How Credit Cards Work | A Complete Guide

A credit card works by allowing consumers to finance purchases and pay them over time. They are also a great way to establish credit and improve your credit score if used responsibly.

When a creditor issues you a credit card, they are extending a line of credit. You can use a credit card to make purchases and have the option to pay off the balance each month or make small monthly payments.

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Credit Cards vs. Debit Cards

While credit and debit cards look very much the same, they work much differently.

A debit card is tied to your checking or savings account and comes in chip-and-pin cards. Each time you use it, the charge is immediately debited from your account. There are no payments, fees, or interest charges when using a debit card.

A credit card is not tied to your bank account, each time you use a credit card, the amount charged is added to your account balance, and you are charged interest. You will need to repay what you borrow at some point. Credit cards also have a magnetic stripe, and many cards are moving to chip cards.

Credit Card Interest Rate

The interest rate you receive from a credit card issuer will depend largely on your credit score. The higher your score, the lower your credit card rate will be. When you apply for a card, the credit card company will pull a copy of your credit history from the three major credit bureaus to see if you qualify.

If you have no credit or bad credit, you should expect an interest rate above 20%. Which means for every $1000 in debt, you will be charged $200 per year in interest charges.

One way to get a lower interest rate when you have credit issues is to have someone with good credit co-sign for you. A co-signer is a second account holder who is financially responsible for the debt and is held liable for any amount due.

Interest is charged on the debt; there is usually a 20-30 day interest-free grace period where you can pay off the balance without being charged interest.

Credit Card Fees

Late Fees

A late fee is typically added to your bill when the minimum payment is not received within 14 days of the due date. Credit card late fees are typically between $25-$35. The higher your balance, the larger the late fee will be.

You can avoid late fees by paying your minimum payment on time each month. However, we are all prone to forgetting or procrastinating from time to time, so it’s good to have a plan in place.

Every credit card company has online bill pay these days, and they also allow you to set up reoccurring payments. You should set your account up to pay the monthly payment on the due date each month. This way, you can rest assured you will never miss a payment.

Over the Limit Fees

Over the limit fees are charged when your credit card balance is higher than your credit limit and are around $35 each month your ending balance exceeds your credit limit.

If you carry a high balance there is a good chance your card issuer will hit you with an over the limit fee when interest starts accumulating. You should do your best to keep your card balances fairly low.

Annual Credit Card Fees

Some financial institutions have annual fees associated with their credit cards. The annual fee is added to your balance once a year; annual credit card fees are usually between $29-$99. If you have good credit, you will avoid this fee by selecting a card that doesn’t have an annual fee.

Cash Advance Fees

Most credit card issuers allow cardholders to get cash out of an ATM using a cash advance. Cash advances usually have a separate interest rate that is higher than the rate you pay for a regular transaction.

The typical cash advance fee is $10 or 5% of the cash amount, whichever is higher.

Balance Transfer Fees

Some credit card companies charge balance transfer fees whenever you transfer the balance of one card to another. The typical balance transfer fee is 3%-5% of the transfer amount.

Types of Credit Cards

There are several different credit card types, from a standard Visa or MasterCard from a large bank such as Wells Fargo to a store card from Kohls or Target. Some lenders strictly offer credit cards such as American Express and Discover. Here are the different types of credit cards that are available.

  • Rewards credit cards – Are credit cards that offer rewards each time you use them. Rewards come in the form of cashback or points that can be used for purchases or airline miles.
  • Secured credit cards – A secured credit card works similarly to an unsecured credit card; however, the cardholder must pay a deposit equal to the credit limit. This deposit is held onto until the account is closed or after 6-12 on-time payments depending on the card issuer. A secured card is a great way to build credit for someone with poor credit or no credit.
  • Charge cards – Charge cards are not as common as they once were. These cards require the entire card balance to be paid in full each month. Each month you will receive a bill for the entire balance instead of a minimum payment.
  • Balance transfer cards– Balance transfer cards are credit cards that allow you to transfer money from another credit card. Usually, these cards have a low initial interest rate between 0%-5% for the first few months. This allows you to transfer the balance from a card with a high-interest rate to a low-interest card.
  • Retail cards – Retail credit cards are cards issued by retailers. Walmart, Best Buy, and Target just a few retailers that offer credit cards that can be used in their retail and online stores. Retail cards often offer many rewards and benefits that can be used for purchases at the location.

Credit Utilization Ratio

Your credit utilization ratio is the amount of available credit you’re using.

For example, if you have a credit card with a $10,000 credit limit, and your balance is $5,000, your credit utilization ratio is $50, which is considered quite high.

Your credit utilization ratio accounts for 30% of your overall FICO score. Only your payment history has a bigger impact on your score than the amount of your card balances.

We recommend keeping your card balance below 15% of the credit limits to maximize your credit score.

In Conclusion…

A credit card works by allowing consumers to finance purchases and pay them over time. They are also a great way to establish credit and improve your credit score if used responsibly.

People use credit cards for convenience, rewards, and to help build credit. When used correctly, they offer many advantages, but you could end up with a mountain of credit card debt when they’re abused.

Use your credit card responsibility, do not use it to make large unnecessary purchases, keep the balance low, and make your monthly payments on time.