How do credit cards work?

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Credit cards offer a convenient way to pay for purchases, whether it be bills, groceries, gas, online shopping, and more.

A credit card account is essentially a permanent loan issued by a bank. You have a credit limit that you can use before the card has to be redeemed. If you carry over a balance from one month to another, you must pay interest on that amount. Once you pay off your balance, you can spend again with your credit card up to this limit (although it’s best to stay well below your maximum).

How credit cards can help or hurt you financially depends on how you use them, which requires understanding how they work.

How do credit cards work?

Unlike debit cards, which are drawn from money you’ve already deposited in the bank, or charge cards that you must repay in full each month, credit cards work by giving you a revolving line of credit. This means that your available credit is replenished as you pay off your debt.

For example, if you have a credit card with a $1,000 limit and spend $500, only $500 will be available on your card. If you pay off the $500 balance, your available credit will go back to $1,000 again. If you choose to repay only $300 of this balance, you will only revert to the $800 available credit until you repay the remaining amount.

In each billing cycle, your credit card issuer sends you a report of all transactions made on your credit card and the minimum payment amount that must be paid to keep your account in good standing. If you do not pay the minimum credit card payment by the due date, you may be subject to fines and fees.

In addition, each month that you carry over your account balance from the previous month, the credit card issuer charges interest. Issuers charge a percentage of the balance that is carried over and apply it to your account. Expressed as a percentage, the credit card interest rate is also known as the APR or APR and represents the cost of maintaining a balance from month to month.

Credit card interest is not applied immediately after the transaction is made – there is a grace period between the date of the transaction and the end of the billing cycle when no interest is charged.

How APR credit card works

A credit card APR is the cost of using a credit card and the balance between billing cycles. Most credit cards are variable rate cards, meaning their APRs are pegged to a benchmark interest rate, called the base rate, set by the Federal Reserve. However, some cards are fixed rate credit cards, so their APR is independent of the base rate.

If you rely too much on credit cards, interest will accumulate on your balance and will accumulate every month if you don’t pay off the card in full. In addition, you will also earn interest on interest added to the account.

It is critical to pay as much of your credit card bill as possible to avoid a cycle of debt in the form of interest payments.

Here are the four main types of annual credit cards:

  1. Standard pa: Your APR determines the amount of interest you will pay if you roll over a balance from one month to another.
  2. Balance transfer per annum: If you are transferring an old balance to a new credit card, the balance transfer APR will determine how much interest you will pay on the transferred balance.
  3. Cash advance per year: If you take cash from your credit card—for example, by writing a check on a credit card or withdrawing cash from an ATM—you will be charged a special APR for cash advances, which is often higher than your regular APR and has no grace period.
  4. Annual penalty: Your credit card issuer may also charge you a higher interest rate, called a penalty annual interest rate, if you are in arrears.

General Credit Card Fees

Most credit cards charge various fees. However, fees are usually associated with additional services such as balance transfers, cash advances and revolving balances. As a result, you may not have to pay any fees at all if you use a credit card with no annual fees, pay your purchases in full every month, and only use your card to make new purchases.

Here are some common charges you may encounter when paying with a credit card:

  • Annual fee: Some credit cards charge a fee just for holding the card. For example, if you open a bonus card with premium benefits or get a secure card for consumers with bad credit, you may be charged an annual fee.
  • Balance Transfer Fee: If you are transferring debt to a new credit card, your card issuer may charge you a percentage of the total transfer amount. The balance transfer fee is typically $5 to $10 or 3 to 5 percent of the balance transferred (whichever is greater).
  • Cash withdrawal fee: Your card issuer may also charge you a percentage of the amount you borrow if you take a cash advance.
  • International transaction fee: Some credit card issuers also charge a percentage of any transaction you make abroad or in a foreign currency. Foreign transaction fees are typically 3 percent of the purchase amount. If you are going to travel abroad, a card with no foreign transaction fees can help you save money.
  • The late payment fee: Your credit card issuer may also charge you a fee every time you pay a bill after the due date. Under federal law, late fees cannot exceed $40.

Pros and cons of credit cards

While credit cards are convenient and can even be rewarding, there are pros and cons to how credit cards work that you need to know before using them:

Credit Cards vs. Debit Cards

The way credit cards work is slightly different from debit cards. While both look the same and you can swipe, insert, or tap both a credit card and a debit card in the register, the accounts are managed differently:

How Credit Cards Work How debit cards work
  • Account activity is reported to credit bureaus
  • Purchases are credited to the account and paid later
  • No checking deposit option
  • Interest may be charged
  • The purchase amount is immediately deducted from the account
  • Account activity not reported to credit bureaus
  • Possibility to receive checks / direct deposits
  • Linked to current account
  • No interest

Various types of credit cards

There are many different types of credit cards. Some of them are for beginners. Some allow you to return a percentage of the purchase in cash, while others help business owners charge commission costs. Categories of credit cards include:

Each category has its own advantages, disadvantages, and requirements, so it’s important to shop around to find the best credit card for you. You can use a tool like CardMatch to find out which credit cards you can qualify for.

bottom line

The way credit cards work is not as complicated as it seems at first glance. As long as you stick to responsible credit card habits, maximize your rewards, or use the card to build your credit score, they can be invaluable financial tools to keep in your wallet. Understanding how they work is the first step to better credit card management and avoiding credit card debt.

Editorial disclaimer

The editorial content on this page is based solely on the objective judgment of our contributors and is not based on advertising. It was not provided or ordered by credit card issuers. However, we may receive compensation when you click on links to our partners’ products.

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