A credit card is a type of financing used to borrow money – funds to make purchases or even to access cash. When used responsibly, credit cards can help you build your credit score and potentially also earn rewards. Without exercising caution, however, it’s easy to accrue large balances and interest on a card. So how does a credit card really work? Keep reading for our in-depth guide.
Key Takeaways
- A credit card is used to buy goods or services with borrowed funds, up to a predetermined credit limit.
- Interest accrues if you don’t pay your balance in full by the due date.
- You must make at least the minimum payment each month to keep your account in good standing.
- There are several different types of credit cards, each with distinct features.
What Is A Credit Card?
A credit card can be physical and/or digital, with an account number that’s linked to a revolving line of credit, which allows you to make purchases with borrowed money instead of having to withdraw funds from a bank account. If you repay your balance by the due date, you typically won’t have to pay any interest. But if you carry a balance past that date, it starts to accrue interest – a percentage charged on the amount borrowed – adding to your initial balance. The interest compounds every day based on your daily balance, which can cause your outstanding principal to quickly grow. You can borrow up to your credit limit, which is set by the credit card company.
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How Does A Credit Card Work?
Once you make charges to your credit card, monthly payments are due on a regular basis. You’ll receive a statement after your billing cycle ends, which shows your statement balance (the total amount owed at the end of the billing period), your minimum payment and your current balance.
There may also be interest charged on the borrowed funds, based on different possible annual percentage rates (APRs), plus any annual fees. The APR is applied depending on how you’ve used your credit card:
- Purchase APR: Applied to purchases made with your credit card that aren’t paid by the due date.
- Balance transfer APR: Applied to balances transferred from other credit cards.
- Cash advance APR: Applied to cash taken out against your credit limit.
You may see a penalty APR triggered after late payments too. Some credit cards also charge certain fees on top of interest, which could include:
- Annual fee
- Authorized-user fee
- Balance transfer fee
- Cash advance fee
- Late fee
- Foreign transaction fee
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What Types Of Credit Cards Are Available?
Credit card definitions can encompass whether a card is secured or unsecured, and from there you’ll find that there are several different types of cards you can carry.
Secured Credit Card
A secured credit card is designed to help people build credit when they have no credit score or a low score. You make a cash deposit, which is used as collateral. Your credit limit is equal to your deposit amount. So if you deposit $500, you can charge up to $500 on your card.
You still have to make payments with separate funds when your bill is due. The idea is that your on-time payments will be reported to the credit bureaus in order to improve your credit score. You eventually get your deposit back once you’re able to upgrade to an unsecured card.
Unsecured Credit Card
An unsecured credit card doesn’t require any collateral. Instead, your credit limit and interest rate are determined by your financial and credit history. Creditors perform a hard credit check and ask about your income. Lower credit scores may correlate to an approval for a card with a higher interest rate and a lower credit amount; you may also not receive perks like points. Each credit card company may offer different tiers of cards based on creditworthiness.
Rewards Credit Card
A rewards credit card acts like a typical unsecured credit card but comes with additional benefits. As an incentive to use the credit card, you earn some type of reward based on your purchases. Often, those rewards are delivered in the form of cash back, travel miles or points that can be redeemed for something else.
Rewards credit cards often require higher credit scores in order to qualify, and you might have to pay an annual fee. Avoid overspending just to accumulate points or miles, especially if you don’t pay your balance in full. Also make sure that any perks you receive make up for the cost of the annual fee.
Student Credit Card
A student credit card can help college students build credit. Because students often don’t have much credit history for creditors to analyze, these cards usually come with low credit limits and higher interest rates.
You may need to meet enrollment requirements in order to qualify. Creditors may also require that you either apply with a co-signer or have income of your own to ensure you can afford your payments. After a period of making on-time payments, you could qualify for a higher credit limit and better terms.
Business Credit Card
A business credit card lets you separate your business charges from your personal charges. However, even though you are using it for business expenses, typically you will still need to personally guarantee the card. That means if your business defaults on the credit card, you are still responsible for the balance owed using your personal assets.
You may be able to qualify for higher credit limits with a business credit card, especially if you have higher levels of revenue and cash reserves. But your personal credit score is also used as part of the approval process.
Retail Credit Card
Retail store credit cards act like regular credit cards, but you’re sometimes limited to where you can use them. With such closed-loop cards, you might only be able to charge purchases at one brand, or you could potentially use it to shop at sister stores as well. Credit limits are typically lower, and you may see higher interest rates as well. Some retailers, though, offer branded credit cards – say, affiliated with Visa or MasterCard – that you can use anywhere.
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How Credit Cards Impact Your Credit Score
It’s important to manage your credit cards responsibly in order to build and maintain a positive credit history. Here’s how they impact your credit score:
- Hard inquiries: Every time you apply for a credit card, the creditor will likely pull a hard inquiry on your credit report. Each inquiry stays on your report for 2 years and can cause your score to dip for several months.
- Credit mix: 10% of your credit score depends on your mix of credit. Lenders like to see a balance of both installment credit – like auto loans – as well as revolving credit like credit cards.
- Credit utilization: Keeping low or no balances on your cards helps your credit score because it keeps your credit utilization low. That’s important because credit utilization – the measurement of how much of your total credit limit you are using – accounts for 20 – 30% of your score.
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The Bottom Line: Use Credit Cards Responsibly To Build Your Credit
Understanding how a credit card works helps you better manage your wallet and mitigate any financial pitfalls down the road. Avoid carrying balances, and pay attention to what’s due on your statement each month. Also be mindful of how frequently you apply for credit cards so you don’t overload your credit report with hard inquiries.
Wondering how credit card debt impacts your ability to buy a home? Check out our Home Affordability Calculator to find out.
Ben Shapiro
Ben Shapiro is an award-winning financial analyst with nearly a decade of experience working in corporate finance in big banks, small-to-medium-size businesses, and mortgage finance. His expertise includes strategic application of macroeconomic analysis, financial data analysis, financial forecasting and strategic scenario planning. For the past four years, he has focused on the mortgage industry, applying economics to forecasting and strategic decision-making at Quicken Loans. Ben earned a bachelor’s degree in business with a minor in economics from California State University, Northridge, graduating cum laude and with honors. He also served as an officer in an allied military for five years, responsible for the welfare of 300 soldiers and eight direct reports before age 25.
