If you’re wondering “how do credit cards work?” you have come to the right place.
Credit cards are a convenient way to pay for just about anything. They allow you to buy things in stores, online, and overseas. Credit cards allow you to take advantage of rewards points and cashback. They can also help you build credit.
However, if you’re not using them responsibly, not only will you rack up fees, you can also hurt your credit score. So knowing how credit cards work can help you reap the benefits of having one and avoid many pitfalls.
Moreover, knowing how credit cards work can provide you with great insights on how to manage your finances.
Understanding How Credit Cards Work
So how do credit cards work? We will begin first with what a credit card is. We will explore how this piece of plastic work. Then, we will address the difference between credit cards and debit cards. Lastly, we will delve into several types of credit cards and how they work differently.
What is a credit card?
A credit card is a physical card that a company gives you. You can use the card for basically anything. You can use it to make purchases, to pay bills, utilities, etc. Think of a credit card as a small loan. The credit card company lets you borrow money with a set of credit limit. The credit limit is the amount of money you have available to use.
As you are making purchases with your card, your credit limit is reduced. You then have to pay that money back over a scheduled period of time with interest applied.
How do credit cards work?
Credit cards can be used to make purchases, pay bills and utilities. They can also be used for cash advances as well. Once you use a credit card to make a purchase, for example, the credit limit is reduced by whatever the transaction amount.
At the end of the billing cycle, the credit card company will send you a credit card statement showing you all of your transactions for that month.
The statement will also include your available balance, your minimum payment and due date. You have a grace period to pay your bill.
The grace period is the time you make the purchase on your card and your due date. If you pay your bill in full on or before the due date, no interest will apply.
If you don’t pay in full and only pay the minimum before the due date, your card issuer will charge you interest. But you will avoid paying late fees.
Credit cards vs. Debit cards
A crucial part of understanding how do credit cards work is to know the difference between credit cards and debit cards.
While a credit card and debit card look the same, they are quite different. Unlike a debit card, where you’re withdrawing your own money directly from your bank, a credit card is money a credit card issuer lets you borrow. You will have to pay that money back usually with interest.
In other words, a debit card is linked to your checking account. When you use a debit card, you’re actually withdrawing and spending your own money that you won’t have to pay back later.
There is no minimum fee, no late payment fee. This is true because the money is yours and has been deducted from your own checking account.
However, you should not charge more money than you have available in your own checking account. Otherwise, you will have to pay overdraft fees for insufficient funds and other fees.
Moreover, credit cards have annual and introductory fees that debit cards don’t carry.
With that said, credit cards have a good advantage that debit cards do not have. For example, credit cards can be used to improve your credit score, making learning how credit cards work crucial. Your credit score is calculated based on 5 factors:
- Payment history
- Credit usage
- Credit mix
- Inquiries for new credit
- Credit age
Your credit card company will report your credit activity to the three credit bureaus (Transunion, Equifax, and Experian). So when to pay your credit card bill is crucial. Paying your bills on time helps raising your credit score.
Similarly, keeping your balance below 30% of your credit limit can have a positive effect on your score.
How various types of credit cards work:
There are several types of credit cards and they all work differently. For example, if you travel often then you should have a travel credit card. If you use a credit card for every day purchases, then rewards cards make sense. Below a list of types of credit cards.
Balance transfer credit cards: A balance transfer credit card allows you to roll over an existing debt over a new balance transfer card with a 0% interest. So if you have a lot of debt on your current plastic, you should apply for a balance transfer card to save you money.
However, the 0% balance transfer rate will only be available for a period of time usually between 2 to 24 months depending on the card. So, make sure you repay the debt within the balance transfer term to benefit from the 0% interest rate.
Interest free credit cards are cards with a 0% interest rate for an introductory period between 3 to 12 months, depending on the card. However, once the introductory term is over, the interest rate will revert to a higher rate.
Rewards credit cards: those are cards where you earn rewards such as cash or points on your purchase. The disadvantage with rewards cards is that they usually come with higher annual fees and higher interest rates.
So, you’ll have to earn enough rewards on a given year to make up for the annual fee and you’ll have to pay off your full balance to avoid interest fees in order to make the rewards worth it.
Travel credit cards: if you travel a lot, especially overseas, it makes sense to have a travel credit card as opposed to a regular card. The reason is because a standard credit card has foreign exchange fee, which could end up costing you big bucks.
Most travel credit cards, on the other hand, have no foreign exchange fees or currency conversion fees.
Secured credit cards: if you have little to no credit or bad credit, then a secured credit card is for you. Secured credit cards are designed for those who want to build or rebuild their credit history.
With a secured card, you make a deposit which essentially is your credit limit. As you pay your bill on time, you can start building your credit and eventually qualify for an unsecured credit card.
Credit card fees
Another key factor in understanding how credit cards work is to know the fees they charge you when you make a purchase.
Annual fee: Credit cards can charge an annual fee, which can be anywhere from $0 to $900. If the fee is high, make sure it is worth it and has other perks such as great rewards and cashback.
Cash advance fee: These are fees when you withdraw cash on your credit card. These fees can be anywhere from 3% to 5% of the money you withdraw.
Late payment fee: If you don’t pay your bill on time, you will be hit with late payment fee which is usually around $10 to $30, plus interest. So, to avoid late fees, set up automatic payments.
Foreign transaction fees: if you make a purchase overseas, you may be charged this fee. However, some credit cards waive foreign transaction fees. So, if you travel a lot, get yourself a travel credit card.
The bottom line:
Credit cards can be a great tool to build your credit score, so learning how they work is crucial. Indeed, so if you’re not familiar with how credit cards work, take the time to figure it out by using the tips above.
Remember, all you have to remember is when you make a purchase, you have to pay the money back. To avoid late fees or interest, pay your balance in full or at least pay the minimum before the due date. Paying your bill on time will help raise your score.
Likewise, not using too much of your credit limit can help you boost your score. So, when you know how credit cards work, you’ll be able to use them responsibly and improve your financial situation.
Speak with the Right Financial Advisor
Beyond learning how credit cards work, you can talk to a financial advisor who can review your finances and help you reach your goals (whether it is making more money, paying off debt, investing, buying a house, planning for retirement, saving, etc). Find one who meets your needs with SmartAsset’s free financial advisor matching service. You answer a few questions and they match you with up to three financial advisors in your area. So, if you want help developing a plan to reach your financial goals, get started now.