HOW DO CREDIT CARDS WORK?
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 treated casually.
>>> Use our Credit Card Calculators to better understand your interest, debt and payment options.
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? Before you get into the process of comparing credit cards and researching your options, go through our comprehensive guide.
SHOULD I 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 (see more on different types of cards below), 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.
CREDIT CARDS VS. CHARGE CARDS, DEBIT CARDS, AND PREPAID DEBIT CARDS
*Each card is different. The chart notes possibilities for each card type; for instance, many credit cards charge an annual fee, but many others do not. On the other hand, debit cards generally do not charge annual/monthly fees. Consult rates and fees tables and card agreements carefully before applying for any card.
- 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. American Express dominates the charge card market. Many credit cards have no annual fee, which can help you reduce expenses overall.
- 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 cardsare 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.
HOW DO CREDIT CARDS WORK?
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.
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.
- 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 or 19 percent 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 percent card, however, and you'll pay it off in 18 months, with no interest (not counting any transfer fee).
Let’s look at an example of how interest relates to and affects an overall credit card balance. In the graph below, we started with a $5,000 credit card balance and we are assuming an interest rate of 19 percent.
In order to pay off that $5,000 balance in six months, you’ll need to pay $880.12 monthly. With interest, in six months you will have paid $5,280.72, so $280.72 in interest. As you lengthen the time to pay off your balance, you can see in the graph that your monthly payment needed goes down, but your total interest paid keeps going up. If you take a full 21 months to pay off what was originally a $5,000 credit card balance, you will have paid $5,916.33 total or $916.33 in interest. Sure, your payments were just $281.73 monthly, but over the long term you’ll be paying about 18 percent more than your original credit card balance.
Keep in mind, too, that this example assumes you didn’t add any further purchases to your credit card during the time you were working to pay down that $5,000 balance. You can see how quickly interest adds up.
APPLYING 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.
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.
CREDIT CARD DEFINITIONS
- 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.
- 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.
Disclaimer: The information in this article is believed to be accurate as of the date it was written. Please keep in mind that credit card offers change frequently. Therefore, we cannot guarantee the accuracy of the information in this article. Reasonable efforts are made to maintain accurate information. See the online credit card application for full terms and conditions on offers and rewards. Please verify all terms and conditions of any credit card prior to applying.
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