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What is a credit card?

Credit cards have some significant advantages over debit cards, but if you don't use them properly, your wallet – and your credit – could take a hit

Summary

A credit card lets you use borrowed money to make purchases. As long as you pay your balance on time each month, you can boost your credit score and earn rewards just by using your card.

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With a credit card, you can borrow money from a bank to buy whatever you’d like, from a fast-food lunch to a night in a hotel to the latest flat-screen TV.

But while a credit card is a convenient way to make purchases and can help build your credit score, there are some potential pitfalls with using them that you’ll want to avoid.

Here’s an in-depth look at how credit cards work, the benefits they bring and the common missteps consumers make when using them.

See related: How do credit cards work?

How credit card interest works

If you don’t pay your credit card balance in full each month, your issuer will charge you interest. And paying interest can make owning a credit card expensive.

“A credit card can be a great way to build your credit score, but you have to be careful,” said Rebecca Hunter, the Coconut Creek, Florida-based writer of the Loaded Pig personal finance blog. “You definitely have to make your payments on time. And you shouldn’t carry a balance. Carrying a balance means you’ll pay too much in interest.”

Each of your credit cards will come with its own annual percentage rate, better known as its APR. This is the interest you’ll face when you don’t pay off your full credit card balance by its due date. The APR attached to your card depends on several factors, but the most important one is your credit. If you have a low FICO credit score, your APR will generally be lower.

At the end of each day, your credit card issuer will multiply your balance by your daily percentage rate to figure your daily interest charge (your APR divided by 365). The provider then adds that amount to your card’s balance the following day. This is known as compounding, and it’s why interest adds up so quickly on your unpaid card balances.

As long as you pay off your balance in full before it’s due, your provider won’t add interest to your balance, which can save you a significant amount of money.

See related: How do credit card APRs work?

Credit card fees: What they are and how they work 

Credit card issuers make money by charging interest on your unpaid balance. But that’s just one way these companies earn their income. They also charge a variety of fees.

  • Annual fee: Some cards – but not all – come with a fee that you pay each year to keep your account active. These fees can vary based on issuer and reward potential. Some high-end travel cards come with an annual fee of $500 or more, while other cards have fees below $100.
  • Late payment fee: This is a fee you’ll receive if you don’t make at least your minimum required payment by your due date. This fee will vary, but it won’t be more than $40.
  • Balance transfer fee: Many credit cards allow you to transfer an existing credit card balance onto your new cards at 0% interest for a limited time. This can help you save money and pay off your balance sooner. But some balance transfer cards charge a fee to do this: usually around 3% or $5 – whichever is higher.
  • Foreign transaction fee: If you use your credit card in a different country, you might face an additional charge – usually up to 3%. Certain cards – especially travel cards – don’t charge this fee.
  • Returned payment fee: If you make a payment to your credit card provider but you don’t have enough funds in your checking account to cover it, your issuer might charge you this fee.
  • Cash advance fee: You can withdraw cash from an ATM with your credit card, but it’s expensive. According to a 2019 CreditCards.com survey, issuers charged an average of 5% of the amount you withdraw.

See related: 6 common credit card fees and how to avoid them

How to get a credit card

To get a credit card, you’ll first have to apply with a credit card issuer. You can do this at any issuer’s website. Credit card providers look at several factors before approving your application. One important factor is your credit score, which gives issuers a summary of how well you’ve managed your credit or paid your bills.

Card issuers will often look at your debt-to-income ratio as well. This looks at how much of your gross monthly income is consumed by your total monthly debts. The lower this ratio is, the higher your chances of qualifying for a credit card.

The pros of using credit cards

Credit cards have some significant advantages over debit cards, like helping you build your credit score and make more secure purchases.

Building your credit score

Each time you make an on-time card payment, your provider will report it to the national credit bureaus: Experian, Equifax and TransUnion. Building a record of on-time payments will steadily boost your score. If you use your credit card every month and pay the full balance each billing cycle, you’ll avoid paying interest and build your credit score.

“If you are opening a card, it should be with the goal of improving your credit,” said Hunter. “Some want to open credit cards for cash back and rewards. But the main goal should be to start building your credit. Pay on time, pay your balance in full and your score will improve.”

Andrina Valdes, executive sales leader and chief operating office of Cornerstone Home Lending in San Antonio, Texas, notes that a stronger credit score can save you significant money on long-term investments.

“Potential homebuyers can use their healthy credit score to qualify for a lower mortgage interest rate,” Valdes said. “Add to that the fact that mortgage rates are sitting close to a 50-year low, and a monthly mortgage payment is probably going to be a lot cheaper.”

Rewards points and cash-back bonuses

Many cards offer you points with each purchase you make. You can then use those points to earn cash back – usually awarded in the form of a statement credit – or for free airline miles, hotel stays or other perks.

John Cabell, director of wealth and lending intelligence at the Troy, Michigan, office of J.D. Power, said rewards are key features for many credit card users.

“When they are accumulating rewards for each purchase, customers feel like they are ‘getting something’ for spending their money,” Cabell said.

Budgeting help

You can examine your card statement to determine where you’ve been spending most of your money. You can then make adjustments to your household budget or change your spending habits.

“With such neat compartmentalization of purchases, consumers can more easily track how much they are spending within a given month and where they are spending funds,” Cabell said.

Some card issuers let consumers organize their purchases by type, which Cabell says gives consumers more control over their spending.

Making safer purchases

Making purchases with a credit card gives you an additional level of security over your money. Since you put purchases on credit instead of handing over money in your account, a thief won’t be able to access money in your bank account just by stealing your card information.

If there’s an unauthorized charge on your credit card, you can contact your issuer and cancel that card as soon as you realize it’s missing. You can also dispute any fraudulent purchases. If you dispute this within the required timeline, the odds are high that your issuer will wipe out these charges. You have 60 days to dispute fraudulent purchases. Your card issuer has 30 days to acknowledge your dispute and 90 days to resolve it.

The potential cons of using a credit card

If you’re not careful, a credit card can severely damage your credit and leave you with piles of high-interest-rate debt. Here’s how:

Credit damage

Every time you make a credit card payment 30 days past its due date, your card issuer reports it to the national credit bureaus. So if you are only two weeks late with your payment, it won’t impact your score as long as you pay as soon as possible. Having a single late payment could cause your credit score to drop by 100 points or more. And these late payments remain on your credit report for seven years.

Milos Varaklic, vice president of operations at Oakville, Ontario-based MDG, an e-commerce platform that predicts the ability of customers to repay their credit, said late payments can wreck your credit score.

“If you don’t budget well, you make late payments and you charge too much with your card, you could see the deterioration of your credit,” Varaklic said. “It goes both ways: Making your payments on time helps your credit. Making them late hurts.”

Running up too much debt on your credit card can cause two problems. First, it will hurt your credit utilization ratio, a measure of how much of your available credit you are using. The higher this ratio, the worse it is for your credit score.

Overspending

Since charging your credit card doesn’t immediately result in money leaving your bank account, spending above your means is easy to do and will cause you to take on some debt. But not paying off your balance each month will also run up significant interest charges, making that debt even more expensive.

When you use credit cards, make sure you do so responsibly. They come with a lot of perks: safer transactions, rewards and the chance to strengthen your credit profile. But without some discipline, using credit cards can also wreak havoc on your finances and your credit.

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 Updated: May 27th, 2020
Business
14.03%
Airline
15.50%
Cash Back
16.06%
Reward
15.82%
Student
16.05%

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