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How Do Credit Cards Work?
A credit card is a type of revolving credit issued by banks and other financial institutions. The card holder can instantly borrow money up to a certain credit limit to conduct financial transactions. Credit cards give consumers flexibility. You could, for example, use them to buy things, obtain cash advances, make balance transfers and perform other functions. They can be used online, in person, through a telephone and through mobile payment platforms.
When the account holder uses the card, the issuer pays the merchant on behalf of the cardholder. The cardholder then repays the issuer based on the terms of the credit card agreement, including any interest charges that apply.
If the balance is not paid in full by the payment due date, interest charges are applied to any outstanding balance on the card. Monthly billing cycles determine the statement period during which purchases and payments are recorded. Cardholders can make payments through various methods, including online payments, checks or automatic deductions. Minimum payments are required each month, and any unpaid balance carries over to the next billing cycle, accruing interest.
Common credit card terms
To help understand credit cards better, let's review some common terms:
APR (Annual Percentage Rate)
For credit cards, the APR is basically the same as the interest rate. APRs can vary based on the type of transaction (purchases, cash advances) and may change over time based on market conditions or your creditworthiness.
Annual fee
Some credit cards charge an annual fee for card ownership. This fee is typically applied once a year and can range from a few dollars to several hundred dollars, depending on the card's benefits and features. Cards with annual fees often offer enhanced rewards, perks and premium services like travel benefits, concierge services and insurance coverage. Any such fees should be listed on the credit card application.
Cash advance
A cash advance occurs when you use your credit card to withdraw cash, either at an ATM or through other cash access methods. Cash advances often come with higher fees and interest rates compared to regular purchases. Additionally, interest begins accruing immediately without a grace period, making cash advances a relatively expensive way to borrow money.
Credit limit
The credit limit is the maximum amount of money you can borrow on your credit card. It is determined by the card issuer based on things like your credit history, income and overall creditworthiness. Exceeding your credit limit may result in fees, penalties and a drop in your credit score.
Minimum payment
The minimum payment is the smallest amount you are required to pay each month to keep the account in good standing. It is usually calculated as a percentage of your total balance, typically around 1% to 3%. Making the minimum payment prevents late fees, penalty APRs, and the damage to one's credit score that can result from too many late or missed payments. However, making only the minimum payment can lead to substantial interest charges over time. Federal law requires that monthly statements include a “Minimum Payment Warning.” It shows how long it will take to pay off the current balance with minimum monthly payments and how much interest you'll pay.
Billing cycle
The billing cycle refers to the period during which purchases, payments, fees, and interest charges are recorded on your credit card statement. It typically lasts around 30 days but can vary depending on the card issuer. At the end of each billing cycle, a statement is generated detailing your transactions, outstanding balance, minimum payment due, and payment due date. Monitoring your billing cycles helps track spending, manage payment processing, and stay on top of your credit card activity.
Common types of credit cards
Banks offer a diverse range of credit cards tailored to consumers' needs. There are two basic types of cards: unsecured and secured. Another way of categorizing cards is personal or business. Here are the details:
Unsecured credit cards
These credit cards do not require a security deposit from the cardholder. Approval for unsecured credit cards is based primarily on the cardholder's creditworthiness, including factors such as credit score, income, employment history and debt-to-income ratio. The credit limit on unsecured cards is based on similar factors. The cards may come with benefits and rewards programs, such as cashback, travel rewards, purchase protections and introductory offers. Unsecured credit cards are widely available and suitable for individuals with good to excellent credit scores who have shown responsible credit management.
Secured credit cards
Secured credit cards require a security deposit, which acts as collateral and establishes the credit limit. The credit card security deposit is usually equal to the credit limit or a percentage thereof and is refundable upon closing the account in good standing. Secured cards offer an opportunity to build credit. They are beneficial for individuals with limited credit history, no credit history, or poor credit scores. Responsible use of a secured credit card, such as making timely payments and keeping balances low, can help improve credit scores over time. Some secured cards may transition to unsecured cards after the card holder has shown responsible credit behavior.
Personal credit cards
These are designed for individuals to use, in contrast to business credit cards. Cardholders can use personal credit cards for a wide range of everyday expenses, emergencies, and purchases, while also building a positive credit history if managed responsibly.
Business credit cards
These cards are designed to meet the needs of businesses. They can be used for business-related expenses like supplies, travel, advertising, equipment purchases and more, helping businesses manage cash flow while earning rewards on eligible spending. Perks and benefits may include expense categorization, employee cards with spending controls, and rewards for business-related purchases. Businesses also benefit from features like higher credit limits, expense tracking tools, accounting integration, and customized reporting for financial management. These cards build a separate credit profile for the business entity, distinct from personal credit.
Differences between debit and credit cards
How do you know whether to use a credit card or debit card? Debit cards are linked to a bank account and pull funds directly from the account when used. You can spend only what you have in the account. Credit cards provide a line of credit that must be repaid. They give the consumer more purchasing power and flexibility. Debit cards do not impact credit scores, unlike credit cards.
Credit card benefits and tips
Credit cards offer many benefits. To make the most of them, you need to understand how they work. Let’s look at some of the ways you can use credit card benefits to your advantage.
- Rewards programs. Many credit cards offer rewards programs that allow you to earn points, cash back, or travel miles on your purchases. By using your credit card for everyday expenses like groceries, gas, and bills, you can accumulate rewards that can be redeemed for travel, merchandise, statement credits, or cash back
- Fraud protection. Credit cards typically come with robust fraud protection measures. Credit card issuers monitor transactions for suspicious activity and may offer zero-liability policies, ensuring you won't be held responsible for unauthorized credit card charges. Take advantage of these protections by promptly reporting any suspicious transactions to your issuer
- Purchase protections. Many credit cards offer purchase protections such as extended warranty coverage, price protection, and purchase security. These features can be a big help when making significant purchases, as they provide added peace of mind and potential savings on repair or replacement costs
- Travel perks. Travel-oriented credit cards often come with valuable perks like airport lounge access, travel insurance, rental car insurance and free upgrades
- Build your credit history. Responsible use of credit cards can help you build a positive credit history. That can help open up future financial opportunities such as obtaining loans and mortgages, as well as getting favorable interest rates. To achieve this: make all payments on time, keep your credit utilization low (don't get too close to your credit limit), and avoid maxing out your credit limit
- Pay your balance in full every month. If you can pay your credit card balance in full every month you avoid interest charges. This can also help you maintain a good credit score, prevent debt accumulation, and cultivate good financial habits and discipline
- Budget and monitor. It's nice to get rewards on your card but set a budget for your credit card spending. You want to keep your monthly credit card bill manageable. To that end, monitor your spending to make sure you are staying on budget. Reviewing all your purchases each month also enables you to find any instances of fraud and unauthorized charges