How do credit cards work?
A credit card is a payment card that allows you to make purchases on credit. It works by borrowing money from the card issuer, up to a set credit limit. You are required to repay the borrowed amount, either in full or through monthly installments, with interest charges applied if not paid in full. Credit cards can be physical, typically a small rectangle of plastic or in digital format.
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- How do credit cards work behind the scenes?
- Credit cards vs. debit and other cards
- Credit cards are the safest way to pay
- How do credit card rates work?
- Credit card interest rates are higher than other loans
- What are rewards credit cards?
- More on credit card rewards perks
- How do credit cards work with your credit score?
- Credit utilization ratio or credit usage
- Your credit card goals
- In a nutshell
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How do credit cards work behind the scenes?
A credit card provides you with a “line of credit.” That means you’re given a credit limit and can run your “balance” (the amount you owe at any one time) up to that limit.
But it’s not like a personal loan or mortgage that you pay back in equal installments. Providing you make the minimum payments required, you can repay the whole or parts of your balance as you wish. You can then borrow again up to your limit. And you can keep repeating that for as long as you have your card. Credit and store cards are sometimes called “revolving credit accounts” because the credit revolves in that way.
Of course, the fact you can do something doesn’t necessarily mean you should. There are good reasons to keep your card balances low, which you’ll read about below.
Meanwhile, you pay interest only on the balance outstanding on each month’s invoice. If you pay off your balance in full every month, you do not pay any interest charges.
Credit cards vs. debit and other cards
Credit cards are different from debit cards. A debit card does not provide you with a separate line of credit. You use it to make payments directly out of your bank account, usually a checking account. Indeed, it can be helpful to think of a debit card as a more convenient form of a checkbook.
Charge cards are also different from credit cards. American Express was a pioneer of these. Unlike with a credit card, you must pay off your charge card balance every month.
Finally, prepaid cards have become more popular over the last decade or so. These provide no line of credit. You must load money onto your card before you spend it. And, when it’s gone, it’s gone, though you can add more money whenever you want.
Credit cards are the safest way to pay
Credit cards are considered the safest payment method available. The Seattle Times dubs them a “consumer protection superweapon.”
By law, credit cards can protect you against fraud and shoddy or misdescribed goods and services. You can get your money back even if you pay a deposit for an item and the retailer goes bust before it’s delivered.
Only credit cards come with these statutory protections, which are provided by the Fair Credit Billing Act. That means that you might not have to pay for such items when they appear on your monthly statement. Naturally, you must try to resolve issues with the merchant first. But, if that company is unresponsive or unreasonable, you can work with your bank on a resolution.
It is also true that most banks ultimately refund your money in many similar circumstances if you use a debit card, but there are important differences. To start with, there’s no law to force them to do so. So, you’re on flimsier ground from the beginning. And, secondly, the money has already left your bank account and you have to wait until your bank chooses to refund it.
This makes credit cards a great way to pay for goods and services in the short-term, when you pay off at the end of the month. However, they are not the best way to borrow over the longer term.
How do credit card rates work?
Credit card rates, also known as interest rates or Annual Percentage Rates (APRs), determine the cost of borrowing on a credit card. Here’s how credit card rates work:
- Introductory rates. Some credit cards offer introductory rates, often called “teaser rates,” which are low or even 0% interest rates for an initial period. These rates are usually temporary and can apply to balance transfers, purchases, or both.
- Standard APR. After the introductory period, a credit card’s standard APR comes into effect. This is the ongoing interest rate charged on any outstanding balances or new purchases. The standard APR can vary significantly depending on the credit card issuer, the cardholder’s creditworthiness, and prevailing market conditions.
- Variable rates. Many credit card APRs are variable, meaning they can fluctuate based on changes in an underlying interest rate index, such as the prime rate. If the index rate goes up or down, the credit card’s APR adjusts accordingly.
- Penalty APR. Credit cards may have a penalty APR that is higher than the standard APR. It typically applies when cardholders make late payments or violate the terms of the credit card agreement. Penalty APRs can be substantial and may remain in effect for an extended period.
- Grace period. Most credit cards offer a grace period, which is the time between the purchase date and the due date when interest charges are not applied if the balance is paid in full. However, if the balance is not paid in full within the grace period, interest will be charged on the remaining amount.
- Calculation of interest charges. Interest charges on credit cards are usually calculated based on the average daily balance method. This method takes into account the daily balances throughout the billing cycle and applies the daily periodic rate to determine the interest amount.
Maintaining a high credit card balance and paying only the minimum payment can lead to substantial interest charges over time. To minimize interest costs, pay off credit card balances in full each month or as soon as possible.
Credit card interest rates are higher than other loans
There are several factors that make credit card rates higher compared to personal loans and mortgages.
- Unsecured debt. Credit cards are typically unsecured debt, meaning they are not backed by collateral. Unlike mortgages or car loans, where the lender can repossess the property in case of default, credit card issuers do not have a specific asset to recover their funds. The absence of collateral increases the risk for lenders, leading to higher interest rates to compensate for that risk.
- Shorter loan terms. Credit card balances are usually revolving, meaning they can be carried over from month to month. This flexibility allows cardholders to make minimum payments and extend the repayment period. The shorter loan terms associated with credit cards compared to personal loans or mortgages mean that interest charges accumulate over a shorter time frame, resulting in higher rates to offset the lender’s potential loss.
- Higher default rates. Credit cards have higher default rates compared to other types of loans. Due to their ease of use and availability, credit cards are often used for discretionary spending and emergencies. This greater risk of default is factored into the interest rates to compensate for potential losses incurred by the lender.
- Higher administrative costs. Credit card issuers incur significant administrative costs, including customer service, fraud protection, credit monitoring, and rewards programs. These costs are built into the interest rates charged to cardholders.
- Market competition. The credit card industry is highly competitive, with numerous card issuers offering various rewards and benefits. This competition puts pressure on lenders to offer attractive features, which can contribute to higher interest rates to cover the associated costs.
Personal loans and mortgages are typically secured debts, backed by collateral such as a home or a car. The presence of collateral reduces the risk for lenders, resulting in lower interest rates compared to unsecured credit cards. Additionally, personal loans and mortgages often have longer terms, allowing for spread-out repayments and reducing the impact of interest charges
What are rewards credit cards?
Rewards credit cards are a type of credit card that offers benefits or incentives to cardholders for their spending. These rewards can come in the form of cash back, points, miles, or other perks. Cardholders earn rewards based on their purchases, which can be redeemed for various rewards or discounts.
- Cash back. As statement credits or by check or electronic transfer to your bank account
- Points. Normally redeemed through your card issuer’s shopping portal, selected online retailers or gift cards
- Miles. Normally redeemed through your issuer’s travel portal when booking flights, hotel rooms and other travel-related costs
- Perks. Additional advantages or benefits provided, such as discounts, exclusive access, or enhanced customer services.
Each credit card company gets to set its own rules for its rewards program. So, you need to make sure that the company and card you choose offer the program that best suits your needs and lifestyle.
More on credit card rewards perks
Some credit cards come with worthwhile perks. For example, an airline- or hotel-branded travel card might offer free access to one or more of the following:
- Airport lounge access
- Priority boarding
- Checked bag
- Discounted car rental
- Hotel room upgrade
- Complimentary breakfast and Wi-Fi
- A higher tier in the company’s loyalty program
- Concierge services
Some non-travel cards offer other perks, including travel insurance, travel upgrades, and protection from theft, damage or fraud on goods purchased using the card. Others may offer VIP experiences at concerts and sporting events.
As a rule, the cards with the most generous perks come with the highest annual fees. So, it’s up to you to shop around for a card with a fee-to-perks balance that suits your needs.
How do credit cards work with your credit score?
Your credit score can affect whether your credit card application is approved and the interest rate you pay. But did you realize how big an impact your cards are likely to have on your score? Paying your monthly card statement on time is hugely important, just as it is for your other bills. But there’s another influence on your score that only store and credit cards exert.
Credit utilization ratio or credit usage
Credit utilization ratio is the percentage of your credit limit that your balance represents. Suppose your card has a $5,000 limit and your statement balance is $3,000. Your credit utilization ratio is 60% because $3,000 is 60% of $5,000.
FICO, the company behind the most commonly used credit scoring technology, used to say you should keep your ratio below 30% to avoid harming your score. And VantageScore still says that.
However, FICO has recently changed its advice about the ideal ratio: “Generally, keeping it below 10% (and consistently paying bills on time) can help you build and maintain a good FICO® Score.”
That 10% sounds very low. But it might be wise to aim for it, especially if you’re applying for a mortgage, auto loan, credit card or other major borrowings anytime soon. This is because 30% of your credit score depends on your credit utilization ratio.
One solution may be to get several cards and spread the load across them all, keeping the ratio for each below 10%. Just leave plenty of time between each application because applying for too much credit over a short time may also harm your score.
Your credit card goals
If you want to get the best from your credit cards, you should aim to:
- Pay off your balances every month. This way you never pay a cent in interest
- Keep each balance below 10% of that card’s credit limit. Your credit score should rise, all other things being equal
- Get the right rewards card. Find the rewards cards that deliver the things you value most
- Avoid cards with annual fees. Pay an annual fee only when it delivers perks and rewards that are worth more than that fee
In a nutshell
Understanding how credit cards work is essential for responsible financial management. By using a credit card, you can make purchases, build credit history, and enjoy various perks and rewards. However, it's crucial to be mindful of interest rates and fees to avoid accumulating debt. Maintaining a good credit score and keeping a low credit utilization ratio are key to accessing favorable terms and unlocking better credit card offers in the future. By using credit cards wisely, you can leverage their benefits while staying in control of your finances.
Credit cards offer a convenient and flexible way to manage expenses and build creditworthiness. They provide a revolving line of credit, allowing you to make purchases and pay them off over time. However, it's important to use credit cards responsibly, paying attention to interest rates, fees, and rewards programs. By being aware of your spending, monitoring your credit, and making timely payments, you can maximize the benefits of credit cards while maintaining financial stability and achieving your long-term financial goals.
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