How Does a Credit Card Work? [Simple Guide and Definition]

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hand holding a credit card with credit card machine

Although credit cards can help people improve their credit and financial situation, they can also tempt people to get into trouble. Whether a credit card will be beneficial or detrimental to your financial health depends on if you use it correctly or incorrectly. This guide will help you understand the basics of credit cards so that you can use them responsibly and to your benefit.

Understanding How a Credit Card Works

Credit cards allow you to access a predetermined line of credit at will. The limit is based on your income, credit history and other factors depending on the issuer. A credit card differs from a debit card in this way. A debit card allows you to access funds that already belong to you. A credit card allows you to access funds that do not belong to you. As a borrower, you must repay any credit that you use along with interest unless there is a temporary zero-interest period. 

The credit card issuer must inform you of any fees, your credit limit and your annual percentage rate. If you pay late, your APR could rise. As you get your monthly bill in the mail or online, you will see how much you owe, how much interest was charged and your payment and transaction history. As a rule, you must make at least the minimum payment each month. You can also avoid interest if you use the card to make a purchase and pay off the entire balance during the grace period

Major Credit Card Networks

There are several big companies that issue credit cards through banks and other organizations. These are the most popular companies.

Visa

Visa is the biggest global cashless payment provider. Its history dates back to 1958. At the time, it helped Bank of America build the first credit card program for consumers. Its growth continued throughout the next several decades with one of the largest IPOs in history. Visa’s operations span more than 200 countries worldwide. You can use services from Visa card providers via mobile apps, online or at financial institutions. Nearly every business that allows credit card payments accepts Visa, which is why it is a common choice for international traveling.

MasterCard

MasterCard started in the 1960s. Many businesses around the world still accept this credit provider today. Its mission is to make cashless payments smart, simple and safe. Although it started as a small group of bankers, it grew into a global cashless payment system. Like Visa providers, card companies that work with MasterCard usually offer online services and apps. Today, the company is especially known for its conscientiousness for social responsibility.

Discover

This credit card company was started in the early 1980s as a financial services arm of Sears. It did not become an independent company until 2007. The main reason why the company was able to grow so much and compete with giants MasterCard and Visa was because it offered the benefit of no annual fee. It also offered attractive cashback bonuses. The company is still thriving and is especially praised for its customer service, which is based entirely in the United States.

American Express

You may also see this company shortened to Amex. As a multinational financial services corporation, American Express has many other facets in addition to its charge cards. Its history dates back to 1850. Although credit cards did not exist then, it started by providing freight forwarding services. It eventually offered both financial services and travel products. The company’s first charge card was introduced in 1958. It went global in the 1970s. Today, Amex is known for its loyalty programs, small business account benefits and support of local communities.

Credit Cards on Bank Statements

Common Credit Card Vocabulary

Before you accept any credit card offer for the first time, it is important to understand these important credit card vocabulary terms.

Available Credit

This is the amount of money that you can spend. It is the difference between your total credit limit and your current balance.

Balance

This is the amount that you currently owe. Paper statements do not reflect charges that were made shortly after the statement was issued. However, the balance is typically updated more often online.

Billing Cycle

This is the time between statements, and it generally lasts between 28 and 31 days depending on the month.

Grace Period

This is the time frame in which the issuer allows you to pay off the entire balance or a recent purchase without assessing an interest penalty. It ranges between 10 and 28 days depending on the issuer and financial institution.

Statement Due Date

This is the date that the payment is due. You should always pay before this date, and this is especially true if you mail a check. Some financial organizations may not process electronic payments after a certain hour. For example, if you try to pay on the due date an hour before midnight, it may show up as a late payment for the following day. Keep in mind that the grace period is not a grace time for late payments.

Minimum Payment

This is the lowest allowed payment each month. While you are free to pay more, you must pay the minimum amount to avoid extra fees or charges beyond the applied interest.

APR

The annual percentage rate or APR is the yearly percentage rate that the issuer charges for any outstanding balance. This means that the rate applies each month for purchases that you do not pay off during the grace period. 

Rewards

Rewards usually refer to points or cash back. If you earn cash back rewards, you can often use them toward future purchases. Some e-commerce sites such as Amazon allow you to link your cards and use cash back rewards when you make purchases. You can also choose to use the cash back as an extra payment toward your balance. With some cards, you can earn points with every purchase based on the dollar amount or what types of purchases you make. You can exchange those points for prepaid debit cards, statement credit or gift cards from participating vendors depending on the card company. With travel cards, you can earn airline miles or hotel points with certain purchases.

Types of Credit Card Fees

Every credit card comes with its own fee structure. The issuer usually includes a pamphlet or a link to these fees, and they vary from one card to another.

Interest

This is the percentage rate of your purchases that you pay if you carry a balance from one billing cycle to the next. There may also be an interest rate cap, which is the maximum interest that the company may charge. Your interest may rise after a promotional period or if you miss one or more payments.

Annual Fees

An annual fee is a set yearly cost that you pay for the privilege of having a card with the company. Some cards may offer the benefit of no annual fee.

Late Fees

A late fee is usually a set penalty that is added to your balance. Some companies have varying tiers of late fees depending on your balance amount.

Cash Advance Fees

Some card companies offer you up to a certain amount of your credit limit as a cash advance. If you need the money for rent or another expense that you cannot use your card to pay for, you must pay a fee to take out cash. Most cash advance fees are usually about three percent of the withdrawal amount.

Foreign Transaction Fees

If you make direct purchases online from certain foreign vendors or if you use your credit card when you travel overseas, you may notice that each transaction comes with an extra charge. Foreign transaction fees may be as much as three percent of the total. However, there are some cards with lower percentages or no foreign transaction fees.

Balance Transfer Fees

A balance transfer happens when you transfer the balance of one credit card to another. People usually do this when they get an introductory rate of zero percent on a new card and want to pay down a high-interest card balance faster. The transfer fee may be between one and five percent. Some card companies offer the benefit of no transfer fees but usually have shorter promotional periods.

mobile banking with credit cards

Types of Credit Cards

If you are thinking about which type of card to use, it is important to know how each option works.

Secured

A secured credit card is ideal for someone with poor credit or little to no credit history. The card holder deposits a sum of up to $1,000, and the credit line is usually equal to the deposit amount. In this sense, it may sound like a prepaid debit card. However, purchases are not deducted from that deposit. It is only refunded when the card holder upgrades to an unsecured card or closes the account. Interest, minimum payments and fees still apply.

Unsecured

An unsecured credit card is the most common type of card. A card company offers you credit based on reasonable creditworthiness without the need for a deposit. You can carry a balance but must pay the minimum payment monthly.

Charge Cards

The main difference between a credit card and a charge card is that you cannot carry over a balance from one month to the next. A charge card is like an advance but with a short repayment time frame. You must repay it within the month or when the billing statement is issued. With a credit card, you can carry over a balance indefinitely as long as you make the minimum payment each month. There is usually no interest with a charge card, and some offer rewards or perks.

Retail Cards

Retail cards are credit cards that are for specific stores or groups of stores. For example, if you shop at a popular department store often, you may sign up for a retail card to earn points and to enjoy the privilege of paying off a big-ticket item over the span of a few months. These cards still come with interest and may have fees. 

Rewards Cards

These are usually unsecured credit cards. Depending on the card company and the purpose of the card, rewards cards often come with multiple benefits. The rewards may accumulate as cash credit or points that can be converted into other benefits such as gift cards or airline miles. While some cards offer benefits on all purchases, these are some types of purchases that earn special rewards on certain cards:

  • Qualified travel purchases
  • Dining
  • Grocery store purchases
  • Gas purchases

Pros and Cons of Getting a Credit Card

These are the pros of getting a credit card:

  • More flexibility for paying monthly obligations or unexpected expenses.
  • A cushion for emergencies during travel.
  • Not having to wait to buy something that you cannot afford right now but can pay off soon.
  • The ability to build and improve your credit history.
  • An opportunity to build financial self-discipline.

These are the cons of getting a credit card:

  • There may be a temptation to misuse it.
  • You usually wind up paying more for purchases than you would if you bought things outright.
  • Missing payments can damage your credit history.

Fortunately, the disadvantages can be avoided by simply understanding credit cards, choosing the right ones and using them responsibly.

Safety Features and Unauthorized Charges

Credit card companies have a duty to protect your identity, information and money. Today, they have extensive security and advanced detection technology to spot unauthorized charges that occur when your number is stolen online or if the actual card is stolen. While it is still a good idea to monitor your statements since not all charges are caught, you will usually get an email, a phone call or a text if there is suspicious activity. Also, credit card companies often refund legitimately disputed charges that you did not authorize. The hologram, magnetic strip and EMV chip contribute to enhanced security. If you plan to travel, be sure to notify your card company beforehand to avoid having your card frozen if you try to use it while you are gone. 

credit report with credit score

How to Apply for a Credit Card

First, check your credit history and score. Every person is entitled to one free annual copy of their credit report and score online or by mail. The site that the government recommends is AnnualCreditReport.com, which is supported by the three major credit bureaus. Once you know your score, you can do some research to determine which cards you may qualify for. 

Required Information

When you apply for a credit card, these are the bits of information that creditors require:

  • Name 
  • Mailing address
  • Date of birth
  • Annual income estimate
  • Social Security number
  • Phone number
  • Email

Determining Factors

Card providers will check your credit on their own with your permission. Your credit history length, payment history, credit score, negative marks and debt-to-income ratio may be considered. 

Pre-qualified Offer Concerns

If you have good or excellent credit, you will probably get plenty of pre-qualified offers with attractive terms. However, the Federal Trade Commission recommends caution if you get offers that promise you major credit cards with better credit, easy approval for other cards, no-fee advances and similar benefits. If you get such offers, read the terms carefully to see if there are unnecessarily high fees.

The Bottom Line

Credit cards can be an asset to you when you use them to your advantage. Some cards even offer additional perks such as limited travel insurance, car rental coverage or other benefits that can save you money. If you only want one or two cards, compare several options to see which ones have the most beneficial fee structures and perks for your specific needs.