If you’re not familiar with how credit cards work, they can be intimidating to use.
I put off getting a credit card for years because I didn’t understand them. Plus, I was afraid of getting into massive debt. In fact, a woman I once interviewed failed to understand just how do credit cards work — and racked up a $12,000 balance as a result.
But once you understand them, you see them for what they are: financial tools that you control. Credit cards can be invaluable for quickly building credit. However, if you’re not careful, it can be too easy to charge more than you can repay.
By understanding credit card basics, you will know how to responsibly spend with one — and always pay it off.
7 essential credit card Q&As
So how do credit cards work? Let’s start with the basics.
1. What is a credit card?
Credit cards – plastic cards that banks and financial institutions grant to cardholders – have information encoded in them that ties them to your credit card account. This information is used by merchants to process purchases and charge them to your credit card account.
2. What is a credit card account?
Your credit card is tied to a credit account — which is a borrowing tool and a form of debt. But unlike an installment loan, a credit card is a form of revolving credit.
This means that instead of borrowing all the money at once like you do with a loan, you borrow as you spend with a credit card. Every time you make a purchase with your credit card, you are doing it with the issuer’s money, not your own.
A credit card account will have a limit. This is the maximum amount the credit card company will let you borrow on the account.
3. What is a credit card balance?
Any transactions charged to a credit card are added to your credit card balance. This is the amount of money you’ve borrowed by charging purchases to your credit card but have yet to repay.
You add to your credit card balance every time you swipe your credit card, and you lower it every time you make a credit card payment.
However, try to limit your credit card balance to what you can repay each month in full. This is a good guideline to follow to keep your credit balance low and ensure you don’t borrow more than you can repay.
4. What is a minimum payment on a credit card?
The minimum payment is the amount you must pay each month to keep your credit card accounts in good standing. Your minimum payment will be due on your credit card due date each month.
A minimum payment is calculated based on your credit card balance. It is usually two to three percent of your credit card balance, or the outstanding interest you owe plus one percent of the balance. Most credit card issuers also have a flat amount that is the smallest they’ll charge on a credit card each month, typically $15 to $35.
The minimum payment on a credit card is small compared to your overall balance. It’s also recalculated each month. This means that the average credit card balance can take over a decade to repay with minimum payments alone — and you’ll pay hundreds in credit card interest during that time.
5. What is credit card interest?
Credit card interest, also called a credit card finance charge, is the cost you pay to have a balance. This is set by your credit card annual percentage rate (APR), which is the rate at which your balance accrues interest.
Figuring out how do credit cards work with interest can be complicated. But put simply, you will pay credit card interest on your average daily balance for the month.
You will usually have a 25-day grace period to repay a balance with your credit card issuer before it charges interest on the borrowed money. Pay off your credit card in full each month and you won’t pay credit card interest.
But if you charge, say, $100 this month and only pay $50 back, you’ll accrue interest on the remaining $50 until you repay it.
Therefore, you should always pay more than the credit card minimum to keep balances low. It will also help you avoid credit card interest and serious credit card debt.
6. What are credit card fees?
An important part of understanding how do credit cards work is to know what your credit card is costing you.
All credit card costs, APRs, and fees will be outlined in your credit card agreement that you sign when opening a credit card. Carefully read this to ensure you understand your credit card.
Different credit cards will have their own fee schedules, and some will charge more while others will charge less ― or skip some credit card fees altogether.
The main fee you should worry about is the annual credit card fee, which you are charged each year simply for the privilege of having the credit card. Depending on your credit card, you could face an annual fee of $0 up to $500. A typical credit card fee is around $50 to $60 a year and will depend on the type of credit card you have.
Credit card companies will also charge other fees on certain transactions such as:
- Balance transfer fees. These are charged when you use one credit card to pay off the balance on another credit card.
- Cash advance fees. These are charged when you borrow from your line of credit in cash, rather than through a purchase.
- Foreign transaction fees. You pay these for purchases made outside of your domestic country.
- Late payment fees. You pay these if you make your credit card payment after your monthly due date.
7. What are the different types of credit cards?
There are various types of credit cards and some work differently than others. Here are some common types of credit cards, as well as what makes them stand out:
- Rewards credit cards give cardholders rewards for making purchases on their credit card. Rewards can be cash back, or points that can be redeemed for travel purchases or other goods.
- Secured credit cards require a deposit of cash that is used as collateral against the credit card balance. Because they are secured by the deposit, these cards are easier to qualify for. They can be a good option for consumers who want to rebuild credit.
- Charge cards require borrowers to repay their balances in full every month. So the minimum payment is always equal to the monthly charges on the charge card.
- Retail cards are credit cards that are issued by a retailer or store, rather than a credit card company or bank. These credit card accounts are with the store itself.
How do credit cards work? Simply, if you’re knowledgeable
At the end of the day, credit cards can be a tricky financial tool to use. Too many credit card users make credit card choices that hurt their finances and credit simply because they don’t understand them.
If you’re new to the world of credit cards, take your time learning about them and figuring out how does a credit card work. When you understand credit cards, you will know how to get the most benefit from them. And you’ll also avoid making disastrous credit mistakes simply because you didn’t know better.
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