How Do Credit Cards Work?

How Do Credit Cards Work
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You walk into the grocery store, fill your basket with everything on your shopping list, head to the checkout lane, and then proceed to swipe your plastic.

It seems like such a simple process — swipe the card a bunch of times, get your credit card bill, and then pay it off each month. But you might be wondering what exactly is going on behind the scenes and how credit cards work. Take a look at our simple guide to how credit cards work and understand that there might be a bit more to it than you thought.

Credit Card Basics

Let’s cover some of the fundamental terminology used for credit cards.

Credit Limit: The amount of money that the credit card issuer allows you to spend on the card at one time or on an ongoing basis. If you have a higher credit score, you will be given a higher credit limit.

Balance: This is the amount of money you have spent on your card in the past, minus any credits or payments you have made.

Available Balance: The amount you can still spend on the credit card until you hit your credit limit (i.e credit limit minus balance).

Billing Cycle: The period in which you make purchases — usually set to end on a specific day of the month. At the end of the billing cycle, you are given a bill for the balance on the card and you usually have a little less than a month to pay it.

Minimum Payment: The minimum amount you need to pay toward your bill each month. This is usually a small percentage of your total balance. Any amount left on your balance after making your payment will accrue interest.

Statement Due Date: The day in which your payment is due. The minimum payment needs to be paid by the end of this day to avoid any late fees or penalties.

Annual Percentage Rate (APR): The interest rate you will pay on your balance expressed as a percentage. This is the total percentage paid over the course of an entire year.

How are Credit Cards and Debit Cards Different?

Credit cards and debit cards look the same, swipe the same, and seem very similar. But the way they work is quite different.

Debit cards pay merchants and businesses with money directly from your bank account. There is no credit involved and you don’t rack up a balance. Anybody with a checking account can get a debit card for the account. But because debit cards are using your own money initially, you don’t get the same protection as you would with credit cards. If your card information is stolen, it is much harder to get your money back.

Credit cards involve a line of credit from a bank so you aren’t using your money when you initially buy something. They allow you to use their money up front with the promise that you pay them back. To protect themselves, they charge interest on the money and have fees if you miss payments. You will also need to have them check your credit history to be approved for a credit card so they know they can trust you.

But because the money is not directly yours, you have a lot more protections in the event your card information is stolen. You can report fraudulent charges and not have to pay them. You minimize the risk when you use a credit card instead of a debit card. You just have to be extra careful with credit cards as they can hurt your credit and rack up high interest credit card debt.

How Credit Card Interest Works

When talking about the interest rates on credit cards, it is good to take note of the different APRs associated with each card. There are multiple different APRs and you don’t want to get them mixed up.

Balance Transfer APR: A balance transfer is when you transfer a credit card balance from one credit card to another. It can be beneficial to transfer to a credit card that is offering a 0% introductory APR offer for balance transfers to keep interest charges from accruing (this usually requires a good credit score). This APR will only apply to the amount transferred.

Purchase APR: This is the APR that applies to purchases you make on the card. These APRs can range anywhere from about 15% up to 30%.

Cash Advance APR: A cash advance is when you are given a short term loan using the available balance on your credit card. Cash advance interest usually starts accruing as soon as you get cash and doesn’t have the grace period like purchases. These APRs are usually higher than purchase APRs as well.

Introductory APR: These are usually low or 0% APRs offered for a set period of time when you open a credit card. They can be for purchases, balance transfers, or both.

Penalty APR: Penalty APRs are higher APRs that come into effect when you miss payments or make late payments on your card. You will want to avoid missing payments as it will hurt your credit score as well as increase the interest you will owe.

Credit cards are known for having high interest rates — much higher than most other types of loans. That means that carrying a balance from month to month on a credit card should be avoided as much as possible.

Luckily, credit card issuers and banks won’t start charging interest on purchases until after your monthly payment is due. During the statement period, purchases will add up every time you use your credit card. At the end of the statement cycle, you will be given a bill with the total balance on the card, a minimum payment required, and a payment due date.

There is usually a grace period of about 25-30 days between the statement close date and the payment due date in which interest won’t accrue. If you pay off the total balance by the due date, you will not be charged any interest. However, if you only pay the minimum payment (or anything less than the full balance) you will start to accrue interest on the remaining balance.

Interest accrues on a daily basis. The interest you accrue on one day becomes part of the balance the next day. Interest is charged the next day on the original balance plus the interest accrued the day prior. As this continues each day, you are effectively accruing compounding interest that you need to pay back. Compounding interest is a great thing when you are investing but it can cause a pile up of debt when it is on a credit card.

The best thing you can do is to pay off your balance in full — and on time — every single month. This way you will never have to pay any interest.

Credit Card Fees

There are a handful of different fees that come with owning a credit card. They are all avoidable in one way or another, but you should be aware of when they might be charged to your account and how to avoid them.

Annual Fee: A fee that is charged to the account as a cost for having the credit card. Annual fees are not charged for every credit card, but usually only those that offer higher rewards earning or benefits.

Balance Transfer Fee: A fee for transferring a balance from one credit card to another that is present on almost all credit cards. The fee is generally about 3-5% of the total balance transferred.

Foreign Transaction Fee: This is a fee charged whenever you use your card internationally. The fee is usually about 3% on average. Many credit cards, especially travel credit cards, will have no foreign transaction fees to incentivize using their card when traveling.

Late Payment Fee: If you are late making one of your monthly payments, this fee will be charged to your account. The first time a late payment is made, the maximum it can be is $29. However, it can be higher on subsequent late payments (up to a maximum of $40). Avoid this fee by being diligent about paying your bill on time.

Cash Advance Fee: If you choose to use a cash advance, you will likely be charged about 3-5% of the amount withdrawn. On top of the fee, cash advances start charging interest immediately without a grace period.

Nobody likes fees, especially ones that you weren’t made aware of beforehand. All of the fees on a credit card can be avoided if you are responsible with your spending and stay on top of making your payments on time.

Types of Credit Cards

Not all credit cards are created equal and many can serve different purposes. If you decide to open a credit card, you will want to know which one best suits your needs.

Rewards Credit Cards: These cards will give you various types of rewards for all of the purchases you make. The two most common types of rewards cards are cash back credit cards and travel cards. As the name suggests, cash back cards will usually give you a percentage back for each purchase you make. Each card rewards some categories more than others. Travel credit cards reward you for all of your purchases as well, but will give you points or miles for hotel or airline loyalty programs; they often include travel perks as well.

Secured Credit Cards: Secured credit cards are backed by a security deposit that the cardholder puts down. The line of credit is usually set to the amount of the security deposit — the best secured cards will sometimes give you a higher credit limit. The purpose of secured cards is to help build credit or rebuild cardholders’ bad credit.

Charge Cards: Charge cards are almost identical to regular credit cards except they require that the balance is paid in full at the end of every month. If you don’t pay the bill in full every month, the fees and charges can be steeper than the interest charged on regular credit cards. Charge cards are not very common but American Express is still known to have a few of them.

Retail Credit Cards: These are credit cards that are issued by a particular store — retail, home improvement, etc. They will usually offer rewards or discounts when you use the card at the store. A closed loop retail card only allows you to use the card at their store while an open loop retail card allows you to use the card at other businesses.

How to Get Approved for a Credit Card

The first step in getting a credit card is the application. You will need to provide your name, social security number, as well as other personal details for your credit report to be pulled from one or more of the credit bureaus. You will also need to state your annual income. The reason they want all of this information is to build confidence that you will pay your credit card payments on time.

The credit card company or bank will then decide if they want to give you a credit card and how much the credit line will be. Your credit line will be determined by both your income and your credit profile.