How Do Credit Cards Work?

How Do Credit Cards Work?

Sean Messier

April 4, 2019

How Do Credit Cards Work?

Credit cards can be a valuable tool, from funding daily expenses to large purchases and more. But even with their popularity, credit cards retain a stigma of negativity. That could be because credit card debt is one of the most common types of high-interest debt that many of us are dealing with.

Part of the reason it’s so easy to end up in credit card debt is because many of us aren’t taught how to use them responsibly. So how do credit cards work? Here are some basic facts about using credit, as well as common credit card mistakes that can keep you in debt.

Credit card basics

In order to have a healthier relationship with your credit cards, you first need an understanding of how they work. Knowing these fundamental concepts can help you understand what you’re getting into before signing up for a new card.

Credit card terms and conditions

A card’s “terms and conditions” refers to the list of rules, guidelines, and other information that governs the use of the card. They’re typically available on the issuer’s website, but you can also contact their support department to discuss anything that’s unclear. The terms should have key information including:

  • The interest rate and how it’s compounded

  • How the rewards program works (if applicable)

  • Information about minimum payments

  • Any fees associated with using the credit card

Read over the terms and conditions before applying, as a card’s marketing materials may not include important details.

Credit card interest

Your card will have an interest rate, which is the amount of interest charged on the main borrower. There is also an Annualized Percentage Rate, known as APR, which is the interest rate expressed as the yearly cost of credit. As you accumulate interest, that interest will be considered part of your balance, and will be factored into future interest calculations. Interest can build up very quickly if you’re not careful, which is why most financial experts recommend paying off your balance in full every month.

The two most common methods with which issuers calculate interest fees are:

  • Daily balance method: Interest is calculated on each individual day of the billing period. The interest may be added to your account daily, or it may be added together and applied to your balance monthly.

  • Average daily balance method: The issuer averages your balance for every day of the month, and then applies your card’s interest rate to that number.

You’ll seldom see another method used, but check your card’s terms and conditions to confirm which approach you’ll be dealing with.

Credit card fees

In addition to interest payments, you’ll likely see that there are many other fees that could apply, including:

  • Annual fee: Many credit cards require cardholders to pay an annual fee. Higher-fee cards generally come with a better selection of benefits that may make such fees easy to offset.

  • Balance transfer fee: Transferring a balance from one credit card to another usually requires a fee that’s a percentage of the balance being transferred.

  • Cash advance fee: Experts strongly recommend against credit card cash advances, as they generally include hefty fees and exceedingly high interest rates.

  • Foreign transaction fee: Some cards charge an additional fee for foreign transactions, although there are plenty of cards — travel credit cards in particular — that don’t.

  • Late fee: Late fees are charged if you don’t pay the minimum amount by the due date. Additionally, your issuer might report missed payments to credit-scoring bureaus, which can hurt your credit score.

Paying your credit card

An important part of answering the question, “How do credit cards work?” is understanding how payments work. Paying your balance in full every month is the common recommendation, but since that’s not always feasible, you should understand how minimum payments work.

How are minimum payments calculated?

Your credit card’s terms and conditions should outline how the minimum monthly payment is calculated. It varies, but you can generally expect a minimum payment somewhere between 2% and 5% of your overall account balance.

Your terms should also outline a minimum amount due for balances that are below a certain threshold. For example, if your balance is at least $15, you may have to pay a minimum of $15, since 2% to 5% of your overall balance would be miniscule.

Is paying the minimum payment enough?

Paying the minimum amount will help you avoid late fees, but you’ll still accumulate interest, which can cause your debts to snowball. It could also leave you with a high utilization ratio—your amount owed compared to your total credit limit—which can damage your credit over time. Paying off your balance in full and keeping a low balance relative to your available credit limit are the best ways to maintain both your financial wellbeing and the health of your credit score.

Common credit pitfalls

Another essential part of answering the “How do credit cards work” question is knowing how they can pose a threat to your long-term financial health. In addition to the points above, keep the following in mind while you’re sifting through your card options, and tailor your spending practices accordingly.

Late payments

Even one late payment can do a number on your credit. In fact, payment history is the most significant factor in determining your credit score—it accounts for 35% of your personal FICO scores. Avoid late payments by setting up your card’s autopay feature.

Not checking your statements

Credit cards come with excellent fraud protections. But they’re not much help if you don’t regularly check your statements in order to identify those fraudulent charges. In some cases, paying your card accepts the charges as valid, and you may not be able to recoup the money spent.

Ignoring the terms of the card

The importance of a card’s terms can’t be understated. For example, many cards feature excellent rewards at the associated store, but they often come with high enough interest rates that you’ll only truly benefit if you spend a great deal of money at the store and pay off your balance prior to every due date. Dig deep into the terms of the cards you’re considering, so you know exactly what you’re getting yourself into.

Using a credit card for a cash advance

When you’re in a pickle, you might be tempted to use your credit card for a cash advance. But most experts agree that you shouldn’t. Cash advances often come with strict terms and exceptionally high interest rates that could be disastrous for your credit if you’re not ready to pay it off in full as soon as possible.

Spend wisely

If you find yourself relying on credit cards to make purchases that you wouldn’t be able to afford otherwise, it may be time to step back and reexamine your financial situation. Doing something as simple as creating a budget could help you avoid additional debt. Sometimes, however, you may need to work with a financial professional to tackle your current debts while keeping up with life’s essential expenses.

Understand more about managing your money

If you do your research and evaluate all your options before taking out a new card, you’ll feel more confident about your credit decisions. But good money management doesn’t stop there–you’ll need to keep your finances under control while taking advantage of all the good that credit cards have to offer. Luckily, learning how to deal with debt, money, and planning for your future doesn’t need to be hard. We’ve developed a simple to follow guide to help you find the tools you need to move to a better financial future. Get started by downloading our free guide right now.

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A credit industry analyst at Credit Card Insider, Sean Messier strives to empower individuals with the knowledge required to use credit cards to their advantage. His writing- and research-based background has granted him experience in an array of topics, from finance to business and beyond.