How Do Credit Cards Work?
- Credit cards make spending safe and convenient.
- There are several types of credit cards, including rewards credit cards, business credit cards, and secured credit cards.
- Understanding how credit cards work can save you money.
In the form of a credit card, plastic can be fantastic. Credit cards offer many rewards, but they also come with risks. When used irresponsibly, credit cards can get you into deep financial trouble. That’s why it’s essential to learn the answer to the question: How do credit cards work?
Truth is, there are many different types of credit cards. You may be curious: How do cashback credit cards work? How do secured credit cards work? How do rewards credit cards work? And how do travel credit cards work? This article answers all of those questions and more, including how to get a credit card, mistakes to avoid, and how to take cash advances on credit cards.
How Do Credit Cards Work?
A credit card works as a line of credit, issued by a credit card company or bank, that allows you to purchase goods and services. You carry a balance on the card and must pay off at least a minimum amount toward that total balance every month. If you don’t pay full for any month you have a balance due, you are charged interest on that remaining amount.
“Credit cards allow you to pay on credit. They’ll have a limit ranging from a few hundred dollars to tens of thousands or more. But you won’t have to pay with money out of your pocket. Instead, the credit card company pays on your behalf, then bills you for the total amount at the end of the month,” says Stewart Guss, a Houston-based attorney.
Visa, MasterCard, American Express, and Discover are the four primary credit card networks. Major issuers of credit cards include Chase, Citibank, Capital One, U.S. Bank, Wells Fargo, Bank of America, American Express, and Discover.
How Do Credit Cards Work for Purchases?
The good news is that you can use credit cards for small and big purchases at most online and brick-and-mortar retailers.
“You are allowed to use a credit card on many things, including necessities such as groceries and gas. If you are spending money on electronics, appliances, travel, event tickets, or online purchases, using a credit card is usually the best and safest payment method,” Cyndie Martini, president/CEO of Member Access Processing, the Seattle-based aggregator of Visa card services to credit unions, says.
Many health care providers and insurance carriers also allow you to pay your bills via credit card.
Some of the items you are not permitted to use credit cards for are monthly rent or mortgage payments; auto, student, and personal loan payments; taxes; and purchases that exceed your available credit limit. Some retailers also require a minimum purchase to use a credit card, such as at least $10.
Credit Card Pros and Cons
“It’s best to think about a credit card as a free 30-day loan,” says Martini. She explains that owning a credit card expands your spending capability and provides several benefits, including:
Depending on the card’s spending limit, you can make major purchases of up to several thousand dollars.
It helps build your credit history and raises your credit score when used responsibly.
Credit card issuers offer protection against fraudulent use of the card.
Credit card issuers can work to resolve a problem or refund your money if you purchase defective merchandise or have a dispute with a transaction.
You can get a cash advance, from a participating bank or ATM, against your credit card’s line of credit.
Many credit cards offer rewards, such as frequent flyer miles or cashback when you use the card.
Credit cards enable you to shop online and reserve hotel rooms and rental cars.
A credit card comes in handy as an extra form of payment during a pinch or emergency.
You can more easily track your spending because every transaction is documented.
“The major drawback of credit cards is that they charge interest for debt held longer than 30 days,” Martini cautions. “The benefits of credit cards become a detriment if you use the credit to buy something you can’t pay off within 30 days. If you carry too much debt, your credit score will fall. And debt is compounded via accrued interest, meaning the debt gets a little higher for each cycle you carry a balance because the interest on the debt is added to the total debt.”
Additionally, many credit cards charge fees, including annual and cash advance fees. These can can make owning the card cost-prohibitive unless you reap any rewards the card offers.
Who Should have a Credit Card?
The best prospects for applying for and using a credit card are financially responsible borrowers capable of paying off their monthly balance in full whenever possible.
“If you are already in significant debt, have poor spending habits, or won’t be able to pay off your credit card purchases on time, you aren’t a great candidate,” cautions Carter Seuthe, CEO of Credit Summit.
You should avoid credit cards if you plan to use them to pay for necessary living expenses like food and shelter that you can’t afford to pay back every month. Borrowing against your card with cash advances that you use to gamble with or purchase discretionary items is also not recommended.
How Different Types of Credit Cards Work
There are several different types of credit cards you can choose from, including cashback credit cards, department store-branded credit cards, travel credit cards, balance transfer credit cards, and secured credit cards. Take the time to learn about each.
How do cashback credit cards work?
One of the most popular forms of plastic is a cashback credit card, which gives you a small percentage of each purchase back as a reward that you can cash in every month for dollars or gift cards. Many cashback cards charge no annual fees, and some have 0% APR introductory offers.
One type of cashback offered is a sign-on bonus.
“For example, a card might issue $150 in cashback for spending $500 within your first three months of opening the card,” says Vishesh Reasonghani, a financial expert at PiggyBank. “By comparison, if a different card offered 1.5% cashback on regular spending, you’d have to spend $10,000 to earn that same reward.”
How do department store credit cards work?
Department store cards can be used at specific branded retailers, such as Kohl's or Target. “The pros are that you can get sign-up discounts, regular discounts on purchases, and what you want when you want it from that particular retailer,” Martini notes. “The cons are that you may pay higher interest rates, they can harm your credit score slightly when you sign up, and they can be less beneficial or flexible than a normal credit card.”
More specifically, you usually cannot use a department store card outside of that brick-and-mortar or online store, per Seuthe.
How do travel credit cards work?
Many credit card issuers also offer travel credit cards or partner with airlines or hotels to offer specialty cards that reward points and perks good toward travel-related purchases.
“Frequent flyer miles cards, for example, are credit cards that allow you to earn miles with purchases to a specific airline. Some advantages include priority boarding, complimentary seat upgrades, airport perks, and free checked baggage,” adds Martini. “Some disadvantages include the potential to limit you to one airline, the possibility of charging an annual fee, and complex reward redemption processes.”
How do balance transfer credit cards work?
A balance transfer card allows you to transfer one or more existing credit card balances to a new card and pay little or no interest for an introductory period. This period can range from six months to 24 months. Martini explains that a balance transfer card can consolidate your payments and save you money on interest. Most balance transfer cards have a balance transfer fee (3% is common), which cuts into your savings somewhat. And when the introductory period ends, your interest rate will increase.
When shopping for a balance transfer card, compare the interest rate, length of the introductory period, and balance transfer fees. Balance transfer cards can be great tools for paying off debt faster.
How do secured credit cards work?
Secured credit cards are not really credit cards because the issuer requires a deposit equal to the amount of your credit line. If you default on your payments, the card issuer retains your deposit.
“On the plus side, you can get approved more frequently with a secured credit card if you don’t have good credit. It can also help you raise your credit if it’s not already good because it reports your payments in your credit report. Some also have rewards programs. On the downside, you may pay fees and higher interest rates,” continues Martini.
Secured credit cards can help you establish or re-establish credit when you’re just starting out or trying to improve a poor credit rating. They look like regular credit cards and can help you with things like hotel reservations and car rentals. Be sure to read the fine print because some secured credit cards have very high fees. And make sure the issuer reports your payment history to all three major credit bureaus.
How Is the Minimum Payment on a Credit Card Calculated?
A credit card issuer determines the minimum payment on a credit card based on factors such as the bank the card is issued from and the dollar amount owed. Credit card minimum payments can be the entire balance (for small balances), a flat dollar amount like $25 (when you owe a bit more), or some percentage of the balance when your balance is larger (2% is common). Your minimum payment is due once a month.
“The minimum payment on a credit card is the lowest amount of money the cardholder can pay each billing cycle to keep the account’s status in good standing,” Martini says. “It is strongly recommended to pay off your balance in full every month so that you remain in good standing with the issuer, your credit doesn’t take a hit, and you don’t end up paying more than your balance. When you make only the minimum payment instead of paying off your balance in full, interest will incur and you will pay more than your original due balance.”
What’s more, if you don’t pay your minimum balance, “the issuer may charge you a late fee. If you are delinquent too long, they’ll freeze your card,” warns Guss.
What Is a Credit Card Grace Period?
Your grace period is the time between the end of your billing cycle and the date your payment is due. Over this time, interest may not be charged if you pay your balance in full by the due date indicated.
“As long as you make your (full) payment on or before the date the payment is due, you won’t be charged interest,” adds Seuthe.
Note that paying less than the full balance will result in interest charges. And be aware that credit card companies are not required to give a grace period.
What Is a Credit Card APR?
“APR” stands for annual percentage rate, which for credit cards is simply the interest rate. With other forms of credit like mortgages, the APR incorporates lender fees and other charges, but that’s not the case with credit cards. According to Martini, the average credit card APR today is 15.56% to 22.87%; the lowest (not including limited introductory rates) is 13.66%, and one of the highest is 25.8%.
“The APR charged will depend on your credit score and other factors. The people with the best credit – those who regularly pay back what they owe on time – tend to have the lowest APR, while people with bad credit pay more,” Guss says.
Credit Card Dos and Don’ts
For best results with a credit card, follow these tips:
Pay off your monthly balance in full and on time every month.
If you can’t pay in full, pay as much as you can to reduce the interest you will owe.
Stay below your credit limit to avoid getting denied when it’s time to purchase.
Check your monthly statement regularly for fraudulent or duplicate charges.
Be aware of the APR you are charged and if/when it will change.
And avoid these mistakes:
Paying only the minimum; credit card minimum payments can keep you in debt for decades.
Maxing out your cards; people with the best credit scores don’t use more than 30% of their credit limits.
Taking cash advances on your credit card; note that interest begins accruing immediately on the amount of cash you withdraw.
Paying late or going over the credit limit; penalty rates or late charges can be expensive
How to Get a Credit Card
You can apply for a credit card by snail mail (many issuers send special credit card offers, with application forms included, to consumers through the mail), online, or at a bank or store that offers them.
“Applying online is the easiest option and very convenient, but applying in person can create an opportunity for instant approval,” Martini says. “Otherwise, it can take up to 30 days to get a notice of approval or denial for a credit card via email or regular mail. Once approved, you can expect to receive your physical card in the mail around 10 days later.”
The experts recommend shopping around online for the best credit card deals. These include no-fee cards that offer generous cashback or travel rewards and cards with low-to-no interest charged for a set period, which can go helpful if you want to transfer a balance from a high-interest card to that new card.
If you pay your balances in full each month and can get cards without annual fees, feel free to have as many cards as you want. The more available credit you have, the better your credit utilization ratio. And credit utilization comprises 30% of your credit score. If you can control your spending, five credit cards is a good number, according to credit bureaus.
Credit cards companies do not provide credit cards, especially those with cashback and other rewards, out of the goodness of their hearts. They do it to earn money. And they set minimum payments so that you have to pay something each month, and so that you'll eventually pay off your balances. But the minimum payment can result in high interest cost and keep you in debt for decades. If you start out making a minimum payment, continue to make at least that payment. Your statement will show a lower minimum payment when your balance drops. But if you keep making the higher payment, you'll pay less interest and zero your balance sooner.
Opening a new card impacts your credit in two ways. First, an application for credit generates a hard inquiry on your credit report, and that drops your credit score by three to five points. And second, increasing your available credit drops your credit utilization ratio (as long as you don't increase your balances). Lowering your credit utilization ratio can increase your credit score quickly and significantly.