How Do Credit Cards Work?

In today's fast-paced world, credit cards have become an integral part of our financial lives, offering convenience, flexibility, and a wide range of benefits. Whether you're a seasoned credit card user or just starting to explore the world of plastic money, understanding how credit cards function is essential.

Just swipe and sign, right? Well, there's a lot more to how credit cards work than that because, with a credit card, you are essentially borrowing money from a bank that you will pay back at the end of the month.

What is a credit card?

Credit cards are financial tools that allow individuals to make purchases on credit. When you use a credit card, you are essentially borrowing money from the card issuer to pay for goods and services. Here's how credit cards work:

When applying for a credit card, you go through a process with a card issuer, such as a bank or a financial institution. The issuer evaluates your creditworthiness by considering factors such as your credit history, income, and financial stability. Based on this assessment, they assign you a credit limit, which represents the maximum amount you can spend using the credit card.

After receiving the credit card, you need to activate it. Activation typically involves following the issuer's instructions, which may include calling a designated phone number or activating the card online. Once activated, you can start making purchases.

Using a credit card for purchases is straightforward. You can present your card to merchants or provide the card details for online transactions. Your transactions are recorded within billing cycles, usually on a monthly basis. During this time, you can make multiple purchases, and these charges will be reflected on your credit card statement.

Credit cards often come with a grace period, which is the time between the end of the billing cycle and the due date for payment. If you pay your balance in full before the due date, you can avoid interest charges on your purchases. However, if you carry a balance beyond the grace period, the credit card issuer will charge interest on the outstanding amount. The interest rate, known as the Annual Percentage Rate (APR), varies based on the issuer and your creditworthiness.

It's important to note that responsible credit card usage can positively impact your credit score. Making timely payments and keeping your credit utilization ratio low (the percentage of available credit you use) can contribute to building a positive credit history.

In addition to the basics, credit cards may offer additional features such as rewards programs, cashback offers, travel benefits, and purchase protection. These features vary depending on the card issuer and the specific credit card you have.

Remember, responsible credit card usage involves managing your spending within your means, making timely payments, and keeping track of your expenses. By understanding how credit cards work, you can make informed financial decisions and use credit cards to your advantage.

Credit card terms to know before applying

Thanks to the Credit CARD Act of 2009, creditors must be very transparent when it comes to interest rates and prominently display the current pricing for your account on each monthly statement.

Prospective cardholders who want to see the terms for a credit card can usually find credit card rates listed on the terms and conditions in what’s known as a Schumer box (named after the Senator who helped it become official). Below the listed rates and fees there’s usually a section that explains how the creditor will calculate your balance, and how much additional interest they may add to the prime rate.

How can you know how to choose the best credit card for your needs? For many Americans, knowing what to look for to pick the right credit card is a challenge.

According to a nationwide survey by major credit bureau Experian, 61% of consumers feel overwhelmed by the “sheer number” of credit card options available when choosing a credit card. Around 57% said they don’t know how to tell if a specific credit card is the best fit for them.

That doesn’t mean they’ve given up on finding the right credit card, however. “The majority (64%) believe the perfect card for them is out there, and they just haven’t found it yet,” says Experian. To find the best credit card for you, it’s crucial to look at the details beyond the card’s offer page.

Interest rate

One of the most important factors to consider when choosing a credit card is the interest rate. That’s because when you don’t (or can’t) pay off the statement balance due each month, you’ll rack up interest charges. Those charges can add up fast, especially if you’re carrying a high balance.

In October 2020, the average APR on new credit cards was 15.97%. Retail card APRs are generally much higher, sometimes even above 25%. To see what a difference the card’s APR can make, punch in some numbers on a credit card interest calculator to see how much you would pay on a balance due amount.

If you’ve already signed up for a credit card with a high-interest rate, pay off your statement balance due monthly to avoid paying interest. When looking for a new credit card, you will find the interest rate in the card’s terms and conditions as well as the card offer details.

Find out: The Ultimate Credit Card Hacks Guide

Introductory promotional period

Before you apply for a credit card with an introductory 0% APR or similar low-interest offer, make sure you know how long the intro period will last. For example, if the 0% APR intro period lasts only six months, you may want to continue your credit card search for a card with an introductory APR period of a year or 18 months.

Generally, a credit card offering a 0% APR will promote that information on the page advertising the card and in the offer details. You will also find both the introductory interest rate as well as the new interest rate that will apply after the promotional period in the terms and conditions, sometimes also known as “pricing and terms.”

Find out: Which Credit Card Should I Pay Off First?

Balance transfer fee

If you want to hit a high credit card balance hard, transferring the balance to a new credit card with a 0% APR for an introductory period for an extended number of months can be a great way to save on interest while paying off the balance. However, make sure you look at the balance transfer fee first.

Most balance transfer cards charge a balance transfer free-ranging from 3% to 5 of the amount transferred to the new card. If you will save more on interest than you will pay on the balance transfer fee, the transfer could be a smart move. However, if the transfer fee will exceed what you would pay on interest on your current card, you may want to skip applying for the new card.

You can find a card’s balance transfer fees in the credit card terms and conditions.

Annual fee

You may get so excited reading about a credit card’s generous rewards program that you jump immediately to the application without noticing that the card has an annual fee. That annual fee may not be just $69 or $99, either. Some cards with super-generous rewards programs charge up to nearly $600 for the annual fee.

Always check the offer details and terms and conditions to find out whether a card charges an annual fee before applying. If the card has an annual fee, the issuer will typically charge that fee on your first statement.

Many cards with generous rewards programs don’t charge an annual fee, so it pays to take some time to compare cards’ rewards and benefits before applying.

Find out: Credit Card Fees and How to Avoid Them

How does credit card interest work?

There are several factors that can affect how credit card APR is applied and how much is charged:

• When you pay your credit card bill
• Whether you pay the full or partial total
• The type of credit card transaction
• If the APR is fixed or variable

Credit card APR is a charge that’s only incurred when a borrower does not pay their statement balance in full (a.k.a. by carrying a balance). The remaining unpaid balance is charged 1/12 of the percentage listed as the APR. Why? APR is a number that reflects the annual cost of borrowing so the number stated on a credit card’s terms and conditions does not reflect the monthly interest charge.

This is the basic formula for calculating credit card interest:

(APR ÷ 12) x Current Balance =  Percentage charged for the current billing cycle

Say, for example, you have a balance of $1,000 on a credit card with an APR of 15%. That month you would be charged 1.25% in interest (the APR divided by the number of months in a year) which would be $12.50. This amount would then be added to your total balance and is subject to being charged interest in the future.

Most creditors use “periodic daily interest charges,” which calculate interest based on the average daily amount of debt you carried that billing cycle. Interest compounds daily on a credit card balance that gets carried month-to-month. Each day the balance remains unpaid, it grows a little more. For this reason, if you pay off an outstanding balance in full in the middle of a billing cycle, you will still have interest charges to pay off on your next bill. Those are the daily interest charges accrued prior to the payoff.

What is a good APR for a credit card?

The goal is always to have the lowest APR possible. That way if you ever need to carry a balance, you’ll end up paying less over time. But credit cards have some of the highest APRs when it comes to borrowing money (there’s no federal law that limits how high they can be) which can make this a tricky endeavor.

In the second quarter of 2022, the average card APR was nearly 17% (though there are some cards with APRs as much as 30% or higher). As such, any rate below that 17% could safely be considered a good APR for a credit card.

But as with most things personal finance, this isn’t completely cut and dry. “Good” is subjective and will depend on two key things: the type of credit card and the state of your credit score.

The type credit card can affect APR

Different types of credit cards have different interest rates. Reward credit cards, for example, which have fun perks like sign-up bonuses or cash back, tend to have higher APR than other general-purpose credit cards. There are credit cards created specifically to have low APRs, but they usually won’t offer things like reward programs. It’s safe to assume that the more incentives a credit card offers, the greater the APR will be.

The current APRs for different types of credit cards as of August 2023.

Source: CreditCards.com weekly rate report

Reward credit cards are less rewarding if you allow interest charges to apply. In fact, the value of any rewards you earn is usually offset by interest charges within the first 2-3 billing cycles. Ideally, you should pay off reward balances in full every month to avoid costly interest charges.

Your credit score can affect card APR

Regardless of whether a card offers rewards or not, the ultimate determining factor of how good a rate you qualify for will be your credit score. The better your score, the lower your rate is likely to be (remember, it’s your credit history that card issuers look at, not just your score). If you have anything less than good credit, expect that you’ll have a higher cost of using a line of credit.

How to tell if you got a good interest rate on a credit card

The easiest way to determine whether you got a good credit card rate is simply to look at a card’s terms and conditions. Since most credit card APRs are determined by creditworthiness, they provide a range of what the card’s APR could potentially be. Compare where the rate you were approved for falls within that range and you’ll have your answer. The closer you are to the lowest rate possible for the card, the better you fared. Bonus, you’ll get an idea about how creditworthy credit card issuers think you are.

How to avoid paying credit card interest

It’s very possible to own a credit card without ever paying interest. Credit cards only charge interest if you don’t pay your balance in full and carry it over from one month to another. As such, borrowers can avoid paying interest charges if they pay:

1. The entire statement balance and
2. Do so within a set number of days after the close of the billing cycle

While that might sound intimidating, two key elements make avoiding interest charges easier than you probably think.

Statement balance vs current balance

By default, the card balance that’s displayed when you view your account is the current balance. This is a total of all your purchases, those from the previous billing period and the current one. A statement balance, on the other hand, only includes the transactions that were made during the current billing period (which may not be a calendar month but in between months).

This is good news if you’re trying to avoid paying credit card interest. You don’t have to pay the entire current balance, only what you’re charged during the billing cycle—far less intimidating. More good news: Most autopay features include the option to just pay the statement balance. This is one of the best and easiest ways to ensure you never pay credit card interest.

Credit card grace periods

But, hey, life happens and you may not be able to pay your credit card bill by the due date, much less set up autopay. Perhaps you don’t have consistent income or you’re waiting on a paycheck to drop so that you can make the payment. In any case, you’ve still got the chance to avoid an interest charge.

Card issuers are legally required to give borrowers a minimum of 21 days after the close of the billing cycle to pay their bill before being charged interest. This is known as a grace period. The precise length of your credit card’s grace period may be longer depending on the card or the issuer, refer to the card’s Schumer box for detailed pricing and fee information of your specific credit card.

Note that this grace period may not protect you from incurring late fees or other penalty fees. Additionally, the grace period does not apply to transactions other than purchases. Balance transfers and cash advances will result in interest charges on the same day of the transaction.

Why making minimum payments can put you in debt

If you have an APR between 15% and 20% and are only making minimum payments, roughly half of those payments you make gets eaten up by interest charges. If your credit card APR is more than 20%, that jumps to two-thirds of your payment. Here is an example with a $1,000 balance:

1. With that balance, you would pay a minimum payment of $25.
2. At 15% APR, $12.50 of your $25.00 goes to pay interest. So, that’s exactly half of your payment that’s used to cover accrued interest.
3. At 20% APR, $16.67 goes to pay interest, so you only pay off $8.33 of principal (the actual debt you owe).
4. At 22% APR (which is a common APR for many reward credit cards), you pay $18.33 in interest charges.

Therefore, most debt management experts recommend paying more than the minimum requirement. You should pay as much as you can to pay off principal faster, because interest charges stay the same, regardless of how much you pay. So, for instance, if you paid $100 instead of $25, then you’d pay off more principal – $87.50 at 15% APR, $83.33 at 20% APR and $81.67 at 22% APR.

It’s easy to see how interest charges can quickly cause your card balance to snowball and make your monthly payments less effective at paying down debt. Reducing or eliminating interest is a key step to digging yourself out of a financial hole. You can try to negotiate a lower APR yourself or work with debt relief professionals who can do the negotiating for you.

The pros and cons of a credit card

Credit cards offer various advantages and disadvantages, which individuals should consider based on their financial habits, needs, and responsibilities. Here's a breakdown of the pros and cons:

Advantages of having a credit card

Generally, rewards credit cards tout their rewards program on the card’s offer page, since consumers love to rack up credit card rewards for airline miles, hotel discounts or cashback. The card may offer cashback at the end of the year, 5% for travel or 3X points for gas or grocery purchases, for example.

Even when the rewards seem clear-cut, however, you need to know the details, including restrictions or requirements. For example, a rewards card may offer higher points each quarter for purchases in certain categories such as gas, groceries or utilities. However, you may not receive those points unless you go on the card’s website and manually “activate” your card during the new quarter.

To find the requirements for rewards programs, look in the offer details, often underpricing. You will also usually find information about how to earn and redeem rewards on the card’s Pricing & Information page.

When you apply for a major credit card based on a low-interest introductory rate, sign-up bonus, or other special offers, you may be so excited to get those perks that you overlook the card’s many other benefits.

• Convenience: Credit cards provide a convenient payment method for purchases in stores, online, and over the phone. They eliminate the need to carry large amounts of cash and offer a secure way to make transactions.
• Build Credit History: Responsible use of a credit card can help individuals establish and build a positive credit history. Timely payments and low credit utilization demonstrate financial responsibility and may lead to better credit scores, which can be beneficial for future borrowing needs, such as obtaining a mortgage or car loan.
• Purchase Protection: If an item you buy with a credit card gets stolen or damaged, you may be able to get some of your money back through the credit card company’s purchase protection benefit. For example, some credit cards offer purchase protection against damage or theft on items you bought with the card for up to 120 days after. American Express offers purchase protection on its cards for up to 120 days and $1,000 per incident, up to $50,000 per year.
• Extended warranty: Next time you purchase an expensive appliance or device, you may want to charge it on your credit card. That’s because many credit cards offer extended warranty protection. For example, when you use a covered Visa Signature card for eligible purchases, the card’s warranty protection doubles the term of eligible U.S. manufacturers’ warranties up to one additional year on warranties of three years or less.
• Primary auto insurance coverage: Most car rental companies try to sell you a collision damage waiver (CDW), secondary auto insurance on the rental vehicle for the amount not covered by your personal insurance if you’re in an accident during the rental period. However, a couple of credit cards come with primary coverage, which means you don’t have to file a claim with your personal insurance provider for an accident with the rental vehicle. For example, Chase Sapphire Preferred and Chase Sapphire Reserved card benefits include primary (no liability coverage) car rental insurance. If you have an American Express card, you have the option to purchase primary auto rental insurance for a flat rate ranging from $12 to $25 per rental period (not per day) to cover theft or damage to a rental vehicle.
• Travel and luggage insurance: If you cut your vacation short or cancel due to sickness, severe weather or other covered situations, the credit card you used to purchase the trip may cover reimbursement. Some credit cards offer reimbursement of prepaid, non-refundable travel expenses up to as much as $20,000 per trip, depending on the card.
• Complimentary concierge services: Ever wish you had a personal assistant to book a hotel in just the right location, make dinner reservations and do the legwork to score tickets to sporting events and concerts? You may already have this service through your major credit card. For example, Visa Signature cards offer free concierge services to manage the details of everything from everyday entertainment to exotic vacations. Select Citi cards also offer a concierge service benefit.
• Cell phone protection: You may not have to purchase insurance from your wireless carrier for that expensive smartphone if you pay your monthly bill with a credit card that offers cell phone protection. Several credit cards offer up to $600 protection (minus a deductible) for eligible claims on cell phones that are damaged or stolen.
• Better access to events and concerts: Next time you’re ready to purchase concert or event tickets, check your credit card benefits first for advance access to ticket sales, along with food and beverage discounts. For example, certain Chase credit cards have Chase Select Experience, a benefit that offers preferred seating, pre-event receptions at select events and exclusive dining experiences.
• Emergency Funds: Credit cards can serve as a backup source of funds during emergencies or unexpected expenses when cash or savings are not readily available. They provide temporary financial relief and flexibility in managing unexpected costs.

Disadvantages of using a credit card

• High-Interest Rates: Credit cards often come with high-interest rates, especially for individuals with lower credit scores or those carrying balances from month to month. Accruing interest charges can significantly increase the cost of purchases and lead to long-term debt if balances are not paid off promptly.
• Temptation to Overspend: The ease of using credit cards can lead to overspending and accumulating debt beyond one's means. Without careful budgeting and self-discipline, individuals may fall into the trap of living beyond their financial capabilities and struggle to repay their debts.
• Fees and Penalties: Credit cards may impose various fees and penalties, such as annual fees, late payment fees, and over-limit fees. These additional costs can erode the value of rewards and benefits associated with the card and increase the overall cost of borrowing.
• Negative Impact on Credit Score: Mismanagement of credit cards, such as late payments, high credit utilization, and carrying high balances, can hurt credit scores. A lower credit score may result in higher interest rates on future loans and difficulties obtaining credit approval.
• Debt Accumulation: Using credit cards irresponsibly can lead to the accumulation of significant debt. Carrying balances from month to month and making only minimum payments can result in a cycle of debt that becomes increasingly challenging to overcome.

While credit cards offer convenience, rewards, and financial flexibility, they also come with risks, including high-interest rates, potential overspending, and the accumulation of debt. Individuals should use credit cards responsibly, maintain good financial habits, and regularly monitor their spending and repayment behaviors to maximize the benefits and minimize the drawbacks of credit card usage.

Credit card security

When you use your credit card, it's important to keep your credit card information safe. Many people wonder about the security of their credit card information in this day and age. Credit card fraud is rampant, especially online. So how do you keep your information secure?

One way that major credit card issuers helped to make your credit cards safer was by implementing EMV technology in credit cards, which stands for Europay, Mastercard and Visa. Also known as chip-and-pin or chip-and-sign technology, the computerized chip embedded in each card is much more difficult to gather information from when skimming a credit card.

Another way to keep your credit card information safe is to avoid saving your credit card information with too many websites. The more sites that have your information, the more vulnerable you are. Thankfully if your card is compromised, you are only liable at most for $50. New technology has also enabled credit card companies to freeze or even deny payments if they suspect suspicious activity on the card outside of your normal spending habits.

It's important to keep track of your spending not just for budgeting, but also to avoid fraudulent attacks.

How to get a credit card with no credit history

If you've never had a credit card before, you'll need to build up your credit. How to establish credit is somewhat of a Catch 22: You need a credit card to build credit, but you can't get one without good credit. Luckily, you have a few options.

1. Sign up for a joint credit card account with an established credit user
2. Get a secured credit card

Authorized user vs joint account holder

While both roles involve sharing access to a financial account, there are significant differences between them.

1. Ownership and Liability: Authorized users have no ownership rights or legal responsibilities for the account, while joint account holders share equal ownership and liability.
2. Credit Implications: Authorized users may benefit from the primary account holder's positive credit history, helping them build credit. Joint account holders share the credit history associated with the account, which can affect all individuals involved.
3. Decision-Making Authority: Authorized users have no decision-making authority and cannot make changes to the account. Joint account holders have equal decision-making power and can modify the account as needed.
4. Access to Account Information: Authorized users typically have limited access to account information and cannot view or modify account details. Joint account holders have full access to account information and can manage the account jointly.

When deciding between adding an authorized user or a joint account holder, several factors should be taken into account:

1. Trust and Relationship Dynamics: Adding an authorized user is suitable for situations where there is less trust or a temporary need for access. Joint account holders are more suitable for individuals with a strong level of trust and a long-term financial relationship.
2. Financial Goals and Responsibilities: Authorized users are beneficial for building credit or providing financial assistance to someone without the need for joint responsibility. Joint account holders are ideal for sharing financial obligations, such as managing joint expenses or achieving mutual financial goals.
3. Credit Goals and Implications: If the primary goal is to improve credit scores, adding an authorized user can help build credit. Joint account holders should be considered when credit accountability and shared credit history are desired.

How do I use a credit card?

When using a credit card for the first time, make sure to call the number on the sticker on the front of the card and activate it. Also, make sure to set up an online account with your credit card issuer. Even if you prefer to receive paper statements, having an online account will allow you to view updated information about your account instantly and make changes if needed.

Decide how you plan on using your card: Are you going to use it for everyday purchases everywhere, at just one place or type of place? Once you decide, it's time to make a purchase.

Credit cards play a significant role in our modern financial landscape, offering convenience, flexibility, and a host of benefits. Understanding how credit cards work is essential to make informed decisions and use them responsibly. By obtaining a credit card, individuals can make purchases, access credit, and build their credit history. However, it is crucial to use credit cards wisely, paying attention to interest rates, fees, and repayment terms. Maintaining a good credit score and keeping debt manageable are key to maximizing the benefits of credit cards. Ultimately, by utilizing credit cards responsibly, individuals can enjoy the convenience and purchasing power they provide while maintaining financial stability and achieving their long-term financial goals.