How Does a Credit Card Work? The Complete Beginner’s Guide
Updated · Nov 04, 2022
Are you thinking about getting a credit card? That might be a good idea, especially if you want to increase your credit score.
But first, make sure you understand the benefits and risks involved. What’s more, you should know a few key things:
How does a credit card work?
How to use it to improve your credit score?
What is the difference between a credit and a debit card?
To help you get the grips, we created this comprehensive guide below. Read on for the answers to these and other questions.
What Is a Credit Card?
A credit card is a plastic payment card that lets you borrow money from the issuer.
It is a type of recurring account. This means you can borrow money repeatedly up to a certain limit. The payments are flexible as long as you meet the monthly minimum.
So, how does a credit card work?
Every time you buy something with it, the issuer pays the vendor. Often, a small percentage of each purchase is due as a fee to the issuer.
Then, you pay back the money you’ve spent in monthly installments. If you pay regularly, you raise your credit score.
So, credit cards can help you build a good credit history. With some types, you can also earn rewards. Plus, they give you access to emergency funds.
On the flip side, there's the temptation to overspend and the high-interest rates if you do. Besides, despite the numerous protections in place, there’s always a risk of identity theft, especially if shopping from dubious sites.
That said, if you can manage your spending responsibly, the pros outweigh the cons. So, let’s see what else you need to know about credit cards.
How Does a Credit Card Work?
Let’s go step by step.
You go to the shop and pay with your credit card. The merchant swipes it through the card reader. You’ve seen this numerous times.
But what happens in the background?
The machine reads the magnetic stripe on the back of the card. Then, it sends the information about the purchase to the credit card company.
Then, the issuer verifies that you have enough balance in your account. If you do, it authorizes the transaction and pays the merchant.
If you have a rewards card, you may also earn points or cash back on your purchase.
That’s more or less what happens when you make a purchase.
Now, let’s cover the basic terms you’ll need when you’re choosing and applying for a credit card.
Credit Card Basics
- Credit card limit is the maximum sum the lender allows you to borrow.
- Available balance is the amount of money on the credit card at a given moment. In other words, it’s the credit limit minus the sum you’re already using.
- Statement balance is the total amount you owe to the issuer at the end of the billing cycle. It includes information about all purchases, fees, and interest during that period.
- Billing cycle is the time between the end of the previous and the current statement. Typically, it is 20-45 days.
- Minimum credit card payments are the smallest monthly installments you can pay to avoid late fees.
- Grace period is the period between the end of the billing cycle and the due date.
- Annual percentage rate (APR) is the interest rate charged per year on a credit card.
This is the basic credit card language you’ll need.
Now, let’s examine in more detail some key terms and services credit card companies offer.
Credit Card Fees Explained
One of the most common questions about credit cards is how to avoid charges.
It’s simple—credit card companies charge various fees, but you pay most of them only under certain conditions.
The most common charges are annual, balance transfer, cash advance, and late payment fees.
Here’s when each one applies:
- Annual fees—This is the charge card issuers impose on cardholders per year. To avoid it, look for a no annual fee card provider.
- Balance transfer fees—This fee applies when a consumer moves their balance from one credit card to another.
- Cash advance fees—The issuer charges a cash advance or withdrawal fee when a consumer uses their credit card to get cash from an ATM or a bank.
- Late payment fees—If you’re late with credit card payments, you’ll need to pay an additional fee as a penalty.
- Foreign transaction fees—This fee is charged when you use your credit card in another country.
So, what can you do to avoid these charges?
We already mentioned finding a provider that doesn’t charge annual fees.
The others are obvious—always pay on time, don’t withdraw cash, and don’t use your credit card abroad.
Most importantly, read the fine print. Make sure there are no hidden fees. As long as you know what the company charges for, you can avoid it.
Last but not least, compare the fees as well as the interest rates when you’re choosing a credit card company.
Sometimes issuers advertise a no or low-fee policy, but that might come at the expense of higher interest.
Speaking of interest rates…
Interest Rates on Credit Cards Explained
Interest rates on credit cards depend on the borrower's credit history and the prime rate.
The prime rate is the most favorable interest rate banks could charge. Most lenders charge a variable APR, which can change over time.
Some credit cards charge a fixed APR. It doesn’t change over time but is usually slightly higher than the variable rate.
According to Investopedia, the median interest rate on credit cards is 19.49%. And predictions are that it will increase during 2022.
That said, if you pay off your balance in full every month, you won’t have to pay interest.
So, when do you pay interest on a credit card?
If you have an unpaid balance, the issuer charges interest on it every day. The daily interest is calculated by dividing the APR by 365.
The following month, the charges will apply to the full amount you owe—balance plus interest. And so on, until you repay the full amount.
That way, charges can accumulate quickly. So, compare the information about different credit cards before choosing a provider.
Interest rates are generally higher for cards with rewards programs, such as cash back or points.
The same goes for cards with special features, such as 0% intro APR periods. That is because the issuer is trying to offset the cost of those perks.
The interest rate on a credit card depends on the credit limit as well. The higher the limit, the higher the interest rate will be.
Last but not least, a good credit score can secure you a lower interest.
Balance Transfer on Credit Cards Explained
A balance transfer is when you move your balance from one credit card to another. This can be helpful if you are looking to get a lower interest rate.
Once the process is complete, you will owe the new issuer the amount of money you transferred.
In other words, you still have to pay off your balance but with lower interest. To qualify for a transfer, though, you usually need a good credit score.
Cash Advance on Credit Cards Explained
When you withdraw cash from an ATM or a bank from your credit card, you're getting a cash advance.
Companies usually charge higher fees for this than for purchases.
Since they can’t get the extra money from the merchant, they’re getting it from you.
Cash Back on Credit Cards Explained
Cash back is a great incentive for using a credit card. It is a percentage of the total amount of money you spend that is refunded to you as cash.
This is a great way to save money on shopping. It’s also an excellent example of how to use a credit card to your advantage.
There are a few things to keep in mind, though.
First, you need to make sure you can pay your bill in full each month. If you carry a balance on your card, the interest charges will negate the cash-back rewards.
Second, check what are the minimum spending requirements to earn the cash-back bonus.
And finally, compare the different cards available to find the one that best suits your needs.
Credit Cards vs. Debit Cards
What are credit cards and debit cards used for?
They are both payment methods that allow consumers to purchase items or withdraw cash.
The key difference is that debit cards are linked to a checking account, not a credit account.
When you purchase something with a debit card, you’re using funds you deposited into the account.
By now, you should know the answer to the question: “How does a credit card work?”
But in case you skipped directly to this section, here’s a reminder. You borrow money from the issuer and pay them back later.
What’s more, debit cards are safer in that there is no risk of accumulating debt. However, credit cards have better protection against fraud.
There is no right or wrong choice between debit cards and credit cards—it depends on your needs and spending habits.
If you’re not skilled at managing your finances, you should stick to a debit card.
Now that you know credit cards 101, though, you can use them to improve your credit score.
Let's see how you can do that.
How to Use a Credit Card to Build Your Credit
If you want to increase your credit score, getting a credit card is a good way to start.
Rule number one is to pay off the balance in full and on time each month. This will improve your payment history, which is a significant factor in calculating your FICO and VantageScore.
But don’t overdo it. If you pay off your credit card balance after every purchase, the credit bureaus won’t detect any activity on your account.
The other rule of thumb is to keep your credit utilization ratio low. This means borrowing less than 30% of your credit limit.
The benefits of having a credit card are numerous. You can improve your credit score, take advantage of rewards systems, use it as an emergency fund, etc.
But before you get one, you need to be able to answer one key question:
How does a credit card work?
Read our comprehensive guide to learn everything there is to know about credit cards.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.