How Does a Credit Card Work?

Posted by Frank Gogol

Credit cards have become quite a convenient tool for paying bills and making purchases. That being said, even if they are so common nowadays, not everyone knows how exactly they work or what makes them such good tools. How does a credit card work exactly? This article is here to explain all the strong points of a credit card and how to choose one – therefore eliminating all the confusion.

What Is a Credit Card?

Credit cards are physical cards that may be used to pay bills and make purchases – and depending on the type of credit card, withdraw money as well. One simple way to describe a credit card is to look at it as if it were a short-term loan.

Simply put, whenever you get a credit card, the credit company offers you a certain credit limit from which you can borrow. The money that you borrow will have to be returned within a certain time limit and may be used for anything from groceries to pricier purchases. This is precisely why credit cards are such a great option for improving your credit score.

The available credit is reduced the more you charge on your credit card. Once you pay back everything you owe to the credit company, you will be able to make purchases with the credit card as well.

Credit Card vs. Debit Card

Credit cards and debit cards may seem like they are the same thing, but they aren’t. The main difference is that while debit cards rely on your own money and your account, credit cards don’t. When you buy something with a credit card, you aren’t exactly using your funds to do so; instead, you are using the money that the credit company made available for you. That money will have to be paid right back – and obviously, it will be paid back with interest.

On the other hand, debit cards are linked to your checking account. Once you make a payment with your debit card, the money will be pulled from your account, as soon as you make the transaction. You won’t have to pay anything back, because after all, it was your money that you used in the first place.

Credit cards and debit cards are also different in terms of how they affect your credit score. If you use a credit card, the things you do will directly affect your FICO credit score. Missed payments may also look negatively on you, so when you use a credit card, it would be exactly like you would be with a loan. Making payments on time will also affect you just the same, as this will work to improve your credit score.

On the other hand, a debit card won’t affect your credit score whatsoever because that’s your money. If you’re broke, that’s your problem. If you don’t add money to your debit card for three months, that’s also your problem. Debit cards are not linked to credit bureaus, so if you use all the money without putting anything back, it won’t affect you (other than the fact that you’ll probably be broke or unable to pay with your debit card).

How Credit Cards Work

As mentioned, credit cards are a way for you to make a payment to a store or a merchant. Regardless of what you use the credit card for, whether you are paying bills or buying something, the details of your card will be sent to the bank of the merchant. The bank will afterward receive authorization from the credit card company and process your transaction. Once the information has been verified, the transaction may be either accepted or refused.

If the transaction has been accepted, the credit company will take from the available credit and pay it to the merchant. Once the billing cycle comes to an end, you will receive a statement from the credit card company, telling you exactly how much you owe for the previous month’s transactions. You will also be told the minimum payments that you will have to make in order to repay your debt.

You will receive a grace period on your statement, during which you can give all the money back without any interest. You will also be able to make payments past that date, but if you manage to pay everything back in full, you will be charged interest as well. The more you drag out the payments, the more it will reflect on your annual percentage rate.

How to Compare Credit Cards

Let’s say that you are on the market to get a credit card. Every credit card is different, so when you decide to get one, you need to consider any comparing aspect. Some key features to look at include:

  • APR for cash advances and balance transfers
  • Variable APR for regular purchases
  • Annual fees
  • Promotional terms and conditions for the APR
  • Introductory bonus offers
  • Reward programs

Moreover, credit cards may have certain benefits and features – so, if you are getting them for a certain purpose, then you might want to consider them as well. For example, a travel credit card might earn you points for hotel stays and flights, so it is helpful to compare any extra benefits.

Types of Credit Cards

There are multiple types of credit cards, which means that depending on your preferences and needs, you might want to go with a particular kind. The basic type that you see everywhere is the bank-issued credit card, but aside from that, here are some other types of credit cards that you might want to consider:

Reward Credit Cards

Exactly the way it sounds, a reward credit card is a type that brings back rewards to its user. The more you use it, the more rewards you can get. This can include anything from flight points to hotel stays, statement credits, and cashback. The first reward credit cards aren’t exactly the most rewarding ones, but if the first one is used responsibly, then it should be easy for you to get a better option later on. The more credit cards you have, the more rewards you may get.

Secured Credit Cards

Most credit cards are unsecured: you apply, you get a credit limit. However, secured credit cards are for the riskier borrowers – those that have particularly bad credit. These credit cards will need a security deposit before they get approved – a certain sum from which the credit bureau can pull if you aren’t timely enough with your payments. With that in mind, payments made with secured credit cards are reported to the credit bureau, so if you make your payments on time, they can be a very good way for you to build credit.

Charge Cards

These are similar to standard credit cards, but there is a big difference between them: they don’t have a monthly borrowing limit (although you do have a limit for charges at a time). Also, unlike credit cards, you can’t carry the remaining balance into the next month. Everything needs to be paid by the due date.

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The Bottom Line

Credit cards are a great way to build your credit score while giving you a way to make payments. Obviously, the money needs to be given back just like a loan would – but at least, you’ll know it will be there when you need it. These great financial tools can help you a lot in the future.

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