How Do Credit Cards Work?

The majority of US citizens have at least one credit card, and many people have at least two or three. Credit cards can help you make purchases and build up a positive credit history with nearly a month to pay them before interest kicks in. When credit cards are used responsibly, they’re an invaluable financial tool. When not used properly, they can be a serious burden that can complicate your finances. Understanding all the ins-and-outs of the credit card process is critical to having and building good credit. Read on to find out how credit cards work.

How Do Credit Cards Work?

Credit cards are wallet-sized, plastic cards that extend users a line of credit — essentially a temporary loan — that they can use anytime to make a purchase. Unlike most traditional loans, credit cards don’t have a defined installment payment schedule. Instead, you must make at least the minimum payment due each billing cycle, plus interest, if applicable.

Credit Card Grace Periods

To avoid interest or finance charges, it’s important to pay off the balance on  your credit card  within the specified grace period to avoid interest. Credit cards can be a great way to finance things short-term so you can put your own money to work earning in investments a little longer. If you do not or cannot pay your full balance within the grace period, however, you will owe interest on your purchases. Interest is money charged on top of the amount you already owe, which is one of the primary ways that credit card issuers earn money. According to the CARD Act of 2009, you’re entitled to a grace period of at least 21 days — from the time you receive your credit card bill until interest starts accruing — to pay off your new balance.

APR and Credit Card Interest Rates

Interest rates are the price a consumer or business pays for the privilege of borrowing money. Credit card interest is typically charged as a percentage of what you owe each month. The percentage of interest you owe each year, called an annual percentage rate, is commonly slightly different from the published interest rate. APR is the annualized version of the interest rate, with fees included in the rate as well. Your APR can vary significantly because it’s based on factors, such as your personal credit profile, credit history or credit score. According to the Federal Reserve Bank of St. Louis, the average commercial bank interest rate on credit card plans has hovered around 15% through most of 2019, with the latest data saying 14.87%. Credit card APRs generally run from 0% to 24.99%, depending on your creditworthiness. One more point on credit card interest rates: Since months aren’t all the same length, card issuers typically use a daily periodic rate to calculate interest charges on your balance. You can find out your DPR by dividing your APR by 365, the number of days in the year.

Introductory Interest Rates

Credit card companies like to reel in new customers by offering rock-bottom interest rates, usually as low as 0% for a certain number of months, such as 12, 15 or 18. After the introductory period, regular finance charges resume. Introductory APRs let you enjoy low or non-existent interest for the length of the offer, which can be as long as two years, though usually between a year-and-a-half and two. These special offers are usually made to applicants with good to excellent credit scores. Introductory rates may only apply to certain balances, such as either purchases or balance transfers. But they can also apply to both. Check the offer details before jumping into a low-interest promotion, because individual terms vary among credit card companies. After the introductory period ends, interest is applied each month at a specified rate — again, you’ll want to check with your individual credit card company — and it will apply to balances that carry over from the previous month. To make the most of an introductory offer, make sure you pay off applicable balances before the offer period ends.

Credit Card Transactions and Additional APRs

Credit cards have multiple uses. For example, using a credit card to buy something at a big-box retailer is just one way of using your credit card. Another is to get hard cash via your credit card, also known as a cash advance. You’ll typically use credit cards for one of three things:

• Purchases
• Balance transfers
• Cash advances

Purchase APR

Store purchases, whether online or in a brick-and-mortar location, are for goods or services you’re buying because you need or want them. Other purchases include paying for vacations, hotels, rental cars, subscriptions, auto repairs, legal fees and any similar transaction of paying for a product or service. When you use a credit card for purchases, it has its own purchase APR. This is generally the APR that the credit card issuer advertises the most clearly and prominently. One example of when a purchase APR might not be touted is when the credit card is specifically a balance transfer credit card — or a card that has a lower APR for balance transfers.

Balance Transfer APR

Credit card balance transfers involve taking a balance that you owe another lender, such as another credit card company, and transferring it to a new credit card. Balance transfers are typically done to save on interest repayments by taking advantage of low introductory interest rates. Typically, you can’t transfer balances to the same card issuer. So, you can’t transfer a balance from one Visa card to another Visa card, for instance. Check with your lender on specifics for balance transfers. When you perform a balance transfer with your credit card, it has its own balance transfer APR. Balance-transfer APRs tend to match the purchase APR, but always double-check the credit card agreement to confirm the exact rate. And like the purchase APR, the APR is based on a range that is, in turn, based on the Prime Rate.

Cash Advance APR

Cash advances let you use your credit card to get a short-term cash loan at a bank or ATM. Keep in mind that most credit card companies won’t let you take your entire credit line as a cash advance. For example, you may have a $1,000 credit line with $300 available for cash advances. Cash advances usually include fees and a separate cash advance APR that’s typically higher than the APR assigned to purchases or balance transfers. Sometimes the cash advance APR will be at the highest end of the purchase APR range. Other times, it’s not based on anything and is simply a higher APR.

Penalty APR

A penalty APR isn’t a credit card transaction, but it does carry its own APR. like balance transfers or purchases do. A penalty APR usually kicks in when you make a late payment — and not just by a few days. In general, credit card issuers will make you pay a penalty APR once your payment is 60 days late. Two months is a significant window of time, however, so if you can track your bills and stay organized, you should be able to avoid a penalty APR.

Credit Card Balance and Credit Limit

Understanding what your credit balance and credit limit are is fundamental to understanding how credit cards work. Your credit card balance is the amount of money that you owe to the credit card issuer on your account. Your credit card balance can be a positive number if you owe money or a negative number if you’ve paid more than you owe. It can also be zero if you’ve paid off the balance in full. Your credit limit is the maximum amount of money that you can spend with your credit card. When you  get approved for a credit card , the credit card issuer will assign you a credit limit that is not only dependent on the brand of card, but also, critically, on your creditworthiness. This is why high-income individuals are associated with having “black cards” with extremely high, or sometimes no, credit limits. There are both advantages and potential downsides to having a high credit limit. An advantage is that you’ll be able to spend more, which is convenient — especially for big purchases like vacations, furniture and other large items. A high credit limit can also potentially help your credit score by decreasing your credit utilization ratio, which is the ratio of your credit card balance to available credit. For example, if you have a balance of $500 on a credit card with a credit limit of $1,000, then your credit utilization ratio is 50%, which is above the recommended 30%. If you have a $500 balance on a credit card with a limit of $5,000, however, your utilization ratio is only 10% — well below the recommended 30%. On the negative side, having a high credit limit could put you in a position to amass a lot of debt, which you could struggle to pay off.

Credit Card Fees

Many credit cards charge various fees, such as annual fees to fees for when you use your credit card abroad. Here are some of the most typical credit card fees:

• Annual fees:  Credit card issuers often charge a fee once a year to cover the benefits provided by the card. While an annual fee might make sense for a credit card with a ton of perks, it might not be worth it for cards that don’t provide any benefits to offset the fee. The good news is that plenty of no-annual-fee credit cards are out there, so try finding those first.
• Cash advance fees:  Using your credit card to take out cash is usually expensive. Cash advance fees apply, plus you have to pay a higher interest rate due to the cash-advance APR.
• Balance transfer fees:  When you transfer a balance from one credit card to another — a smart way of utilizing 0% APR cards to move a large balance of debt — you will typically pay a fee equal to a percentage of the balance transferred. Balance-transfer fees generally range from 3%-5% of the amount transferred.
• Foreign transaction fees:  Foreign transaction fees mainly apply when you make purchases in another currency. If you travel outside of the country often, you should look for a credit card without foreign transaction fees to avoid those charges.
• Late fees:  The credit card issuer charges late fees when you don’t make the required payments by the statement due date. Recurring late fees can lead to even worse repercussions, like a penalty APR.

How To Make Credit Card Payments

There are several options for making credit card payments. You can do it the old-fashioned way and mail a check. However, nowadays, most people find it convenient to make online payments, which are usually instantaneous or at least process within a business day or two. Some card companies also let cardholders make payments via phone with a debit card, another credit card or a checking account — although you may need to pay a fee for this service. It’s financially responsible to pay your credit cards in full each month because it allows you to avoid interest charges. If you can’t pay your card balance in full, always pay at least the minimum payment to avoid late fees and adverse credit reporting.

Credit Card Minimum Payments

Your credit card minimum payment is the minimum amount you can pay per statement cycle in order to continue using the card. Just making the minimum payment each month is a surefire way to increase your cost exponentially because you’ll continue to accrue interest on the remaining balance. Depending on your terms and how much your balance is, paying the minimum amount could mean paying your credit card bill for more than a decade or longer.

Credit Cards vs. Debit Cards

Credit cards work very differently from debit cards. A credit card offers you a line of credit that can be used to make purchases, balance transfers and cash advances. You are then required to pay back the loan amount in the future, with interest charged on top of the amount you borrowed. Debit cards involve no form of credit and interest does not apply. Debit cards pull funds directly from your checking account at a bank, rather than pulling funds from a line of credit through a credit card issuer. Thus, with a debit card there are no minimum monthly payments or annual fees. Just don’t spend more than you than you have available in your checking account, as this can trigger an overdraft or insufficient funds fee.

Types of Credit Cards

One of the most basic ways to classify credit cards is whether they are unsecured or secured. Here are some fundamental differences between the two to be aware of.

• Unsecured credit cards: Unsecured credit cards are the most common form of credit card. They feature a line of credit that is not secured with a deposit of cash. In essence, what this means is that the bank is lending you money without collateral. Unsecured credit cards are for consumers with good to excellent credit. But even those with fair credit can get an unsecured card, but it may feature higher interest rates.
• Secured credit cards: Secured cards, on the other hand, require you to make a deposit of money as collateral for the line of credit. Secured credit card issuers commonly set the deposit equal to the line of credit itself. For example, a $1,000 deposit could allow you to charge up to $1,000 on the card. If you fail to pay your bill, the bank may take your deposit. In general, secured credit cards are for people with poor credit or people just starting to build their credit profile, and thus have trouble qualifying for a traditional, unsecured card.

Beyond secured and unsecured credit cards, there are several categories of credit cards that comprise a variety of different types of unsecured credit cards. The groups are:

1. Credit cards
2. Retail cards
3. Charge cards

When used responsibly, credit, retail and charge cards can help you build credit and possibly even save money.

Credit Cards

Credit cards are the most common financial instrument and have become essential for everyday life. When used properly, credit cards can help you save money, manage your budget and earn great rewards. Credit cards are issued by large multinational banks, regional banks, credit unions and other major credit card issuers. Within the credit card category, there are many types of cards, including:

• Balance transfer credit cards
• Reward and cash-back credit cards
• Airline miles credit cards

Balance transfer credit cards are designed for transferring high-interest balances from one credit card to another — usually one with a better APR. It is common for balance transfer cards to offer a 0% APR introductory period on balance transfers for a limited period. During this period, you can pay off your transferred debt without interest. Rewards credit cards are credit cards that reward you in some way for spending. A rewards credit card can provide you with rewards points every time you spend, which you can then redeem for services, products or sometimes a statement credit. Another type of  rewards credit card  is a cash-back card, in which the reward is actually a percentage of cash back based on the amount of purchases made with the credit card. Airline mile credit cards, which give you rewards in the form of air miles and sometimes hotel perks, are another type of unsecured credit card. Typically with these cards, your spending helps you accumulate airline miles that you can redeem as tickets on a future flight. Sometimes, you can use airline miles earned to reimburse a previous trip. These airline miles credit cards also tend to award you more miles when you use your credit card to make purchases with an airline that the credit card is co-branded with.

Charge Cards

Charge cards aren’t as common today as they once were. Options are fairly limited, but they do exist. These cards do not grant you credit but rather are spending tools. Charge cards do not include a preset spending limit, but each billing cycle your balance is due in full. Even though charge cards do not offer revolving credit, they often offer great benefits like initial bonuses, high reward rates and statement credits. Depending on the issuer, there also might be ancillary benefits such as excellent customer service. If you pay off your credit card balance in full each month and desire great rewards and excellent benefits, a charge card could be a great pick for you.

Retail Cards

Retail cards are typically for a store. Retail cards can often be the first card someone may get in order to establish credit. A retail card may also be branded with Visa or Mastercard, which means not only can it be used at the retail store but also anywhere Visa or Mastercard are accepted. Retail card issuers may approve applicants with no or limited credit. However, the initial credit line may be small — just enough to make a few purchases at the retail store. One of the biggest benefits of a retail card is that the store will often grant the largest sales and discounts to cardholders. The ability to build credit, potentially make purchases wherever Visa and Mastercard are accepted and receive great store discounts and rewards make retail cards a must-have for anyone looking to establish or grow a sound credit history.

Impact on Credit Score

Credit cards can have an impact on your credit score in a variety of ways. On the positive side, you can use credit cards to improve your credit score. A credit card issuer will report each monthly payment that you make to one or more of the three credit reporting agencies. Behaviors such as paying on-time, as well as more than the minimum due can help your credit score increase. In fact, regularly using credit cards responsibly allows you to build credit and thicken your credit profile because it shows lenders that you can manage credit. On the negative side, irresponsible credit card use can be detrimental to your financial health. For example, if you charge too much on your credit card and are forced to make just the minimum payments, you will be in debt for a long time before you can fully pay off your credit card balance. Even worse, if your  credit limit  is especially high, you could build a credit card balance so high that even the minimum payment is difficult to meet. Having such as high balance can lead to late payments or even outright delinquency — both of which will negatively impact your credit score. What’s more, even just having a high credit card balance to credit limit — aka credit utilization ratio — can negatively affect your credit score. One more way credit cards can impact your score is during the application process. When you apply for a credit card, the issuer will almost certainly initiate a hard inquiry to check your credit. As a result, you will most likely see a temporary dip in your credit score — around five to 10 points. And, if you apply for multiple credit cards at once, you may see your credit rating change altogether, such as going from a good score to a fair score.

The Bottom Line

Credit cards are neither inherently good or bad. They are what you make of them, so it’s essential that you know how to use credit cards responsibly — mainly as a tool to help build your credit. Credit cards are one of the most important financial instruments you might ever have. They can be the first step in building a great credit profile that can one day help you achieve your financial dreams.