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Account management

How do credit cards work?

A credit card offers you a more secure shopping experience than a debit card. Here's how they work.

Summary

When used responsibly, a credit card can help you finance new purchases, shop securely or earn rewards in exchange for spending. Here’s a closer look at modern credit cards and what you need to know about them.

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Credit is a loan you take out from a bank or other financial institution, such as a credit union. Some loans – such as purchases you make on a charge card – are expected to be repaid quickly. For example, a charge card requires you to pay off your purchases in full when you receive your monthly bill.

Other loans, such as credit cards, give you more time to pay off your purchases and only require you to pay a minimum amount each month. In exchange for allowing you to carry over your debt from month-to-month, your credit card will charge you interest.

Unlike charge cards and installment loans, credit cards give you a revolving line of credit, which means that your available credit replenishes as you pay your debt. For example, if you applied for a traditional loan of $1,000, you would get that money to use once and pay it off over a set period of time. On the other hand, if you had a credit card with a $1,000 limit, you could spend all $1,000, pay it off, and then have $1,000 in available credit once again. You could also choose to only pay off $300 of that balance, which would give you $300 in available credit once again.

The amount of interest you’re charged will depend on the card you choose and your credit history. For example, travel cards tend to charge higher amounts of interest. So do cards that are designed for consumers with low credit scores. Picking the right card can help you avoid interest charges, a must for building your credit score.

See related: What is a credit card? video

Common credit card charges

Most credit cards charge a wide range of fees. However, the fees are typically tied to optional 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 no annual fee credit card, pay off your purchases in full each month and only use your card to make new purchases.

Here are some common charges you might encounter on your credit card:

  • Standard APR: Your annual percentage rate (APR) determines the amount of interest you’ll be expected to pay if you carry a balance from one month to the next. Most credit cards are variable-rate credit cards, meaning their APRs are tied to a benchmark interest rate called the prime rate. However, some cards are fixed-rate credit cards and so their APRs are unaffected by the prime rate.
  • Balance transfer APR: If you transfer an old balance to your new credit card, your balance transfer APR will determine how much interest you’re charged on your transferred balance.
  • Cash advance APR: If you borrow cash from your credit card – for example, by writing a credit card check or taking out cash from an ATM – you’ll be charged a special cash advance APR that’s often significantly higher than your regular APR.
  • Penalty APR: Your credit card issuer may also charge a higher APR, called a penalty APR, if you fall behind on payments.  
  • Annual fee: Some credit cards charge a fee just for owning the card. For example, if you open a rewards card with extra generous benefits or get a secured card for consumers with bad credit, you may be charged an annual fee.
  • Balance transfer fee: If you transfer debt onto your new credit card, your card issuer may charge you a percentage of the total amount you transferred. Balance transfer cards usually charge a fee of $5-10 or 3-5% of the transferred balance.
  • Cash advance fee: Your card issuer will also charge you a percentage of the amount you borrowed if you take out a cash advance.
  • Foreign transaction fee: Some credit card issuers also charge a percentage of any transaction that you make abroad or in a foreign currency. Foreign transaction fees tend to be 3% of the purchase. If you’re going to be traveling overseas, a card with no foreign transaction fees can help you save.
  • Late payment fee: Your credit card issuer may also charge you a fee each time you pay your bill after your payment due date. Under federal law, a late payment fee can’t exceed $40. 

Credit card terms to know

Here are a few terms to help you understand the basics of how a credit card works:

Balance

Also referred to as credit card debt, this represents the amount of money you’ve spent on your card that hasn’t yet been paid back. As you pay for things with your card, you accumulate a balance. So if you make $1000 in purchases and pay $400 off, you’ll have a $600 credit card balance.

Credit limit

Determined by your card issuer, this is the maximum balance you can have on your credit card. Overspending beyond the threshold can lead to fees and penalties, so it’s important to be conscious of the set amount. Your credit limit serves as a spending limit for your card and can be adjusted based on your financial situation and credit card use. Increasing your credit limit is a good goal for early cardholders.

Available credit

The amount you have available to spend before hitting your credit limit. In math terms, it’s your credit limit minus your balance. Making regular payments down on your balance will free up more available credit, and it’s a good habit to get into to boost your credit score by improving your credit utilization ratio.

Billing cycle

Used to organize payments and purchase history, this is the set window of time between billing statements. Typically they’re about a month in length, and you’ll receive a bill for payment after the period is over. The length of each billing cycle will be in your card agreement with your provider.

Minimum payment

The least amount of money you must pay your credit card provider each billing cycle. Oftentimes, this is a particular percentage of your total balance. We recommend paying off your balance in full, but making the minimum payment amount is essential. If the payment isn’t sent to your provider on time, you could be subject to a late fee. Even worse, if it’s late enough, it could linger on your credit report for seven years.

Statement due date

Specified on your credit card bill, this is the date for when your minimum payment is due to keep your account in good standing.

APR

The annual percentage rate is the interest rate you’ll pay on any leftover balance that remains after the due date if you don’t pay in full.

Types of credit cards

Rewards credit cards

Fitting their name, these cards reward cardholders for their purchases. These typically require good credit and are best suited for those who are used to a routine of paying off their balance in full. There are a few types:

  • Travel credit cards: These options will reward your spending with points or miles that can be redeemed for travel expenses, like flights, hotels or a night out. They give travelers some flexibility, rewarding their regular purchases and giving multiple redemption options.
  • Cash back credit cards: With a cash back card, you earn money back on your eligible buys. Rather than accumulating and exchanging points, you literally earn cash back on purchases. Some cards offer higher percentages in certain categories, so pay attention to how each option earns rewards. Your money can come as a check or be deposited to a bank account or paid down on your balance.
  • Airline credit cards and hotel credit cards: Some more niche options for travelers, these cards give points or miles that can be exchanged for plane tickets or nights at a hotel. Oftentimes, these cards come with extra restrictions when it comes to redeeming, such as blackout dates and limiting to select partners.

See related: Credit card special offers, limited-time promotions

Low and no interest credit cards

These cards won’t always reward you, but they will provide you with a low interest rate to make carrying a balance more manageable. These cards often require good credit. Here are the types:

  • Low interest credit cards: They may not come with too many add-ons, but these cards give you a continuously low interest rate. An ongoing low interest rate can be a savior in a situation where you unexpectedly have to carry a balance.
  • Zero interest credit cards: Some cards offer 0% introductory APR periods, which allow you time to make purchases without interest. These 0% interest windows are often over a year long, and can be best utilized by making a large purchase and paying it off over time, interest-free.
  • Balance transfer credit cards: One of the best ways to consolidate and manage debt, these cards let you transfer a balance from another card to carry at a 0% interest rate over a specific period of time. By moving your unpaid debts to an interest-free account, your repayment schedule can rapidly improve. Just remember that the 0% interest intro period will end, after which you will pay the ongoing interest rate on any remaining balance.

Credit builder cards

There are plenty of credit cards designed for beginners, too. With the options below, nearly anyone can get started with a credit card to build their credit score. Here are the types:

  • Secured credit cards: As insurance for the card provider, opening up a secured card account requires you to submit a security deposit, which is often refundable. The amount you deposit usually matches your credit limit. These options often accept all levels of credit scores because of the initial requirement to put some of your own money down.
  • Student credit cards: To help those new to the credit card world, these cards often come with features that make getting into a routine of regular payments easy, like payment reminders and auto-pay. These credit cards are a great way for college students to learn good spending habits and build their credit scores. Plus, some even reward cardholders for good grades.
  • Credit cards for bad credit: These cards are made with any and all cardholders in mind. Often lacking in the “extras” department, these options have very little barriers to be approved and often will allow for prior bankruptcy in new cardholders. Just watch out for sky-high interest rates.

Business credit cards

These cards mostly work the same as a traditional credit card, but are tied to a business account rather than a particular person. These credit cards often provide rewards on common business expenses, such as travel, office supplies, internet and phone services. In many cases, you’ll be rewarded for all purchases. Some even allow you to select your business’ bonus categories.

What to consider before getting a credit card

Opening up a credit card account can lead to several changes in your routine, so it’s best to know what may come along with it:

Pros:

  • Opportunity to build credit. When you open a credit card account, your payment habits will be tracked and contribute to your credit score. A routine of good habits will boost your score and help you in the long run financially.
  • Get rewarded for your spending. Although they may not be immediate, credit cards provide an opportunity for cardholders to regularly spend at a discount. Over time, proper credit card use can help make special occasions, vacations and everyday purchases a little easier on the wallet.
  • Convenience. The ease of swiping your card, inserting a chip or using a mobile wallet is one of the most attractive qualities of carrying a credit card. There may not be a simpler, more organized way to make everyday payments.
  • Additional perks. Credit cards give cardholder benefits when it comes to insurance, travel perks, fraud protection and more.

Cons

  • Expensive pitfalls. A credit card can be a dangerous tool if the minimum payments, fees, interest or anything else seems overly daunting. Considering your debt situation and checking your budget before applying for a credit card is a must. Any situation where you end up falling behind on payments or getting stuck in an uphill climb should be avoided.
  • Additional responsibility. Coming along with a credit card can be a whole new list of responsibilities. While none are overly difficult to manage, you want to be sure that you can handle the tasks of remembering due dates, budgeting out payments and using your card appropriately.

Federal protections

Credit cards are also subject to a number of consumer protection laws, including:

  • The Credit CARD Act of 2009: This law offers a number of protections for consumers, including protection from sudden rate increases and excessive fees.
  • The Fair Credit Billing Act: Among other protections, this law gives consumers the right to dispute fraudulent or inaccurate charges.
  • The Fair Credit Reporting Act: This law gives consumers the right to access their credit reports once per year from each of the three credit bureaus – Equifax, Experian and TransUnion – for free through AnnualCreditReport.com and dispute errors on their reports.

See related: 8 things you must know about credit card debt



How to get a credit card

You’ll need an established credit history with a track record of on-time payments in order to qualify for most credit cards. However, some credit cards are easier to get – even if you’ve never used credit before.

Secured cards and cards for bad credit are designed to help cardholders build a positive credit history. If these are the only options available to you, a routine of proper payment habits will be the savior in the long run.

Once you’ve built up a track record of using credit responsibly, you’ll eventually be able to qualify for other cards – including cards that offer rewards and other benefits. For more, read our step-by-step guide to choosing the best credit card for you.

Editorial Disclaimer

The editorial content on this page is based solely on the objective assessment of our writers and is not driven by advertising dollars. It has not been provided or commissioned by the credit card issuers. However, we may receive compensation when you click on links to products from our partners.

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Credit Card Rate Report
Business
14.22%
Airline
15.53%
Cash Back
16.03%
Reward
15.84%
Student
15.98%

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