how do credit cards work?

How Do Credit Cards Work?

Credit cards are a financial tool that gives you a line of credit—or a credit limit—that allows you to spend up to a certain amount. What you spend on a credit card must be repaid, usually with interest.

Credit cards often get a bad rap, but when used correctly, they can be an excellent way to earn rewards, build credit, and improve your financial situation.

This Wealth Rocket article covers the basics of using a credit card, how do credit cards work, their pros and cons, as well as some helpful terms to help you maneuver their usage while staying out of rotating debt.

Table of Contents

How Does Credit Cards Interest Work?

One of the most important things to keep in mind when using a credit card is that the credit card company charges interest on what you owe if you don’t pay off your balance in full each month.

Carrying a balance from month-to-month, also known as a revolving balance, means you will pay interest not only on what you owe but also on any new transactions that you make.

In other words, your interest is compounding, and that can add up quickly.

Credit Card Scanning

Additionally, the average Annual Percentage Rate (APR) on a credit card or APR is around 16%. That’s why you should make a conscious effort to pay off your balance in full each month.

However, using a credit card responsibly is rewarded when paying your balance in full each billing cycle, which can improve your credit score.

It’s worth noting that many credit card issuers offer introductory offers of 0% APR for new cardholders.

This is a great perk, especially if you’re carrying a credit card balance and are considering transferring a balance from another credit card. Typically, those offers are only valid for one year to 18 months from the time you open the card.

However, the interest rate will likely dramatically increase. That means you’ll still need to commit to paying off that balance before then.

50/30/20 Rule

Credit Cards vs. Debit Cards

A credit card allows you to borrow money for purchases and expenses.

Anyone with a credit card can swipe or insert your card to make point-of-sale transactions, similar to how a debit card works.

Since credit cards are essentially a line of credit, anything you spend on a credit card must be repaid, with interest.

Credit cards require you to make a minimum payment each month to pay off what you spent. However, it’s best to pay off your balance in full each month to avoid paying more in interest.

Debit cards are also an easy way to make transactions by swiping or inserting your card. They're also the best method for getting physical cash.

However, debit cards draw the money directly from your checking account. That means you won’t get a monthly statement, won’t pay any interest, and will not build credit.

How to Use a Credit Card

Using a credit card is similar to the way that you would use a debit card. You can swipe or tap your card to pay for purchases or even bills (depending on your credit card provider).

You can also use your credit card to pay for online purchases. You’ll need to input information such as your card number, expiration date, and CVV security code.

Any purchases made on your credit card go towards your credit card balance, which you’ll (ideally) pay in full at the end of each billing cycle.

If you don’t pay off your bill in full each month and instead only pay the minimum payment, interest will accumulate to your statemen

Using a credit card responsibly is a great way to build or improve your credit, as long as you pay off your balance each month and keep your credit utilization rate relatively low.

How to Get a Credit Card

To get a credit card, you’ll need to fill out an application and meet some minimum requirements before you can get one.

For example, you’ll need to be at least 18 years old, have a Social Security number, income, and credit history.

If you don’t meet the requirements, you may be approved for a secured credit card, need a co-signer, or require an authorized user to a parent or guardian’s credit card.

Some cards have additional requirements, such as good credit history, length of credit history, or a certain credit score.

You can check your credit history with one of the three major credit bureaus.

When deciding what card to open, it’s wise to compare the cards’ interest rates (APR), annual fees, and any perks offered by rewards cards.

Tangerine-World-Mastercard-243x153

Tangerine World Mastercard

Tangerine World Mastercard

Receive a 1.95% Balance Transfer promo for 6 months (1% fee) with Tangerine World Mastercard

Pros & Cons of Using A Credit Card

Credit cards, while useful, are not entirely flawless or right for everyone. We’ll take a look at some of the pros and cons of using a credit card below.

Pros

Logo It’s an easy way to pay for everyday purchases, travel, and even bills.

LogoIf you have a rewards credit card, you can also earn points for certain purchases. Sometimes, the rewards are airline miles on purchases, which can go towards travel.

Logo Using a credit card and paying the balance in full each month is also an excellent way to build or improve your credit. Paying your bill on time each month is also important to build your credit by using a credit card, so be sure to keep your due date top of mind.Keeping your credit utilization low (i.e., how much you spend each month of your credit limit) is another way to improve your credit by using a credit card

Cons: The Not So Good Stuff

Logo It’s very easy to spend more than you can afford to pay off each month on your credit card, compared to a debit card, because the latter will usually only allow you to spend what you have readily available in your bank account.

Logo Overspending on a credit card can lead to carrying a balance month to month, which means paying more in interest, or, worst-case scenario, spending more than you can pay back. For example, data shows that the average household in the U.S. has nearly $9,000 in credit card debt.

Logo Acquiring too much credit debt can lead to less-than-ideal financial decisions, like debt consolidation or even bankruptcy.

Common Credit Card Terms

If you’re using a credit card, getting the lingo down increases your chances of using one properly and effectively. Get yourself familiar with the following credit card terms.

Annual Percentage Rate (APR)

An annual percentage rate, or the interest rate, is the rate of interest paid on unpaid purchases at the end of the month.

Annual fee

Some credit card companies charge cardholders an annual fee, which pays for their benefits and other features. The average annual credit card fee is $110, though they can be lower or higher.

Balance

A credit card balance is the total amount that you owe on your credit card.

Statement Balance

A statement balance shows you how much you owe the credit card company at the end of a billing cycle. In other words, your statement balance is the total amount of your credit card bill.

Billing Cycle

A billing cycle is the time between your last credit card statement and the one that follows. The average billing cycle is at least 21 days.

Credit Limit

A credit limit is the maximum amount you can charge to your credit card.

Minimum Payment

A minimum credit card payment is the lowest possible payment you can make each month on your credit card.

While it can be tempting to pay only the minimum payment each month, it typically only covers the interest on your balance.

Credit Utilization Rate (CUR)

A credit utilization rate (CUR) is the balance you currently carry on your credit card, versus the amount of your total credit card limit.

Grace Period

A grace period if the time between when your statement ends and when your bill is due.

Frequently Asked Questions

Not necessarily. However, if you don’t use your card for a certain period, your credit card company may close your account, which can affect your score.

You can build credit by paying your bills on time, keeping your debt-to-income ratio low, or even by being added as an authorized user to a parent or guardian’s account. However, responsibly using a credit card and paying off the balance each month is usually the easiest way to build credit.

Immediately call your credit card company and alert them of your lost card. They will cancel your current card and issue you a new one. Then keep an eye on your statement for fraudulent purchases.

About the Author

Related Guides