How do credit cards work?

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 percent 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 (many credit cards have no annual fee). American Express dominates the charge card market.

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. 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.

>>> Confused about a particular credit card term? Check out our searchable glossary below.

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).

>>> Plug your own numbers into our revolving balance interest calculator.

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.

Authorized users

An authorized user is someone who has permission to use an account holder's credit card but is not responsible for the credit card bill. This person's credit history and income are not considered in reviewing a credit card application and setting a credit limit.

Becoming an authorized user on someone else's account has several advantages. It gives you access to the convenience of a credit card if you don't have the credit required to qualify on your own and also can help build your credit, though not all issuers report authorized users to the credit bureaus. It can be particularly handy for spending situations in which the primary account holder plans to pay for expenses, such as when a parent plans to pay for a child's college textbooks.

The biggest risk to being an authorized user is that, if the account holder gets into trouble with the credit card account, that could have a negative impact on your credit score, so don't take becoming an authorized user lightly. You also won't benefit from any credit card rewards, such as cash back, airline miles or travel vouchers.

You'll have to stop using the card if the account holder removes you as an authorized user, cancels the card or, though it should go without saying, dies. Continuing to use a card after the account holder dies can have dire ramifications, including putting you on the hook for any unpaid balances (not just what you spent) and potential legal prosecution.

On the flip side of this conversation is being the primary account holder who wants to add someone as an authorized user to your account. As noted above, it's handy for helping someone, like your child, build up credit or pay for expenses you plan to cover anyway. Keep in mind a couple of things:

1. You are responsible for all balances on the card, so the biggest risk is that the authorized user will run up big bills, with consequences for your bank account and, potentially, your credit score.

2. Most credit card issuers will allow you to set limits on what the authorized user can spend, either by dollar amount or even transaction type. That could be particularly useful if you're expecting the card to be used for specific purchases, such as buying books or groceries while your child is away at college. The specific rules surrounding an authorized user for a specific card are rarely provided in the credit card agreement. Instead, you'll want to call the company and speak with a representative to make sure you understand all the ins and outs.

3. Some credit card issuers will actually offer you welcome bonus rewards for adding an authorized user. Be sure to look into that possibility if collecting rewards is important to you. 

4. You should also note that some higher-end credit cards charge additional annual fees for each authorized user. For instance, the main annual fee might be $450, but each authorized user will cost an additional $150.

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; and

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.