How Do Credit Cards Work?

How Do Credit Cards Work

You get credit card offers through the mail, at your local big box retailer, online, seated in an airplane – they are everywhere. Whipping out that piece of plastic to make purchases seems really terrific. But then you remember that the average American has about $5,700 in credit card debt and credit card debt has bankrupted many people. And if you’ve attempted to read the fine print, it’s a morass of legalese and alphabet soup.

We’ll look at how credit cards work, terminology, and types of cards in this blog.

What is a Credit Card?

When you get a credit card, the company sets up a “loan.” When you use the card, they lend you the money. You then get charged interest for using their money. There are benefits to using credit cards and we’ll go over that later. First, let’s work through credit card terminology.

Credit Card Terminology

  • Account – Your credit card will be tied to an account. This is a revolving loan.
  • Revolving loan – A revolving loan is one that doesn’t have a set time period in which to pay off the loan.
  • Balance – A balance is the money that you have charged to your card but haven’t paid off. You can also have a revolving balance or balance that is not paid off monthly (hint: bad idea).  
  • Limit: This is the amount of money you can charge to your credit card. Your credit limit is based on your credit history. Some cards will let you charge over limit but will have a high penalty for doing so.
  • Available credit: Your limit minus your balance is your available credit.
  • Minimum payment – If you have a balance, the minimum payment is the amount you have to pay to keep your account current. We’ll discuss minimum payments in the Credit Card Don’ts section.
  • Interest – The credit card company charges you interest to use their money. This is also called a credit card finance charge. Your interest rate is based on an APR.
  • APR – Annual Percentage Rate is how much interest charged in a year. APR is variable. If you miss a payment, your APR may skyrocket.
  • Grace Period – You generally have a 25-day grace period to repay the balance without being charged interest.
  • Billing cycle: Your billing cycle is usually a month. You will receive a bill for all purchases made within the month. You will have roughly a month to pay the bill.
  • Statement due date: The date you must pay your bill by to avoid a late fee.
  • Preapproval – A preapproved card means that the card company feels you are a good risk. They may later turn you down if there is an issue with your credit report.
  • Fees – Charges placed on your account by the card company. We’ll discuss these in a separate section. Between interest rates and fees, you have your answer to “How do credit card companies make money?”

Credit Card Fees

  • Annual credit card fee – You may be charged an annual fee for the privilege of having the credit card. Not all credit cards have annual fees, and some have variable fees. Some cards charge as high as $500 per year.
  • Balance transfer fees – If you have a balance on one card and want to transfer this to a card with a lower APR, you may be charged a balance transfer fee to do so. The 0% on balance transfer card offer you got may not be a great deal after you factor in the transfer fees.
  • Cash advance fee – If you use you card to get cash, you will be charged an advance fee. They may charge a higher APR on cash advances
  • Foreign transaction fees – If you use your card outside the US, you may be charged a foreign transaction fee.  
  • Late payment fees – If you are late paying your credit card, you will be charged a late fee. Your APR may increase after making a late payment.

Credit Card Benefits

There are very good reasons to have a credit card. Responsible use is one of the easiest ways to build credit history or repair damaged credit.

Credit cards may come with excellent rewards.

Credit card companies actively look for fraud, both from stolen credit card numbers or issues with merchants (double charges, failure to provide services, etc).

Airlines, rental cars companies, and hotels often require credit cards to make purchases or rent a room or car.

Credit Card Drawbacks

The biggest single drawback is that you can spend more than you can pay off. You can end up in financial difficulties thanks to your credit card.

The number one rule is do NOT charge more than you can afford to pay off IN FULL each month.

Minimum payments are not going to pay off your card in any reasonable time frame.

Types of Credit Cards

Every credit card company, big box store, and financial institution offers credit cards by the dozens. It can be hard to understand what you are getting, what benefits you are getting, and how much you will be charged. Here’s a quick look at the overall types of cards.

  • Charge card – A credit card that must be paid IN FULL each month
  • Rewards credit cards – These let you earn travel miles, cash back, or points based on your purchases. Generally, the better the rewards the higher the annual fees
  • Retail cards – You are offered these at stores like Target or Penneys. Often the cards are only good at that specific chain and have higher interest rates
  • Secured credit cards – These are great for credit builders or those with damaged credit. You put an amount in escrow and that amount is your limit. You can’t overspend and you will build good habits and credits by paying your bill on time

Getting a Credit Card

The credit card application is fairly simple. Fill out an application on paper or online. You’ll need your Social Security number, income, address, etc. The company will then do a “hard pull” on your credit report. They will then approve or deny your application.

Before you apply, look over the card requirements carefully. Some take excellent credit rating and if you don’t have that, you will be denied. Since the credit card company is doing a “hard pull” your credit report takes a short-term hit.

Take a look at prequalified card offers. You may be able to get a card more easily through this venue.

Do not apply for every credit card that comes your way. First, your credit report takes a hit by having so many hard pulls. Some credit card companies won’t issue cards to people with more than a certain number for credit card application made within a certain time period. Second, the temptation to use them is great.

If you are ready to look for real working credit cards, check out our Best Credit Card for Travel, Best Credit Cards to Build Credit, and Credit Cards for Fair Credit.