Credit Cards: How Do They Work?

Credit Cards: How Do They Work?
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If you’ve ever shopped or watched people pay in a store, no doubt you’ve seen someone using a credit card.

When you pay for something with a credit card, you make a promise to the credit card issuer that you will pay back the money you borrowed at a later date.

How Do Credit Cards Work?

Credit cards work by allowing you to purchase items and services now and pay for them later. In exchange for this loan, the credit card issuer may charge interest and fees.

Credit card companies often put a cap on how much you can charge. This is called your credit limit. If you exceed your credit limit, you’ll face additional fees and penalties. The credit card company may also increase your interest rate.

If you have good credit, you can likely get a credit card with lower interest rates. You may even be able to get a zero percent interest credit card. That is like getting a free loan to buy what you need now and pay for it when your credit card bill comes due. You may also get a rewards credit card that offers you cashback or points you can put toward travel, merchandise or gift cards.

Each time you make a purchase with your credit card, the credit card company keeps track of how much you spent. You’ll receive a list of all your purchases in your monthly credit card statement, which arrives with your credit card bill.

If you only make the minimum payment, it could take years to pay off your credit card balance, since your payment goes toward interest and fees first. Meanwhile, interest continues to accrue.

Credit card companies must provide a minimum payment warning that shows how long it will take to pay off your credit card if you make only the minimum payment, and how much you’ll pay in interest over time.

Heed that warning. That ​$800​ 4K TV you purchased could end up costing ​$1,000​ or more in the long run. That’s one way people get in trouble with credit card debt.

But, if you use your credit cards wisely, you’ll discover a number of benefits.

Using Your Credit Card to Make a Purchase

Today’s credit cards work in several different ways, designed to help protect the cardholder’s information and prevent credit card fraud. The most common technology in use today is EMV (EuroPay, Mastercard, Visa) chip technology.

In March 2019, ​99 percent​ of U.S. payment volume came through EMV chip cards, accounting for ​$81 billion​ in purchases, according to the technology company Thales Group. There were ​1 billion​ EMV cards in circulation at the end of 2019.

When you use an EMV card to make a purchase, you insert your credit card into the slot at the point-of-sale machine. You have the option of entering a personal identification number (PIN) or signing for the purchase. On some smaller purchases, no additional steps are required to process the transaction beyond inserting your card and clicking “yes” that you accept the charges.

Credit cards with a magnetic stripe are still accepted in many places. You swipe the card in the machine at the point of sale, and then sign for your purchase. This technology is not as secure as EMV chip technology.

Some of today’s newer credit cards combine EMV technology with Near Field Communications (NFC). To make a purchase, you only have to wave your card in front of the machine to transmit data securely.

People also use credit cards to shop securely online, entering their credit card number, expiration date, billing address and CVV code, which is a three-digit code on the back of the credit card.

The Difference Between Debit Cards and Credit Cards

At the point of sale, debit cards work essentially the same as credit cards. However, debit cards take money directly out of the bank account tied to the card each time you make a purchase. If you don’t have money in your account, your purchase could be declined.

You don’t pay interest on debit card purchases, since you’re using the money in your bank account. Most debit cards do not offer rewards to their customers, either, although a few banks do have debit card rewards programs.

You can use a debit card at an ATM to take money out of your bank account. Some credit cards allow you to take out a cash advance at an ATM, but credit card cash advances usually have high interest rates and cash advance fees.

Debit cards allow you to access the money in your bank account easily, and to enjoy the convenience of a digital payment method for in-store or online shopping without going into debt.

In addition to the chance to earn rewards, credit cards offer a few other benefits over debit cards. Many credit cards provide purchase protection; if an item you purchased with the card is lost, damaged or stolen within the first few months of purchase, the credit card company will refund the money or provide a replacement for the item.

Some cards provide price protection, which means if you find the item advertised for a lower price somewhere else within a certain time frame, the credit card company will refund the difference.

It’s worth noting that some rental car companies and hotels do not allow you to pay with a debit card. They require a credit card for payment so that if you damage the vehicle or hotel room, they can charge your credit card. Some credit cards also offer rental car insurance, which can protect you from added costs if your rental car gets into an accident.

Types of Credit Cards

Credit card companies offer different types of credit cards to fit people’s needs and their credit score. Let’s take a look at some of the most common types of credit cards.

Rewards Credit Card​ – Rewards credit cards fall into two buckets: travel rewards and cashback rewards. You typically need a good credit score of ​670​ or higher to qualify for a rewards credit card. Each time you use a rewards credit card, you earn points that you can then redeem for travel, gift cards, merchandise or experiences. Some travel rewards cards let you redeem your points for a statement credit.

Cashback credit cards give you cash back, usually in the form of a statement credit, for each purchase. If you have a good credit score and patience, you can save a lot of money leveraging credit card rewards programs.

Secured credit card –​ If you have no credit history or poor credit, a secured credit card can help you build credit. When you open a secured credit card, you make a deposit to the credit card issuer. That deposit becomes your credit limit. This way, if you default on your credit card payments, the credit card issuer is protected.

You can use a secured credit card just like any other credit card. You must make sure to make the minimum payment on time each month to build credit. Over time, the credit card company will review your payment history and may convert your secured credit card to a regular credit card, refunding your deposit. Many people apply for a secured card as their first credit card.

Charge card –​ A charge card like American Express Green works like a credit card, except you must pay the balance in full each month. Usually, charge cards have no credit limit, but you will face penalties and fees if you can’t make the bill in full when it comes due. Late payments can also damage your credit rating. The credit card issuer may even cancel your account.

Charge cards can help business owners and individuals manage expenses and earn rewards without the danger of getting into debt.

Prepaid credit card –​ Prepaid credit cards, sometimes called prepaid debit cards, bear the logo of one of the major credit card providers, such as Visa, Mastercard or American Express. They work just like credit cards, except you are accessing money you’ve pre-loaded onto the card.

They are different from secured credit cards because you don’t have to make monthly payments. They also don’t help you to build credit.

Store credit cards​ – Store credit cards are usually only good in one store, or perhaps a family of stores. They might offer discounts and coupons to loyal customers. Store cards, however, often have high interest rates, so you want to be sure to pay your balance in full each month.

Student credit cards​ – Some college students open a student credit card as their first credit card, taking advantage of perks and benefits tailored toward students.

Business credit cards​ – Business credit cards are designed for business owners. They may have added features such as the capability to generate itemized expense lists for the year, free cards for additional cardholders or rewards tailored toward businesses.

How Do You Get a Credit Card?

To get a credit card, first do the research. Check your credit score to determine what card you can likely obtain. Each time you apply for new credit, your FICO credit score drops by a few points. You want to apply for a card where you are likely to get approved on the first try.

Decide what’s most important to you in a credit card. You may consider aspects such as:

  • Low interest rate
  • No annual fee
  • Rewards program
  • Introductory APR
  • No balance transfer fees
  • Other perks and benefits

Once you decide what credit card will work best for you, go to the credit card issuer’s website to apply. You will need your full name, mailing address, Social Security number and gross annual income. The credit card application may also request additional financial information, such as your monthly rent or mortgage payment.

If you’re approved, the credit card issuer will send your card in the mail. You can activate the card by calling the number on the sticker attached to the card.

Why Should You Use a Credit Card?

Using a credit card for purchases and then making on-time payments can help you establish a credit history and build credit. This increases your credit score, which can help you get better interest rates and save money on vehicle leases and loans, mortgages and car insurance.

Using credit wisely allows you to keep your money in the bank longer, where it can earn interest for you. You may also earn credit card rewards that can put cash in your pocket or help you save money on things like travel and entertainment.

Depending on the credit card, you can gain access to perks and benefits like price protection, purchase protection, insurance and even discounts.

How Credit Card Interest Rates Work

Your credit card interest rate is largely determined by your credit score, as well as the card itself. Most credit cards have a variable annual percentage rate, or APR. That means the interest rate can go up or down depending on the prime rate as determined by the Federal Reserve.

The APR determines how much you will pay in interest based on the balance you carry on your credit card. Your credit card issuer must disclose how they calculate your APR.

How Credit Card Fees Work

Some credit cards come with a number of fees you should understand. An annual fee is the price you pay to use your credit card.

Many credit cards have no annual fee, but some of the top-tier rewards cards can have fees of $100 or more. If you plan to carry a card with an annual fee, make sure the rewards you earn more than cover the fees.

You will get hit with a late fee if you pay your credit card bill past the due date. A late payment may also cause the credit card company to raise your interest rate. This higher interest rate is called the default rate or penalty APR. Late fees can range from $28 to $39. A late payment can also lower your credit score, which is why it’s so important to pay your credit card by the due date each month.

Your credit card issuer may also charge a late fee if you exceed your credit limit, or the total amount you’re allowed to charge on the card.

How to Save on Credit Card Interest

Credit cards have many benefits, but high interest rates can quickly diminish any savings you might enjoy from credit card rewards and other perks. To avoid paying interest, find a credit card with a grace period and pay your balance in full every month.

The grace period describes the amount of time before the credit card company starts charging interest on your purchase. If your credit card has a 25-day grace period, you have 25 interest-free days to pay the balance without accruing finance charges.

Keep in mind, if you carry a balance, you’ll get charged interest on your purchases from day one. The grace period only applies when you begin the billing cycle with no balance on the card.

You can also avoid finance charges by finding a credit card with a zero percent introductory APR. If you have a credit card with a high interest rate, you may consider opening a credit card with a zero percent introductory APR for a balance transfer. That can give you more time – anywhere from ​six to 18 months​, usually – to pay down your debt, interest-free.

Credit cards can be an easy, convenient way to pay for your purchases online or in stores. Use them wisely and pay your bill by the due date to build credit, increase your credit score and take advantage of the rewards provided by top-tier cards.