Credit card basics
A credit card is a type of cashless payment method that uses borrowed money to pay for goods and services. A key factor of credit cards is that they pay for your purchases now and let you pay them off at a later date. When you use a credit card, a bank lends you the money and pays the store for you. Then, you are expected to pay the bank back for what you owe.
Credit cards have a limit to how much you can spend before you need to begin paying back what you owe. If you spend more than you are able to afford and don’t pay back what you spent by the end of the month, the bank will charge you more on top of what you already owe. This is known as interest.
Credit cards can be risky if you spend more than you can afford to pay back. Many people find themselves in credit card debt as the interest rates for credit cards are quite high. Therefore, the key to using a credit card is to not spend more than you can afford and to pay back what you owe on time and in full each month.
In a lot of ways, a credit card can serve as a flexible, short-term loan. Just keep in mind that, like personal loans, auto loans, and other types of debt, you’re responsible for repaying every cent you borrow plus transaction fees and interest charges.
How do credit cards work?
When you apply for a credit card, credit card companies consider your credit score, your credit history, your income, your debt-to-income ratio, and other factors before they approve you. If they deem you creditworthy, you’ll be issued a credit card with a set credit limit you can borrow against.
You can use a credit card to pay for purchases and bills in-person or online until you spend up to your credit limit. In some cases, credit cards can also be used to withdraw cash from an ATM, although cash advance fees will apply.
Your credit limit depends on factors like your current income and credit history and can range from $300 to $20,000 or more. This figure represents the limit you can spend on purchases and bills using your credit card. As you make purchases on your card, the amount of available credit you have will decrease until you pay it back.
Over time, your card issuer may offer you an increase to your credit limit if you remain in good standing.
How credit card transactions work
When you use a credit card to pay for a purchase, your credit card details are sent to the merchant’s bank for authorization. The bank seeks out authorization from the credit card network, which allows them to process the transaction and approve your card for the charges.
If the transaction is approved by all the interested parties, your credit card issuer will pay the merchant electronically on your behalf.
How credit card bills work
Your credit card also has billing cycles, which are usually around 30 days long. You’ll get a credit card bill at the end of each billing cycle that lists all the purchases you made. From there, you’ll have a period of time known as a grace period to make a payment on your credit card.
You can choose to make a minimum payment on your credit card, which is usually anywhere from 2% to 4% of your balance. If you choose to make the minimum payment or any payment that’s less than the full amount you owe, you’ll begin accruing interest charges based on your credit card’s APR and your revolving balance.
On the flip side, you can also pay your credit card balance in full by the due date. In this case, you won’t owe any interest charges since you’re not carrying a revolving balance from one month to the next.
How do credit card payments work?
If you use your credit card to make purchases, the bank will pay the merchant for you and send you the bill at the end of the month. Each month you will receive your credit card bill that includes an outstanding balance showing how much you owe, the minimum required payment amount and the payment due date.
Most companies offer the options to pay online, over the phone, or to set up automatic payments.
You aren’t required to pay the full outstanding balance each month. However, paying in full each month is the best practice to follow with a credit card to ensure you maintain a good credit score.
If you don’t pay off your balance each month, you will begin to rack up extra debt from interest charges on the outstanding balance which is how people get into trouble with credit cards.
If you can’t pay your balance in full, then you should aim to make at least the minimum payment required, as this will help reduce any negative impact on your credit score. It’s also important to make sure you pay by the due date to avoid any late fees.
Learning how to use a credit card can be difficult to master, but with good payment practices you’ll soon begin to see good fruit.
Here are three examples of how credit card payments work in different payment scenarios:
Credit cards vs. debit cards
Credit cards and debit cards can look very similar. However, these two financial products are very different.
The main differences between credit cards and debit cards come down to:
- Borrowing money vs. spending your own money
- Reporting spending & building credit history
- Fraud protection and liability
- Rewards for spending
When you make purchases with a credit card, you’re borrowing money with the promise to pay it back at a later date, including interest and fees. On the other hand, when you pay for something with a debit card, you’re paying for the purchase with cash savings directly from your bank account.
On another note, credit cards report your credit balances and payments to the credit bureaus — Experian, Equifax, and TransUnion. As a result, they help you build credit which means using a credit card can help you improve your credit score.
By contrast, debit cards don’t report your purchases to the credit bureaus since you’re spending your own money. This means purchases on a debit card won’t help you build credit.
It’s also worth noting how different credit cards and debit cards work in terms of liability.
If a fraudster gets their hands on your credit card or your card number, you can only be liable for up to $50 in financial losses per details in The Fair Credit Billing Act (FCBA). On top of that, most credit cards promise their customers 0% liability protection.
With a debit card, on the other hand, you won’t have similar protections. In fact, if you don’t report a fraudulent debit card charge within 60 days after receiving your credit card statement in the mail, the Federal Trade Commission (FTC) says you could lose “all the money taken from your ATM/debit card account, and possibly more; for example, money in accounts linked to your debit account.”
Finally, credit cards offer the potential to earn rewards in the form of cash back, statement credits, gift cards, or travel points. Co-branded credit cards from hotels and airlines also make it possible to earn airline miles or hotel loyalty points. Similarly, it’s possible to do things like rent a car with a debit card but debit cards don’t come with any car rental protection, whereas many credit cards do.
With a debit card, you’re unlikely to earn any type of reward at all.
Credit cards vs. debit cards at a glance
|
Credit Cards |
Debit Cards |
Where the money for purchases comes from |
A line of credit you borrow against |
Your own bank account |
Builds credit |
Yes |
No |
Ability to rack up credit card debt |
Yes |
No |
Potential to earn rewards on spending |
Yes |
Unlikely |
Common credit card fees explained
Credit card fees are different from interest. Interest happens when you don’t pay off your monthly balance, but credit card fees will be charged based on the type of transactions you make. In that sense, it’s possible to incur both fees and interest with a credit card.
Learning how to use a credit card without getting charged extra fees is key to helping save you money in the long run.
Here are some common credit card fees to watch out for:
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Annual Fee:
The annual fee is the yearly price you pay for having a credit card. The annual fees of the most popular credit cards can vary widely, and range from $0 to $695 per year. For this reason, many people opt for credit cards with no annual fee.
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Late Fees:
Credit card companies usually charge late fees any time you pay your credit card bill after its due date. You may also pay interest on your balance if you do not pay on time. To avoid this fee, simply make sure you pay by the due date listed in your monthly bill.
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Returned Payment Fees:
Returned payment fees happen if your payment bounces or is returned back to you (i.e. a bounced check). This can happen if you don’t have enough money in the bank, for example.
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Balance Transfer Fees:
Balance transfer fees are charged if you move debt from one credit card to another. These fees are typically 3% to 5% of the total balance that you transfer. However, these fees may be worth paying if you can move debt from a high-interest credit card to one with a lower interest rate.
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Cash Advance Fees:
A cash advance is when you take out cash from your credit card. Cash advance fees can apply when you use your card to get cash from an ATM or if you use your card to send a wire transfer. Typically you will pay fees based on the amount of cash you withdraw as well as interest until you repay the sum.
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Foreign Transaction Fees:
Foreign fees may come into play when you use credit card to make purchases abroad. However, many travel credit cards don’t charge foreign transaction fees.
Common types of credit cards
There are many types of credit cards on the market today, each of which comes with its own selection of pros and cons.
Common card types include the following:
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0% APR Credit Cards:
Credit cards in this niche offer 0% APR on purchases for a limited time, after which your interest rate reverts to the regular APR.
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Balance Transfer Credit Cards:
Balance transfer cards charge 0% APR on balance transfers for a limited period of time, usually up to 21 months. This means you can avoid paying interest on the debt you transfer. This can be a tactic to help you pay off your debt faster. Just keep in mind that a balance transfer fee will apply when you move the debt over.
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Low-Interest Credit Cards:
Low-interest credit cards charge a lower APR than the average credit card charges. You can find credit cards that offer promotional periods of 0% APR for up to 21 months. However, it’s important to look at the annual APR that will come into effect when the promotional period expires. Keep in mind that a good APR is 16% or less.
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Rewards Credit Cards:
A rewards credit card can come in many forms. For example, you’ll find flat-rate rewards cards, cash-back credit cards, and co-branded cards. Either way, these cards let you earn credit card rewards for each dollar you spend.
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Retail Credit Cards:
Retail cards are co-branded credit cards offered in conjunction with merchants and retail stores. These types of credit cards and not typically great cards to have as they offer few benefits. Some will not contribute to building credit as they may not report to the credit bureaus.
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Secured Credit Cards:
Secured credit cards require applicants to put down a cash deposit as collateral upfront. This will typically amount to your credit limit. These cards can be offered by any major issuer, and are great options for people with bad credit or no credit history.
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Travel Credit Cards:
Travel credit cards let users earn travel rewards points for each dollar they spend. Most card issuers offer popular cards in this niche including Chase, American Express, Citi, and Capital One.
Benefits of using a credit card
Using a credit card can be beneficial in more than one way, but it all depends on how you use credit on a daily basis.
Some of the main benefits of using a credit card include:
- Building credit history
- Earning rewards for spending
- Convenient cashless payments
- Increased buying power (borrowed funds)
- Fraud protection on purchases
- Emergency funds
The number one benefit of having a credit card is building a positive credit history which will allow you to get approved for loans and other important financial products in the future. By using your card for purchases and paying it off early or on time each month, you can prove your creditworthiness and boost your credit score over time.
Credit cards typically come with rewards such as points or cash back. If you use a credit card to earn rewards or take advantage of cardholder perks or consumer protections, keep in mind that the high interest rates credit cards charge can wipe out any benefits in a hurry. Therefore, we only suggest using credit cards for purchases you can afford to pay off and striving to only carry a balance if you have to.
Credit cards can also become valuable in an emergency. If you lose your job, face surprise car repairs, or run into any other financial emergency, having a line of credit in place can help you get back on your feet faster than you might be able to otherwise.
How to build credit with a credit card
If you decide you do want your own credit card, you should use it to build credit you’ll definitely need later in life.
Important steps you should take to build a good credit score include the following:
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Always pay your credit card bill by its due date.
Because your payment history is the most important factor that makes up your FICO score, you should make sure you never pay your bill after its due date. If you’re worried you’ll forget, set a reminder on your phone or set your credit card bill up for autopay.
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Keep your credit utilization below 30%.
Racking up a large balance can make you seem risky to lenders. It’s best to keep your credit utilization below 10% of your credit limit, or 30% at the absolute maximum. This means carrying a maximum balance of $1,500 if your credit limit is $5,000, or a balance of $500 or less for the best results.
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Keep an eye on your credit reports.
Also, keep a watchful eye on your credit reports to check for errors. Fortunately, you can look at each of your credit reports from Experian, Equifax, and TransUnion for free using the website AnnualCreditReport.com.
Credit card basic terms glossary
While we already explained how credit cards work in general terms, knowing all the basic credit-related terms can help you understand more about this financial product.
Below you can find an explanation of the most common credit card terms you should know about:
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Annual Percentage Rate (APR): A credit card’s APR represents how much interest you pay if you carry a revolving balance on your card.
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Annual Fee: This fee is a type of fee some cards charge on an annual basis. However, there are plenty of credit cards with no annual fee.
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Balance Transfer: A balance transfer takes place when someone transfers a balance from any credit card or loan (or multiple credit cards and loans) to a new credit card.
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Balance Transfer Fee: Most balance transfers require a balance transfer fee that usually equals 3% or 5% of the balance transferred.
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Cash Advance: A cash advance takes place when someone uses their credit card to get cash at an ATM. In some cases, cash advances take place when the credit card issuer sends the consumer cash advance checks in the mail.
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Credit Bureaus: The credit bureaus include Experian, Equifax, and TransUnion. These agencies collect credit reporting data and assign consumers with credit scores.
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Credit Card Statement: This document is mailed to you at the end of each billing cycle. Your credit card statement will include information like the purchases you made, your minimum payment, your due date, and any interest and fees being charged.
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Credit History: Your credit history is a summary of all your credit movements made in the past.
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Credit Limit: Your credit limit is the maximum amount of spending power you have on your credit card at any given time.
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Credit Reports: Your credit report is a listing of information kept regarding your credit history. Information on your credit reports can include the balances you owe, your payment history, and more.
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Credit Score: A credit score is a three-digit representation of your credit health.
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Credit Utilization: Credit utilization is the amount of credit you’re using in relation to your credit limits. If you owe $3,000 in balances on available credit of $10,000, for example, your credit utilization would be 30%.
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FICO Score: FICO scores are the most popular type of credit score that is used by 90% of top lenders.
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Foreign Transaction Fees: Foreign transaction fees are added fees some cards charge when you use a credit card for purchases outside the United States.
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Interest Rate: Your credit card’s interest rate is the amount of interest you’ll be charged on a monthly basis if you carry a balance.
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Late Fees: Most credit cards charge late fees when you pay your credit card bill after its due date.
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Grace Period: Your grace period is the time between the day your billing cycle closes and your credit card bill becomes due. Most grace periods last for 21 days.
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Secured Credit Card: Where traditional credit cards offer a line of credit you can borrow against with no collateral required, secured credit cards require you to put down a cash deposit as collateral.
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VantageScore: VantageScore is another type of credit score that works similarly to the FICO score.