Many people use credit cards every day for groceries, gas, online shopping and recurring bills. While you are no doubt familiar with credit cards to some degree, it’s important to understand the nuances of how they really work. Here, we’ll drill down on the basics: what is a credit card, how one works and how to make sure you’re using yours in a way that doesn’t cause you financial harm.
Key Takeaways:
- A credit card is a revolving line of credit that lets you borrow money up to a preset limit.
- If you pay your credit card balance in full every month, you can avoid paying interest.
- Credit cards can help build credit and earn rewards, but carrying balances can become expensive, and missing or late payments will likely damage your credit score.
The Basics of Borrowing with a Credit Card
A credit card is a type of revolving line of credit issued by a bank or financial institution. When you get approved for a credit card, the issuer gives you a credit limit, which is the maximum amount you can borrow at a time.
For example, if your credit limit is $10,000, you can spend up to that amount using your card. As you repay your balance, your available credit becomes available again. If you charge $3,000 and pay off that $3,000 a few weeks later, you should then have $10,000 of credit available on your card again.
A credit card differs from a traditional loan in that it allows you to borrow money continuously as long as you haven’t maxed out your card (used up your entire credit limit). With a loan, you get a lump sum of money to borrow with fixed payments. But as you make payments, your potential loan amount doesn’t “refresh” as it does with a credit card.
You can use a credit card for everyday purchases, one-off purchases and emergency expenses. Many credit cards also offer additional features, such as cash back rewards and fraud protection.
Compare Personal Loan Offers From Verified Lenders:
How Do Credit Card Transactions Work?
Credit card transactions might seem like they happen instantly, but there’s a lot going on behind the scenes. Here’s a breakdown of what happens when you use your credit card:
You Make A Purchase
You swipe, tap, insert or enter your credit card information at a purchase point or on a website. The merchant sends the payment request electronically.
The Payment Processor Receives The Request
The merchant’s payment processor sends the transaction information through the card network, such as Visa, Mastercard or American Express.
The Card Issuer Approves Or Declines The Transaction
At this point, the transaction will either go through or get declined. Your credit card issuer will check whether you have enough available credit and whether the transaction seems legitimate.
If fraud is suspected, the transaction may be denied, or you may need to go through an additional verification step. The transaction will generally be denied if you’ve used up your credit limit.
The Merchant Gets Paid
If the transaction is approved, the merchant gets paid and you’re good to go.
The Charge Appears On Your Account
Once a transaction is approved, it should appear on your credit card statement – perhaps first as a pending transaction and then as a posted transaction. At the end of your billing cycle, all of your credit card transactions are grouped into a monthly statement.
What’s Your Goal?
Buy A Home
Discover mortgage options that fit your unique financial needs.
Refinance
Refinance your mortgage to have more money for what matters.
Tap Into Equity
Use your home’s equity and unlock cash to achieve your goals.
How Does Paying A Credit Card Bill Work?
After your billing cycle ends, your credit card issuer will send you a statement showing how much you owe and when your payment is due. That statement will typically include:
- Your total balance
- The minimum payment due
- The payment due date
- A list of transactions for that billing cycle
Once you receive your credit card statement, you can either pay the full balance or make a partial payment. As long as you make your minimum payment, you won’t be considered late and therefore should not incur late payment fees.
Paying your credit card in full by the due date is generally the best option if you can afford it. That’s because you won’t accrue interest on your balance this way.
If you can’t pay your balance in full but can pay more than the minimum payment due, that’s your next best option. The smaller a balance you carry forward, the less interest you should rack up.
What Happens If You Miss A Credit Card Payment?
Missing a credit card payment could lead to:
- Late fees
- A penalty APR, which is a higher interest rate for violating the terms of your credit card agreement
- Damage to your credit score
If you go too long without making a payment (often 90 – 180 days), your credit card issuer may send your account to a collections agency to recover the unpaid balance. The agency will first contact you to try to get you to pay, or potentially sue you and obtain a judgment against you.
Get A Personal Loan Today
Find a lender that can help you find the right loan terms for your financial situation.
How Much Does It Cost To Use A Credit Card?
There is generally no charge to apply for a credit card. And it’s possible to use a credit card without ever having to pay a dime extra.
If you pay off your credit card in full every month, you shouldn’t accrue interest and your credit card shouldn’t cost you anything, unless the card carries an annual fee. If you do not pay your full balance, the remaining amount begins accruing interest.
What Is A Credit Card APR?
Credit card interest rates are expressed as APR, or annual percentage rate. A credit card with a 24% APR charges approximately 24% annual interest on unpaid balances, though APR and interest rate are not the exact same thing.
With a credit card, interest is usually calculated daily, not annually. This means that for every day you carry a balance, you accrue more interest.
As an example, let’s say you carry a $1,000 balance and your credit card APR is 24%. Your issuer will convert the APR into a daily rate: 24% ÷ 365 = 0.0658% per day.
That daily rate will then be applied to your balance as follows: $1,000 × 0.000658 = about $0.66 of interest per day.
Then, multiply that daily rate by the number of days in a billing cycle. If it’s 30, you’re looking at $0.66 x 30 = $19.80, or almost $20 a month, in interest. The higher your balance and credit card APR, and the longer you carry a balance, the more you’ll pay.
Get A Personal Loan Today
Find a lender that can help you find the right loan terms for your financial situation.
Benefits Of Using A Credit Card
How does a credit card work in terms of benefits? Consider these perks that can come with a card:
Rewards Programs
Many cards offer rewards like:
- Cash back
- Air miles
- Hotel points
- Points that can be converted to statement credits or gift cards
Improved Cash Flow
Credit cards let you make purchases immediately and pay the bill later. This flexibility could make it easier to manage your monthly expenses.
Convenience
With a credit card, you don’t have to worry about carrying cash all the time. Credit cards can also make it easier to track your spending, since you can see all your transactions when you log in to your account.
Fraud Protection
Credit cards often include strong fraud protection measures. If your credit card issuer detects unusual activity on your card – such as a purchase that’s larger than usual or a gas or grocery purchase far from where you live – the issuer may flag the purchase and prevent it from going through until it can be verified as legitimate.
If unauthorized charges do end up on your card, you can typically dispute them and avoid having to pay for things you didn’t buy.
Building Credit History
Payment history and amounts owed on revolving credit are two of the biggest factors that go into calculating your credit score. By paying your credit card bill on time every month and keeping your balances low relative to your credit limit, you can boost your credit score.
The length of your credit history also plays a role in calculating your credit score. If you keep a credit card open for many years, it could increase your score. A higher credit score could make it easier to qualify for other types of loans, like an auto loan or mortgage, as well as lock in a competitive interest rate.
Drawbacks Of Using A Credit Card
Despite their benefits, credit cards also present their share of risks.
High Interest Rates
Credit cards often have significantly higher interest rates than other loan types, so carrying a balance could cost you.
Potential For Overspending
Because credit cards don’t require you to pay your balance in full every month, you may be inclined to carry a balance while continuing to use your card. This could cause you to spend more than what you can actually afford and end up with debt you struggle to pay off.
Fees
Some credit cards charge different fees, like annual fees, which could add to your costs.
Potential Credit Score Damage
If you don’t make your minimum credit card payments on time, you could damage your credit history and drag down your credit score in the process. Maxing out credit cards or carrying large balances could also hurt your credit score, even when you make your minimum payments on time.
Common Credit Card Fees
Not all credit cards charge the same fees. Here are some of the most common ones you might encounter:
- Annual fee: Some cards charge a yearly fee simply for having the account open. However, credit cards with annual fees sometimes offer strong reward programs or perks that make the annual fee worth it.
- Late payment fee: If you don’t make your minimum payment by its due date, you may be charged a late payment fee.
- Foreign transaction fee: Some credit cards charge foreign transaction fees on purchases made outside the U.S.
- Balance transfer fee: Some credit cards allow you to transfer balances from another card, which often incurs a balance transfer fee.
- Cash advance fee: Many credit cards allow you to use your card to withdraw cash, but there is often a fee that accompanies it.
How To Find The Right Credit Card For You
There are certain factors to consider when shopping around for a credit card, especially if you are a first-time cardholder:
Reward Programs
These can differ from one card to the next. It pays to choose a rewards program that matches your lifestyle and spending habits. For example, if you travel a lot, you may want a credit card offering extra cash back on flights and hotels.
Fees
The more fees your credit card charges and the higher they are, the more costs you might incur.
APR
The higher your credit card’s APR is, the more it might cost to carry a balance. If you think you may not pay off your balances in full every month, then it pays to seek out a card with a lower APR.
Introductory Offers
Some credit cards have special offers for new cardholders. You may be eligible for a 0% introductory APR, which means your balance doesn’t accrue interest for a set period. It’s also common for credit cards to offer a welcome bonus, such as extra reward points or cash back, for meeting a spending requirement within a certain time period.
The Bottom Line On How A Credit Card Works
Credit cards offer easy purchasing power without having to fork over any money right away. It’s important to understand how a credit card works so you can enjoy its benefits without negative consequences.
Ready to find a credit card that fits your spending habits? Explore credit card options with Quicken Loans and start earning rewards today.
Maurie Backman
Maurie Backman has more than a decade of experience covering personal finance topics that include mortgages, loans, retirement, Social Security, and investing. Prior to becoming a full-time writer, she worked in the financial industry as well as in product design and marketing. Maurie holds a bachelor's degree from Binghamton University, where she studied creative writing and finance. She was happy to combine her two areas of study into a career that allows her to educate consumers on a host of financial topics.
