How Credit Cards Work

How Credit Cards Work article image.

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Credit cards work by letting you borrow up to a certain amount of money and repay it at your own pace.

As a credit card holder, you agree to certain terms and limits on your borrowing and pay interest on the amount you borrow. Interest fees are charged as a percentage of your borrowed amount, and it's important to understand how much these charges work before you start making purchases.

Responsible credit card use builds up your credit history and can help you reach your goals such as owning a vehicle or buying a house. Credit card mismanagement, however, has some serious consequences.

What Is a Credit Card?

A credit card is what's called revolving credit, which means you can borrow and repay using the same card repeatedly. When you make a purchase with a credit card, you're not agreeing to pay it off on any set timeline or term. Your credit card payments can vary as long as you're meeting a certain minimum monthly payment amount set by the company that issued your credit card.

Revolving credit works very differently from installment loans, such as student, auto and home loans. With installment loans, you borrow a certain amount and repay it in fixed monthly installments. Once the term ends and the money is repaid, the loan is done—you can't borrow any more on the same loan.

Because credit cards let you borrow on an ongoing basis, they provide more flexibility than installment loans. But because credit card repayment is less rigid, it's possible to get in over your head.

Beyond using credit as a means to borrow money, there are plenty of reasons to carry a credit card:

  • Build credit: Establishing a responsible repayment history with a credit card is one of the easiest ways to build and improve your credit score. A higher credit score can help you secure better terms on future borrowing, such as a mortgage.
  • Earn rewards: You can use a credit card to earn rewards on the purchases you're already making. Many cards provide cash back on purchases or discounts on travel.
  • Additional protections: Credit cards offer better fraud protection than debit cards. Many credit cards also come with benefits such as purchase protection, price protection and extended warranties.
  • Track spending: If you like to budget or just keep a close eye on your purchases, using a credit card for all your spending can make it easier to see all your transactions in one place. Some issuers let you sort spending by categories.

Credit cards have numerous benefits, but won't improve your financial health if they're not used properly. Make sure you're familiar with credit card basics before you apply.

How Do Credit Card Balances and Payments Work?

When you hear the phrase "credit card balance," it can mean one of two things:

  • Current balance: This indicates the current tally of charges on your card (plus any interest and fees). It's how much you owe on your card in total at any given time.
  • Statement balance: This is how much money you owe at the end of each billing cycle. Credit cards only require you to make a minimum monthly payment; you are not required to pay the entire balance.

Credit cards are billed on a monthly cycle. If you make purchases on the card and pay them off in full by your due date, you won't pay any interest on those transactions. However, if you can't pay them all off and carry a balance, the remaining balance rolls over and begins to accrue interest.

When your monthly bill is due, you are only required to make a minimum payment in order to keep your account in good standing. However, you should try to pay off as much of your balance as you can; otherwise, interest fees can add up and make it harder to get out of debt.

Keep in mind that you can also make a payment toward your credit card at any time—not just when your statement balance comes due. If paying small amounts over time works better for you than making one larger payment once a month, consider doing that instead.

If you're worried you may forget to pay, setting up an automatic payment for at least your minimum payment will help make sure you don't end up with a late payment in your credit report. Alerts can help too, whether they remind you to pay your bill or to prevent you from overspending by letting you know your balance has reached a certain amount.

How Does Credit Card Interest Work?

Your credit card's annual percentage rate (APR) indicates how much interest you'll pay on revolving balances—in other words, the balance you carry from month to month if you can't pay it off in full.

Credit cards have a grace period in between the statement closing date and the due date, and if you pay off your statement balance in full during this time, you won't owe any interest. The length of the grace period varies by issuer, but it's typically around 21 days.

If you do carry a balance, you'll have to pay interest. Credit card interest charges are calculated based on your average daily balance, the number of days in your billing cycle and the percentage rate the card issuer applies to the balance.

Be aware that some cards have different APRs on purchases and balance transfers. Additionally, some cards begin with 0% APR for a set time period and then later switch to a standard APR—this is called an introductory or promotional rate. APRs can be fixed or variable.

In addition to repaying your purchases and paying interest fees, you may at some point owe other credit card fees in your bill. For example, if your card has an annual fee, it will be added to your statement balance once a year. You will also typically face fees for returned payments, late payments, exceeding your credit limit as well as interest charges on cash advance and balance transfers. Some credit cards charge foreign transaction fees on purchases made in other countries or in other currencies.

How Do Credit Cards Affect Your Credit Score?

Credit cards affect your credit score significantly, though it's up to you to make sure they're doing so in a positive way. Your payment history is the single most important factor in your credit score, and thus making all your payments on time can improve your score over time. Making late payments, or missing them altogether, can hurt your score. Here are a few other ways credit cards can affect your credit score:

  • Credit utilization ratio: This measures how much of your available credit you're currently using and is the second biggest factor in your credit score. Carrying a balance on a credit card that brings it close to its limit can be a red flag to lenders, and reflect negatively in your credit scores. Find a card's utilization ratio by dividing its balance by its limit and converting to a percentage by multiplying by 100. Credit scoring models consider credit utilization on a per-card as well as a total basis. A ratio above 30% can start to harm your scores, but the lower, the better.
  • Hard inquiries: Whenever you apply for a new form of credit, such as a credit card, something called a hard inquiry is added to your credit report. These tend to hurt credit scores, but their impact shouldn't be huge or long-lasting. Many hard inquiries over a short span of time, however, can start to drag down your credit scores more significantly.
  • Credit mix: Credit scoring models also consider your experience with diverse forms of borrowing. Having a mix of installment loans and revolving credit accounts in your name can make a positive impact on your scores, but it's not wise to take on new debt solely to address this factor.
  • Age of accounts: The more experienced you are with borrowing, the more it can benefit your credit score. If you open a credit card account and use it wisely over several years, that longevity can help your credit score rise.

How Do You Get a Credit Card?

Credit cards come in many different forms, so you'll need to choose a type of credit card you want to apply for. There's a lot of variety among the credit cards on the market, but here are a few types you should familiarize yourself with:

  • Secured credit cards: If you're new to the world of credit, a secured card can help you establish yourself as a borrower. You'll have to put down a security deposit, which becomes the amount you can borrow up to. Because the card is secured with collateral, credit card issuers are usually more open about granting these to new borrowers. Once you've used the card responsibly for six or more months, you may be eligible to move up to a traditional unsecured credit card and get your deposit back. Secured cards may come with fees charged on regular intervals, such as annual fees.
  • Unsecured credit cards: An unsecured card doesn't charge a security deposit but may be harder to qualify for. Unsecured cards don't require collateral, but may charge fees to maintain your account.
  • Student credit cards: College students may be best served by a student credit card, which is geared toward those with no credit history.
  • Store credit cards: You may have been offered a card like this at the checkout counter of a major retailer. These cards can help you build your credit just like any other card, but you may be limited to using it at only certain businesses.

Once you've decided what type of credit card you'd like to have in your wallet, it's time to apply for a credit card. If you know which card you want, or which bank or issuer you'd prefer to work with, you can usually apply online directly. If you're not sure which card you want, or you're unsure what you could qualify for, you can try Experian's free CreditMatch™ tool to get personalized credit card offers based on your credit profile. Once you select one, you'll apply with the credit card issuer.

To apply, you'll have to provide some basic personal and financial information, such as your income and your Social Security number. In some cases, you'll receive an immediate decision. You may, however, have to wait for your application to be reviewed before you find out if you're approved or declined. If you are declined due to reasons related to your credit, the issuer has to explain why.

How to Use Your Credit Card Responsibly

Once you've received your card, make sure you know how to use it responsibly so you can build and maintain solid credit.

It's easy to rack up charges on a credit card, but don't forget to repay them along with any interest they may have accrued. Make sure you only charge what you can repay, ideally in full.

Paying your credit card bill on time every month will make a big positive impact on your credit, as will keeping your credit utilization low. Make sure you don't max out your card, and avoid carrying a balance larger than 30% of your credit limit.

Start by Checking Your Credit

If you haven't checked your credit score before, or haven't in a long time, consider checking your Experian FICO® Score for free. Then, periodically review it over time. Checking your credit regularly can help you see how your credit card use impacts it.

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