Credit cards are an essential convenience of modern life for most people and, at least in the U.S., are an option for making your purchases everywhere from the gas pump to the post office to the local farmers market. When used responsibly, they make paying for things quick and convenient, and even provide the opportunity to rake in rewards including cash back, free flights and a multitude of other products and services.
But they’re also complex financial instruments that can leave cardholders under a rapidly growing pile of debt if not used properly or if treated too casually.
So how do credit cards work? What, exactly, are they as compared to debit and prepaid debit cards? And how do you navigate the many, many options available? Let’s dive in….
Credit cards vs. charge cards, debit cards, and prepaid cards
- Credit cards and charge cards are similar. Both allow you to buy things now and pay for them later. But there are important differences, starting with what “later” means. You have to pay the balance on a charge card at the end of every billing cycle, while credit cards require paying just a small fraction of what you owe (generally a minimum of 10% of your balance), and charge interest on the remaining balance. This makes charge cards a good option for people who want to avoid the temptation of running up a balance. It should be noted, however, that charge cards often come with hefty fees if you run late on a payment or, worse yet, fail to pay off the full amount.
That said, charge cards also tend to have higher rewards than credit cards, although they also come with relatively high annual fees.
- Debit cards are essentially electronic checks, allowing you to pay with money from your bank account.
- Prepaid debit cards are similar, but instead of drawing on your bank account, you load the card with a balance that you then can spend, so think of them like gift cards. Prepaid debit cards are a way to have the convenience of buying with credit cards without the temptation to spend money you don’t have. They’re also safer than carrying cash. On the other hand, they don’t provide the rewards, purchase protection, credit building and emergency spending ability that credit cards can.
Additionally, neither debit cards nor prepaid debit cards can help you build or rebuild your credit since you aren’t paying off a bill, per se, and issuers aren’t reporting your responsible use of the cards to credit bureaus.
|Card type||Carry a balance||Annual/monthly fee||Transaction fee||Chance to earn rewards||Help build/rebuild credit|
|Prepaid debit cards||N||Y||Y||Y||N|
Now that we’ve laid out the basic differences between credit cards and charge and debit cards, we can start unfolding the basics of how credit cards work.
How do credit cards work?
Technically speaking, when you try to buy something with your credit card, the merchant’s acquirer contacts your issuer using the card network to get approval for the transaction. After transactions go through, issuers send payments to acquirers through the network. The issuer bills you, while the acquirer pays the merchant, minus a fee. The fees to the merchant vary by acquirer, which often figures into why merchants might accept one type of credit cards, but not another.
On a more practical level, credit cards work in that they allow you to spend money up to a preset limit. Credit cards are a type of revolving credit account, meaning you can spend and pay down the money you’re borrowing repeatedly while the account is open.
When you open a new credit card you’re assigned a credit limit. You can use your card to make purchases up to your credit limit, and will then be required to pay a percentage of your balance each month. You can choose to pay your balance in full, or you can pay the minimum balance due and pay interest on the unpaid balance. Your APR (annual percentage rate) will be determined and provided at the time of application, and it’s this rate that you’ll pay on unpaid balances. If you pay your balance in full by the due date, you can avoid this fee, however, interest charges are a very important part of credit cards you should know about, so let’s break that down further:
How does credit card interest work?
- Fixed vs. variable rate: A fixed APR credit card will have a rate of interest that doesn’t change. Under federal law, credit card issuers must give 45 days’ notice before changing your fixed rate and cannot change the rate on existing balances except under certain conditions, such as the expiration of a promotional rate or failure to make the minimum payment. Variable rate cards automatically adjust the APR to be a set amount above a benchmark rate, such as the prime rate.
- How interest is calculated: The interest is generally calculated by dividing the APR by 365 or 360 to get a “daily periodic rate” and then either applying that rate to the balance at the end of each day, or multiplying the rate by the number of days in the billing cycle and the average daily account balance during the billing cycle. Some cards use a monthly periodic rate, which means dividing the APR by 12. Interest rates, on the other hand, are determined by your credit worthiness.
- Rates make a big difference: Rate calculators can show just how much a high APR can cost you. For instance, if you have a $4,000 balance on a credit card with an APR of 19% and make a monthly payment of $222, it will take you 22 months to pay off the balance and you’ll end up spending about $900 on interest. Transfer that balance to a 0% card, however, and you’ll pay it off in 18 months, with no interest (not counting any transfer fees).
➤ LEARN MORE: How to avoid credit card interest rates and fees
How do rewards credit cards work?
Rewards credit cards are a type of credit card that allow you to earn something in order to incentivize you to use the card.
If you choose to pay your balance in full each month, you can really benefit from your credit card by earning cash back and other rewards on your purchases. You can of course earn rewards even if you can’t pay your bill in full each month, however, you’ll want to be mindful about any balances you’re carrying as they can quickly outweigh the cost of any rewards you earn from your card.
The following are the most popular types of rewards cards:
Cash-back credit cards
Cash-back cards will give you cash back based on the amount that you spend. Usually, the card will give you a percentage back for the dollar value of what you spend on purchases, but in some cases, you may be able to accrue points that are converted into a specific amount of money. Cash-back cards may give you the rewards you earn by depositing the money into your bank account, providing a credit on your card, or by issuing a check.
There are four distinct types of cash-back rewards cards:
- Flat-rate cash back cards offer a single percentage rate of cash back no matter where you make a purchase.
- Tiered cash-back cards offer a tiered percentage rate in particular categories. For example, a tiered cash-back card may offer 3% cash back on dining purchases, 2% at the supermarket, and 1% on everything else.
- Rotating category cash-back cards offer a higher percentage rate in particular categories that rotate, usually quarterly. This type of card may offer 5% on gas purchases one quarter, and 5% on online purchases another, for example.
- Customer-choice cash-back cards offer a higher percentage rate in a particular, customer-choice category.
➤ LEARN MORE:How do cash-back credit cards work?
Travel reward credit cards
Travel cards allow you to earn points or miles from your purchases to redeem for travel purchases. Sometimes these cards earn rewards on all purchases, but oftentimes these cards earn rewards on travel specific purchases like airfare and hotel stays. Rewards can then be used to cover or offset costs of future travel. There are a few different types of travel rewards credit cards:
- General travel rewards cards allow you to accrue rewards made on all travel purchases, despite the category. Accrued rewards can then be used directly through a credit card issuer’s travel portal, or as a statement credit to cover travel-related purchases. Another option with some of these cards is to transfer rewards directly to an airline or hotel loyalty program. These cards are ideal for those who want more flexibility in how they travel.
- Hotel and airline rewards cards earn rewards in the form of points or miles in a branded loyalty program. These cards are a good fit for those loyal to particular airline or hotel brands.
- Gas rewards cards earn rewards at the gas pump, so these are a great fit for anyone who spends a lot of time on the road.
➤ LEARN MORE:How do travel reward cards work?
Should you get a credit card?
These days, it’s virtually impossible to get by on cash and checks alone. Those options generally don’t work online or even for some in-person transactions (for an in-flight meal purchase on a plane, for instance). You could use a debit card for your non-cash purchases, but credit cards have some important advantages. Here are the biggies:
- Building credit: A history of using a credit card responsibly builds up your credit rating, which you’ll need for things like taking out a car loan or home mortgage. Credit scores also factor into things like apartment rental applications and car insurance rates. Some potential employers even run credit checks on job candidates.
- Rewards: Want to earn cash back, airline miles or discounts at your favorite retailer with every purchase? Credit cards can do that. Some come with other perks, like free checked bags on an airline or special shopping bonuses.
- Purchase protection: Many credit cards will compensate you if something you bought using the card is lost, stolen or damaged or even if it goes on sale within a certain time frame after your purchase.
- Security: If your credit card is stolen, you won’t be on the hook even if the crooks use it to buy stuff. If cash is stolen, you’re out of luck.
- Convenience when traveling: These days credit cards are accepted around the world, and many don’t even charge foreign transaction fees. It’s easier and often less expensive than changing money to local currency. Plus, it’s more secure than carrying wads of cash with you in an unfamiliar city.
- Just in case: You don’t want to spend more money than you have – the ease of doing that with credit cards is one of their big drawbacks. But credit cards do provide money you can draw on in case of an emergency, like a medical bill, urgent car repair or travel mishap.
Steps to take before getting a credit card
When you decide to get a credit card, there are certain steps you should take before you actually apply:
- Research cards: There are many cards out there that you can choose from, so it’s important that you do your research to understand what’s out there. From rewards to interest rates, cards have different things to offer, so you should find out the terms of different cards, the rewards that you may be able to earn from these cards, and the penalties that may be applied to your account if you’re not able to keep up with your payments.
- Consider your lifestyle: In some cases, a credit card can actually do more harm than good, so it’s important for you to consider your lifestyle before you apply. Do you make enough purchases to justify getting a card in the first place? Will you be able to keep up with the payments if you do get one? Ask yourself some hard questions about your budget and lifestyle in order to determine if getting a credit card is really the right choice for you.
- Know your credit score: As you think about the type of card you want, you should also think about the type of card that you’re eligible to receive. Checking your credit score will help you determine how likely it is that you’ll be approved for that type of card you want. You can get credit report from one of the three credit bureaus, Experian, TransUnion, or Equifax. Also, if there’s an error on your credit report, you want to be sure to dispute it because that may help you improve your score.
- Gather personal information: You should have your personal information handy so you are prepared to apply for a credit card. The information that you’ll need include income, employment, asset, financial liability, and bank account information.
➤ LEARN MORE:What to know before applying for your first credit card
How to compare credit cards
Although credit cards can make your life easier as you build your credit rating, not all cards are created equally so it’s best to compare offers before you sign on the dotted line. First you have to know what features are the most important to you and what you want to get out of using a credit card. Some of the items you will want to consider with each card include:
- Variable APR terms, including regular and promotional rates
- Introductory offers
- Annual fees
- Rewards programs, including travel and cash back rewards
To make your comparison easier, you can use our credit card comparison tool, which includes information about each card you’re considering based on your credit situation and preferences.
How to apply for a credit card
Applying for a credit card and getting a decision on your application is fast and simple these days, particularly if you apply online. Expect to be asked to provide your name, address, phone number, Social Security number, citizenship status, employment status, occupation, income, assets and housing costs.
But just because it’s simple to do doesn’t mean you should take it lightly. Perhaps the most important thing to do before you begin looking at credit cards is to investigate and fully understand your credit situation.
Generally speaking, you’ll need a FICO score above 650 to qualify for a card aimed at people with fair credit, 700 for a card for people with good credit and 800 for the best offers. Of course, your credit history (as shown on your credit report), income and housing costs also will play into what you can get. Be honest about your financial situation when applying for a credit card – lying on an application is fraud and can lead to serious consequences.
Lastly, don’t apply for too many cards at once; each application will result in a check of your credit report, and credit inquiries can hurt your credit score. That means you should only apply for cards for which you have a decent expectation of being approved.
➤ LEARN MORE:Guide to understanding different credit scoring models
The biggest decision you’ll face is which of the many credit cards to apply for. Don’t just go with an offer that your bank sends you or that you see on television. You might well be able to find something better, especially if you have a solid credit history.
If you have little credit history, poor credit, or little or no income, you might have to opt for a secured credit card or get a co-signer. Other options include prepaid debit cards, though those come with a different set of fees than more traditional credit cards. When choosing among cards, you should first decide what your priority is. Possibilities include:
- Building a credit history: for people who are looking to bounce back from a less-than-ideal financial past or those just getting started building a financial profile.
- A low interest rate: for people who are likely to carry balances.
- A no- or low-interest balance-transfer rate: for people looking for time to pay off existing balances.
- Low fees: for people who want to avoid expenses like annual fees and foreign transaction fees.
- Rewards: for people who plan to generally pay off balances every month and are looking to benefit from using their card regularly.
The selection of rewards cards has exploded in recent years. Rewards generally fall into the categories of cash back, travel discounts and shopping discounts. But there are many flavors of each. Cash-back rewards may be a set percentage back on every purchase (flat-rate cash-back cards); a base percentage, with more for certain categories, such as gas and groceries (tiered-rate cash-back cards); or a base percentage, with more for a rotating list of purchase types, such as restaurants in one quarter and gas in another (rotating categories cash-back cards).Travel and shopping rewards may be usable with many partners, or may be specific to an airline or retailer. Some cards are co-branded, meaning they can be used for purchases anywhere, but rewards just apply to one airline, hotel chain, retailer, etc. Purchases from the co-branded retailer may earn extra rewards on these cards. These are different from store credit cards, which can only be used at a specific retailer.
Credit card comparison tools make it easier than ever to find the right card for you, based on your credit situation and preferences.
How to use a credit card
Whether you want to raise your credit score or save money on travel, you can only meet your goals if you use your credit card responsibly. In order to use your card correctly, you should:
- Keep your card at least 30% below your credit limit
- Pay your bill on time and if possible, pay the entire balance every month
- Regularly review your statement to ensure that you don’t go over your limit and that there is no fraudulent activity on your account
- Set up automatic payments so you never forget to pay your monthly statement
- If you have multiple cards make sure to use the right cards for the right purchases – use a card that earns bonus rewards on dining at restaurants, use your travel card when buying plane tickets, etc.
- Be sure to redeem any rewards that you have earned
- Ask for a credit increase after you have been in good standing for about a year in order to make it easier to keep your balance well below the limit
- Use your card so that it does not become inactive and negatively impact your credit score
Credit card definitions
– Annual percentage rate (APR): This is the interest rate you’ll pay on any credit card balance that you don’t pay off by the monthly due date. You’ll pay interest on new purchases if you’re carrying a balance and you’ll pay interest on whatever balance you carried over from the month before. Many credit cards do come with a low of even 0% introductory APR, but that rises after a set period. Federal law requires any introductory period last at least six months, though you can find deals that last 12 or even 18 months. Note that balance transfers and cash advances may have different APRs and rules about when interest applies.
– Authorized user: People authorized by the primary account holder to have and use a copy of the credit card. Their credit situation doesn’t factor into the approval or credit limit, and they’re not ultimately responsible for balances. An authorized user’s credit score, however, can be impacted both negatively and positively by how that credit card is used.
– Available credit: This is the difference between your credit limit and the balance you have on your card.
– Balance transfer: A situation in which a credit card holder transfers the balance from one credit card to another credit card, usually to secure a better APR while paying off the balance. Sometimes the APR for balance transfers is different than that for purchases and there are often fees, known as balance transfer fees, associated with making the transfer. Even so, a balance transfer can be an excellent option for saving on interest if you need some extra time to pay off a balance and you’re eligible for a low or zero-APR balance transfer offer.
– Balance transfer fee: Many credit cards charge a fee for balance transfers that is separate from the interest rate on the balance. The most common fee is 3% of the balance transferred, although you may qualify for balance transfer offers with no fee.
– Cash advance: A cash advance is essentially a short-term loan from your credit card, subject to a separate cash advance limit. You can get a cash advance from a bank or ATM with a PIN or by using a convenience check that your credit card issuer sends you. Cash advances may have several disadvantages compared with regular credit card transactions, including transaction fees, interest that immediately starts accruing and higher interest rates.
– Chip: Most new credit cards come with a chip embedded in them. The idea is that, when you go to buy something, you insert your card into a chip reader rather than sliding it through a magnetic stripe reader. This is more secure because chips generate a unique code for each transaction, rather than transmitting your credit card details. Many merchants are not yet set up to process chip transactions, however.
– Co- signer: A co-signer is someone who provides a guarantee on a credit card account for someone else. For instance, a parent might co-sign a card for a child who has little or no credit history or income. Co-signers are responsible for balances the cardholder racks up.
– Credit limit: This is the total balance you can build up on your credit card at any given time. If you try to spend more than your credit limit, your purchase will be declined unless you’ve authorized your credit card company to allow purchases over your limit, in which case you’ll likely have to pay a fee. Credit card issuers determine this limit by looking at such factors as your credit score, income, debt, payment history, amount of credit on other cards, how long you’ve lived at your current address and whether you own your home. Issuers may increase your limit if you reliably pay your bill each month. You can also request an increase. The credit limit may be much more than you can pay off in a reasonable amount of time, so be careful. Remember, as mentioned above, that your credit limit is different than your cash advance limit.
– Credit report: A credit report lists your financial history, including bank, credit card and utility accounts, outstanding loans and account balances, any collection actions and any history of late payments. Three nationwide consumer credit reporting companies issue reports: Equifax, Experian and TransUnion. You’re entitled to request a free copy of your credit report from each of these companies every 12 months.
– Credit score: A credit score is a number that credit card issuers (or others you might do business with) use to evaluate you. You’ll often see this referred to as your FICO score, though there are other companies that produce credit scores. It considers such factors as your history of paying bills on time, how much credit and debt you have, and how long you have maintained financial accounts. Credit card issuers use credit scores to decide whether to approve your application and then set your credit limit.
– Default APR (also known as a “penalty APR”): This rate may kick in if you let your bill get 60 days past due. You’ll generally have to make six months of at least minimum payments before your APR goes back down.
– Foreign transaction fee: This is a fee charged for transactions in a foreign country. The fee will be a percentage of each transaction, such as 1% or, more commonly, 3%. Some cards have no foreign transaction fee, which could save you a solid chunk of change if you plan to use a card when you travel abroad.
– Grace period: The grace period is the time between the end of the billing period (the statement closing date) and the due date. If you start the billing period with no balance and pay your new balance in full before the end of the grace period, you won’t owe any interest on purchases. By law, if you have a grace period, it must be at least 21 days. Taking advantage of the grace period means that you can spend with a credit card, potentially accruing rewards, and pay it off without paying any interest or anything more than you would have paid if you’d used cash or a check. Note that there’s generally no grace period on cash advances.
– Issuer: Issuers, acquirers and networks (or processors) are the major players in the credit card world. An issuer is the bank — like Chase, Citi or Bank of America — that approves your credit card application, sets your credit limit and collects your payments. Most often, your issuer will be your bank and your network will be Visa or Mastercard; however, American Express and Discover are issuers of credit cards that then function on their own respective networks.
– Joint account holders: People who apply for credit cards together.
– Minimum amount due: This is the least amount of your balance that you have to pay to avoid a penalty. Paying only the minimum each month will cause interest to pile up.
– Network: Networks facilitate the transactions. For most cards, the network is either Visa or MasterCard. Discover and American Express are distinctive in that they are both issuers and networks.
– Penalty APR (also known as a “default APR”): This rate may kick in if you let your bill get 60 days past due. You’ll generally have to make six months of at least minimum payments before your APR goes back down.
– Periodic rate: The periodic rate is the interest rate applied to your balances. Generally, issuers use a daily periodic rate, which is the APR divided by 365 or 360. Some use a monthly rate, which is the APR divided by 12.
– Primary account holder: A person who applies for a credit card, whose financial situation is part of the basis for approving the card and setting the credit limit, and who is responsible for paying the balance.
– Prime rate: This is a base reference rate that banks set, based partially on the federal funds rate, which is the rate banks charge each other for overnight loans of money on deposit at the Federal Reserve. Adjustable rate credit cards generally set the APR at a certain level above the prime rate.
– Revolving balance: A revolving balance is the amount of your balance that you don’t pay off by the due date. When you have a revolving balance, you’ll pay interest on that balance and on new purchases. Having high revolving balances can hurt your credit score (not to mention make a depressing dent in your wallet as you rack up interest charges). This calculator can show you how long it would take to pay off your balance at different monthly payment levels, or how much you’d have to pay each month to to pay off your balance in a specified number of months.
– Secured credit card: If you have little credit history, poor credit, or little or no income, you may not qualify for an unsecured card. In this case, you can build up your credit through responsible use of a secured credit card. With secured credit cards, you must put up money with the credit card issuer, a deposit that is kept by the bank until you either close the card or graduate to an unsecured card, and that amount becomes your credit limit.
– Statement balance: This is the balance on your card on the date that your statement closes each month.
– Transaction fee: This is a charge that may apply to certain types of transactions, such as cash advances, purchases above your credit limit or purchases in a foreign country.
– Unsecured credit card: Most credit cards are unsecured, meaning you don’t have to put up any collateral or deposit to get the card. The issuer approves a certain amount of credit (your credit limit) based on your history, income and other criteria.