What is Credit Card and How Does It Work?

Our wallets are full of little plastic rectangles that seem harmless but can do serious financial damage. It’s easy to forget you are spending money when you whip out a credit card or (even worse) pay with a phone app (tied to a credit card) or use the one-click checkout (tied to a credit card). 

Every time you swipe the card (or the app, or the one-click checkout), you borrow money, and the credit card issuer lets you borrow until you reach your credit limit (and sometimes lets you keep doing it). This convenience comes at a price, and most people do not realize how much these loans (yes, they are loans) cost until they are loaded with credit card debt.

What Is A Credit Card?

Credit cards are issued by financial institutions, usually banks, and allow the cardholder to borrow funds from them. Cardholders agree to repay the money with interest, based on the institution’s terms. Categories of credit cards include:

  • Standard credit cards: These cards do not have an annual fee, and users can use them for purchases, balance transfers, and cash advances.
  • Premium credit cards: In addition to perks like concierge service, access to airport lounges, special event access, and more, premium credit cards usually charge a higher annual fee.
  • Reward cards: Cashback, travel points, or other benefits are offered to customers who use rewards cards.
  • Balance transfer cards: The introductory interest rates and fees on balance transfer cards are low compared to those on other credit cards.
  • Secured credit cards: Collateral is held by the issuer on secured credit cards in the form of an initial cash deposit.
  • Charge cards: Unpaid balances on charge cards are not carried over from month to month because there is no set spending limit.

Rewards cards offer credit card holders many benefits not available to debit cardholders, including cashback, discounts, travel points, and more. You can earn rewards at a flat rate or at a tiered rate. You might have a card for purchases that offers two miles per dollar and another card that gives three miles per dollar for travel, two for dining, and one for everything else. The miles could then be redeemed for travel in the future.

Major credit card issuers include Visa, Mastercard, and American Express. These card companies allow you to make purchases up to a preset credit limit ranging from $500 to $10,000 or more, depending on your income and credit history. You can pay the balance in full each month, the minimum required by the card company (typically around 2 to 4 percent of the balance), or any amount in between.

Learn more about the common credit card fees.

What You Need To Know Before Using A Credit Card

Under the Truth in Lending Act, credit card companies must clearly disclose certain information on both their applications and cardholder agreements. Most people skip over this. It’s a lot of information and numbers that may not seem important, but they play an enormous part in your financial future. At the very least before you apply for and use the card, make sure you know this information:

  • Regular APR (for purchases), which may include multiple rates or a range of rates, and whether that APR is fixed or variable
  • Promotional APR, when that promotional rate ends, and what can invalidate the promotional rate (a late payment, for example)
  • Penalty APR, what causes it to go into effect (usually missed payments), and how long it lasts
  • Grace period, how long you have to pay your full balance without incurring interest charges
  • Finance charges, including how they’re calculated and the minimum finance charge
  • Fees, which must include every fee you could possibly be charged with

Pros of Using A Credit Card

There are many reasons people use credit cards, but the number one reason is simplicity; it’s easier to use a credit card than virtually any other payment method. 

Credit cards are easier to physically carry than cash, don’t limit your purchase to the amount in your wallet, and give you the option of paying now or later (you can make credit card payments every time you use them if you want to). 

In some circumstances, paying with a credit card may be your only option. Common examples include booking a hotel room, renting a car, prepaying for E- ZPass, or buying plane tickets (though you might be able to make these purchases with a debit card). 

Plus, credit cards add a layer of safety. If you lose cash, it’s just gone, but if you lose a credit card, you can cancel it and request a new one.

The Costs of Credit Cards

There are several types of costs associated with credit cards. The annual fee is a flat dollar amount the issuer charges each year for the use of the card. Many, but not all, issuers charge annual fees.

Finance charges are calculated based on the interest rate your card issuer charges and are the main cost of using credit. These rates vary significantly from one card to another, so you can save a lot of money by shopping around for a card with a lower interest rate.

Other fees that you might incur on your credit card include application fees, processing fees, charges for exceeding your credit limit, late-payment fees, balance-transfer fees, and fees on cash advances.

How Credit Cards Work

Online and in-store purchases can be made using credit cards. In either case, the bank of the merchant receives your credit card information. From the credit card network, the bank obtains authorization to process the transaction. After verifying your information, your card issuer will approve or decline the transaction. 

Once the transaction is approved, payment is made to the merchant and the available credit on your card is reduced. Card issuers will send you a monthly statement at the end of the month that shows all the transactions, the previous balance, the new balance, your minimum payment amount, and the due date. 

The grace period, commonly twenty-five days, is the time between the date you’re billed and the date your payment is due. If you pay your entire balance within the grace period, you may not incur any interest charges.

If you carry a balance, there’s often no grace period on new purchases, so interest starts accruing from the date of purchase. Some issuers charge interest from the day you make the purchase, even if you pay your balance in full, so in effect, there is no grace period.

When you add the fact that charges made at the start of the monthly billing cycle already give you a one-month deferral on payment, this grace period may result in a six-week, interest-free deferral on payment. The Credit CARD Act of 2009 mandates that the grace period, if offered, shall be for a minimum of twenty-one days.

Your card issuer can charge you interest if you carry a balance month after month. Annual percentage rates (APR) on credit cards reflect the cost of carrying a balance over an annualized period. If your credit card has an annual fee, your APR will also include the annual fee. 

The Prime Rate determines the APR for most credit cards. APRs can change over time, however, the CARD Act of 2009 establishes strict guidelines for when credit card companies can raise your rate.

Learn more about how to use a credit card effectively.

Credit Cards vs. Debit Cards

Although they may seem the same, credit cards and debit cards are not the same. Credit cards enable you to make purchases without spending your own cash right then. Instead, you spend the credit card company’s money, which you will have to repay with interest. 

A debit card, on the other hand, is linked directly to your checking account (it’s not the same as a prepaid card). As soon as the transaction is processed, the money is automatically deducted from your bank account. The money has been taken from your account already, so you don’t need to pay it back later.

As far as credit scores are concerned, debit and credit cards differ. Debit card usage is not reported to the credit bureaus, so it has no impact on your credit score.

In contrast, credit cards can directly affect your credit score. The FICO score, for instance, is calculated using:

  • Payment history
  • Credit usage
  • Credit age
  • Credit mix
  • Inquiries for new credit

Your credit score can improve if you make your credit card payments on time, while a late payment could damage it. In addition, maintaining a low balance in relation to your credit limit can positively impact your score, while maxing out your cards can negatively impact it. 

Debit and credit cards also differ greatly in terms of fraud protection. Credit cards, according to federal law, are more protected from fraud than debit cards. 

How to Compare Credit Cards

It is important to compare cards before buying a credit card, whether it is your first card or your next one. Here are some key factors to consider:

  • Variable APR for purchases
  • APRs for cash advances and balance transfers
  • APR promotional terms and conditions
  • Annual fees
  • Rewards programs
  • Introductory bonus offer terms

Before you choose a credit card, think about how you intend to use it. If you pay the balance in full every month, the annual fee and other charges may be more important than the APR (the interest rate charged), so you should look for a no-fee or low-fee card.

Even if the issuer charges an annual fee, you may be able to get it waived by calling and asking the company to remove it. If you carry a balance and pay for your purchases over time, the APR and the method of computing your balance are most important, so you’ll want to look for the lowest interest rate and the longest grace period.

Beware of teaser rates, which sound tempting because the introductory rate is much lower than the going rate on most cards.

The downside is that if you have a balance on the card when the introductory rate ends, you could be in worse shape than if you’d had a higher rate all along, depending on how high the rate spikes at the end of the introductory offer and whether interest accrues all the way back to the original purchase date.

It is also imperative that you make all minimum payments during the introductory period in a timely manner, or the rate will revert instantly to that higher rate.

The Minimum Payment Con

Minimum payments on credit cards are specifically calculated to keep you in debt for as long as possible. It’s how credit card companies maximize their profits, by charging you interest for years. 

If you carry a balance (which is what they want and encourage you to do), everything you buy could end up costing you double or triple (sometimes even more, depending on the interest rate) the original charge. When you stick with their minimum payment plan, you lose money and they win effortless profits.

Minimum Payment Math 

Minimum payments are based in part on how much you owe, usually the larger of an extremely small percentage of your balance due or a fixed dollar amount (often $25). You can find the details for your card in your cardholder’s agreement in the “payments” section. 

Some issuers go with a flat percentage (usually 2 percent, sometimes as high as 5 percent, but that’s rare) of the balance due; for example, if you owe $5,000, your minimum payment would be $100 ($5,000 × 0.02). Others go with a lower percentage plus interest, normally 1 percent plus whatever the current month’s interest charges work out to. 

If you’re behind on payments, your current minimum payment will also include prior months’ missed minimums plus penalties and fees. Remember, the credit card company’s minimum payment amount is for their benefit, not yours. 

Paying this amount by the due date will let you avoid late payment fees and higher penalty interest rates, but that’s all. It will keep you in debt for years (maybe decades) and cost you a ton of money in interest—exactly what the card issuer wants.

The True Cost of Minimum Payments

Credit card statements now come with minimum payment “warnings” that show you explicitly how much making only these payments will cost you over time. Don’t just glide over that part of your bill (and, yes, you absolutely must look at your credit card bill every month). 

The sticker shock might help jolt you into making bigger-than-minimum monthly payments. If you follow the credit card company’s plan and pay just 2 percent of your balance every month, it will take you years to pay it off. Your minimum payment probably just covers more than the prior month’s interest charge, making only a teeny dent in the original principal balance. 

By paying any amount more than the minimum—even just $5 or $10—you’ll pay off your credit card debt faster and pay less interest over time. Consider this example: Let’s say you have a $5,000 balance due on an 18 percent credit card, and you don’t make any new purchases. If you make their 2 percent minimum payment every month (which starts at $100), it will take you 39 years to pay it off. 

Plus, you’ll pay $13,396.53 in interest, which quadruples the cost of whatever you bought. But if you add just $10 a month to your minimum payment, you’ll pay off that debt in just six years, and pay $3,460.53 in interest. 

And if you add $25 a month to the minimum, your debt will be done in just over five years, with total interest charges of $2,693.11. 

Go online and play around with some credit card calculators to see what an enormous difference paying any amount more than the minimum will make. You can find credit card minimum payment calculators at www.bankrate.com and www.creditcards.com.

Final Words

Credit cards can be a credit-building tool if used responsibly. Paying your bill on time, maintaining a low balance and only opening credit cards as needed can help you build and maintain good credit. Also, keep in mind that the best way to avoid interest charges and build a strong credit score is by paying your bill in full each month

Frequently Asked Credit Card Security Questions

How to keep your credit cards safe?

Your best protection against credit card fraud is to know where your cards are at all times. Don’t carry credit cards with you unless you know you’re going to need them. Don’t leave them lying around on your desk at work or in your car or anywhere else they could be accessible to others.

When you get a renewal credit card or you cancel a card, cut the old card up into small pieces, being sure to cut through the number. Ideally, run old cards through the shredder. Don’t disclose your credit card number over the phone unless you’re dealing with a reputable company and you’re the one who placed the call to them.

Scammers often use phishing scams whereby a computer dialer poses as your bank and asks you to call in to discuss transactions in your account. They send emails that look like they’re from your credit card company, warning you about fraudulent charges and asking you to enter your login information to verify your identity. Your bank will never ask you for personal information by email.

What to do if your credit card is lost or stolen?

As soon as you realize your credit card, ATM card, or debit card has been lost or stolen, report the loss immediately to the bank or other issuer in order to limit your liability if the card is used fraudulently. Keep a list of your credit card numbers in a safe place so you can report the loss as quickly as possible. Under federal law, if you report the loss before any unauthorized charges are made to your credit card, you can’t be held responsible for any charges.

If a thief uses your card before you report it missing, the most you will owe for unauthorized charges is $50 per card. If somebody uses your credit card number fraudulently without physically stealing the card itself, you are not liable for the charges.

After the loss of your card, review your monthly statements carefully and report in writing any unauthorized charges. Lost credit cards should also be reported to each of the major credit reporting agencies: Experian, TransUnion, and Equifax. Ask them to place a security alert or a freeze on your account to intercept possibly fraudulent applications for credit.

How to deal with identity theft?

Identity theft occurs when someone uses your personal information such as your name, credit card number, or Social Security number to commit fraud or theft. Using just your date of birth and Social Security number, thieves can apply for a credit card in your name, and rack up big charges before you even know the account has been opened.

When the balance isn’t paid, the delinquency is reflected in your credit history. Some thieves will even call your credit card company and report a change of address on your account, or they’ll access your account online and change the password and contact information so you can no longer access your account.

Other scams include setting up cellular phone service in your name or opening a bank account in your name. Be careful of how and where you dispose of bank statements, credit card offers, credit card statements, or any document that includes your date of birth or Social Security number.

Consider purchasing a personal shredder and shredding these documents before throwing them in the trash. If you believe you have become a victim of identity theft, file a report with your creditors, the three credit reporting bureaus, the IRS, and your local police as soon as possible.

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