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 if treated too casually.

 ➤  MORE: 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, read through this 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 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.

 ➤  RELATED: 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 DO REWARDS CREDIT CARDS WORK?

Rewards credit cards allow you to earn something in order to incentivize you to use the card. The following are the most popular type of rewards card:

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.

Travel Rewards 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.

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).

 ➤  MORE: 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%.

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% 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.

WHAT IS A CREDIT CARD AUTHORIZED USER?

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.

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.

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.

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.

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