with a credit card.
As long as you pay the balance back in full within your grace period, you just got a short-term loan at 0% interest.
Whether you’re short on a cash purchase you need to make, are stuck without cash while traveling, or simply forgot your debit card at home, getting the cash you need can be as simple as visiting any bank branch or ATM — even if they don’t belong to your bank or card issuer.
>> Read More: What is a Cash Advance?
Responsible use of a credit card, including paying the balance off in full each month, shows creditors you are financially responsible. That can translate to lower interest rates on other types of credit you may need, such as a mortgage or auto loan.
The best credit cards offer rewards for your purchases, or even just for being a cardmember. They could take the form of cashback, airline miles toward a free trip, statement credits, or even discounts on events like sports games or concerts.
Common Credit Card Fees
Not everything about credit cards is convenient; in fact, some of the fees and extra charges you’ll pay are decidedly inconvenient.
Even if you’re keeping your balance manageable, you may find that you’re paying quite a few fees, all of which are being added to your balance and are therefore accruing interest. Here are some of what you may expect, depending on your card:
- Annual fees. You could be charged $75 to $400 or more each year to own your credit card, but many no annual fee cards are available as well.
- Cash advance fees. These are levied if you use your card to take out cash at a bank or ATM. They’re typically $5 or 3% of the advance, whichever is greater.
- Balance transfer fees. You may see these if you’re transferring a balance from one card to another, such as when you’re taking advantage of a 0% APR offer.
- Late payment fees. If you don’t make your monthly payment on time, you’ll be assessed a late fee that could be anywhere from $25 to $35 or more.
- Foreign transaction fees. Some cards will charge you 3% of the purchase amount if you use your card abroad. If you travel overseas often, you could end up paying a lot of these fees, potentially adding hundreds of dollars to your overall balance.
How Credit Cards Affect Credit Scores
There is a very close relationship between how you handle your credit cards and what your credit score is. Since your credit score dictates not only what your interest rate or terms may be on other credit you apply for but often whether you get approved at all, it’s important to understand that relationship.
Creditors and reporting agencies like to see a card balance that’s under 30 percent of your total credit limit. It means you’re not reaching for your credit card every time you want to buy something you can’t afford, you’re not using your cards to get yourself into financial trouble, and you’re managing your balance appropriately.
You should also continually make on-time payments each month to ensure that your score does not take a hit. If you miss payments or start to max out your cards, your score will likely take a hit.
Choosing the Card That’s Right for You
There are hundreds of credit cards on the market, and each of them is designed for a specific demographic or type of use.
Before choosing a card, you’ll want to ask yourself what you plan to use the card for and what kind of lifestyle you have. If you like to dine out, attend shows and sporting events, or otherwise engage in entertainment, then a card offering discounts and reward points for doing so could be a good fit for you. The frequent traveler might be more interested in a card that offers airline miles.
You’ll also want to look at the interest rate and APR, any annual fees, and other costs of owning and using a prospective card. Based on how often you use it, the fees might outweigh the benefits, which means you should check out other credit card options.
Credit cards are incredibly common means of paying for things, and many cardholders have more than one. Whether you’re interested in rewards credit cards or ones that offer low introductory APRs, there’s a card out there that will fit your lifestyle.
With all the credit cards on the market, it can be confusing. Understanding how credit cards work, what they cost, and how to best use them can go a long way toward helping both your credit score and overall financial health increase.