How Do Credit Cards Work?
Posted by Frank Gogol
More than 191 million Americans own a credit card. Credit cards are an option considered by many when it comes to saving money or building credit history. Still, before creating your card, you may not know exactly what this card is and how it works.
So, how do credit cards work? Read on to find out!
Table of Contents
What Is a Credit Card?
A credit card is a physical card that works like a short term loan. Getting a credit card gives you access to a credit limit, and you can use this amount for various purposes. You can withdraw money, make purchases, or pay bills. It all depends on the type of credit card that you own. The credit limit on your card is basically how much cash the company allows you to use.
When you use the card for any payment or money withdrawal, the amount you have there will be reduced, and you’ll then have to repay the amount you spent. You are borrowing money from the card issuer – money that you’ll have to pay back, obviously.
Difference Between Credit Cards and Debit Cards
It’s easy to confuse credit cards with debit cards – they’re both plastic cards that you use for payments. However, they are different in several aspects and it’s important to understand that so you aren’t making any confusion.
A debit card is a nice way for you to directly withdraw cash from your checking account. This is not a loan. So, you will not be charged any interest when you use the card. Besides, you are not asked to make any monthly payments for it. You just have to pay attention to it and not charge more cash than you have available in your checking account. Debit cards usually don’t charge annual fees – they may only have overdraft fees if you don’t have the necessary funds in your checking account. Also, these cards cannot help you improve your credit rating.
On the other hand, a credit card is used for payments or withdrawals, but the money you use will have to be paid back. Every month, you will have to make at least a minimum payment towards the card and do that by the due date. The payments will have to be made every month as well. Interest will also be charged if you don’t pay off the full balance. Credit cards also come with an introductory annual fee or an annual fee. They can also help you improve your credit score.
How Credit Cards Work
So how do credit cards work? Well, the first thing that happens is that you’re approved for a credit card with your bank. After that, you are going to get a credit limit authorized, which is the amount of money you are allowed to borrow and then use for whatever you want. The bank will calculate the credit limit based on several factors. These usually include your income, debts, and the amount of credit you may have on other credit cards.
As previously mentioned, you can use a credit card to withdraw money, buy stuff online, or pay bills. When this happens, the details of the card will be sent to the merchant’s bank, after which they get authorization from the credit card network for processing the transaction. Then, the card issuer will have to take a look at your information, and then decide if they’re going to approve or decline the transaction.
The payment networks are the ones processing credit card transactions, and such networks include MasterCard, Visa, American Express, and Discover. After they process the transaction, they ensure that the money is going to the merchant to perform the purchase, after which the cardholder is getting billed accordingly.
Then, when the end of the billing cycle arrives, you will receive a statement from the card issuer where all your transactions for the month will be visible. It will also show you your previous or current balance, as well as how much you have to repay and the due date for the repayment.
You can choose to only pay a minimum amount every month or pay the entire balance in full. Paying in smaller amounts every month is going to be more expensive because you’ll be charged interest for all these payments. On the other hand, if you pay in full every month, you will have a grace period. This will let you avoid paying interest on any of your purchases, which is a better option in the long run.
Not to mention that your payments will be reported to the credit bureaus and thus build a credit report for you. The credit history is 35% of your credit score. If you want to avoid your credit score being damaged, you have to pay the minimum amount you owe every month.
How to Compare Credit Cards
Are you planning on getting your first credit card, or even a second one? If that’s the case, you must know how to compare different companies and cards. The main things to pay attention to when comparing credit cards are:
- Annual fees
- The APR for cash advances and balance transfers
- Introductory bonus offer terms
- The regular variable APR for a purchase
- Promotional APR terms and conditions
- Rewards program
Types of Credit Cards
There are various types of credit cards and you should know them so that you can choose wisely.
Low-interest cards are those that can give value with a smaller interest rate which makes carrying a balance less expensive. They may come with a 0% introductory APR period.
Students can get this credit card as long as they are over 21 years old, or if they have a co-signer or proof of income. It can help pay the tuition fee or they can use it for other expenses.
Cards for Average or Bad Credit
Although limited, it is possible to get a credit card for average or bad credit. You get higher interest rates and fewer rewards, though. You can use them to improve your credit rating over time.
Balance transfer cards let you transfer your debt to another issuer so you can have a lower interest rate. You need to have good credit to do this.
A reward credit card will reward you for every purchase, and you need good credit to obtain one.
Reasons to Get a Credit Card
Now, why would someone get a credit card? Here are a few reasons:
- Credit building – Owning a credit card can help build credit if you are a responsible user and pay back on time.
- Sign-up bonuses – You can get a bonus that helps you start an emergency fund.
- Rewards – Some cards offer you rewards for part of the amount you spend.
- Flexibility – You can pay your balance over time or pay in full every month.
- 0% Introductory APR period – This benefit lets you avoid interest on balance transfers or purchases for a certain period.
If you know how to use it and you’re responsible, then a credit card can be a blessing. However, make sure to compare various credit cards before you get one. Also, remember to make the repayments on time to build your credit.