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How Do Credit Cards Work?

How Do Credit Cards Work?

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This article was last updated Mar 30, 2020. Terms and conditions may have changed. For the most accurate information, please consult the issuer website.

If you’ve ever wondered about the finer details of how credit cards work, we’ve got the answers. We break down the ins and outs of credit card applications, payments, how interest is computed and more to help you gain a clearer understanding of these ubiquitous pieces of plastic.

What is a credit card?

You’ve probably used a credit card at some point in your life, and if you haven’t, you’ve likely seen friends or family use them. A credit card is a plastic card that can be used to make payments. You’ll find a number on the front or back — usually 16 digits, or in the case of American Express cards, 15 digits long. These cards are issued by financial institutions, such as a bank or credit union, and the number on the card ties it back to your account. (It’s important to note that not all payment cards are credit cards. There are also debit cards, prepaid cards and charge cards.)

When you’re approved for a credit card, you are given a credit line from which you can borrow funds and then repay them. Because you borrow money as you spend, rather than borrowing a set amount of money at one time like you would with a loan, credit cards are considered “revolving credit.”

When it comes to paying off your debt, you have the option of paying off what you charge to the card in full each month, making just the minimum payment (which is a portion of your balance plus interest and any fees) or paying an amount somewhere in between. If you pay less than the full balance, you’ll owe interest on the debt that’s carried over to the next month, as well on any new charges you make to the card. (See below for details on how credit card interest works.)

Credit cards can also help you protect your money. This is thanks to a combination of legal protections against fraud, credit card issuers being willing to assist cardholders with disputes and benefits offered by some high-end cards that protect purchases against damage and theft.

How do you get a credit card?

Ways to apply for a credit card include online, over the phone, by mail or in person at a bank branch. You’ll need to provide personal information like your name, Social Security number, address and annual income. It may be possible to get an immediate decision on your application, and some cards even offer a digital number that can be used to make online transactions before the physical card arrives in the mail. In other situations, your application may go to a pending status, and in such cases you’ll be notified of approval or denial after a period of several days. Pending applications may require you to verify information such as income or other details.

Some issuers allow you to check if you prequalify for any of their cards. Prequalification means that you’re more likely to get approved once you actually apply, though it’s not a guaranteed approval. If the issuer of the card that you’re interested in offers an online prequalification tool, you can enter your information that way and check what types of cards you may have a higher chance of being approved for. However, even issuers that don’t offer online tools may sometimes send out prequalification offers through the mail.

There are also credit card comparison websites, such as CompareCards, where you can search and compare different types of cards based on what you’re looking for and then apply for the one you want.

For more information on how credit scores work and how to check yours, take a look at our credit score guide.

How does credit card interest work?

If you pay your credit card balance off in full each month, you can avoid being charged interest as credit cards typically offer a “grace period” of at least 21 days between the end of your card’s billing cycle and when payment is due.

However, only paying off a portion of the balance means you’ll incur interest, unless you’re in an intro 0% APR period. The way your interest is calculated is by taking your APR and turning it into a daily rate via dividing it by 365. Your balance is then multiplied by the daily rate to arrive at the interest that will be added to your bill.

One reason credit card interest charges can be expensive is that most issuers compound your interest daily. This means your daily interest is calculated based on the day’s average balance, then it’s added to the next day’s average balance. In other words, your interest is being calculated based on higher balances each day. (However, interest is generally waived if you pay off your card before the payment due date.)

It’s also important to understand that when you only make the minimum payment due, just a portion of your payment goes toward your principal debt. Your minimum payment generally includes fees, interest and just 1% of the principal debt. That’s another reason why it’s crucial to pay in full every month.

Finally, most credit cards these days are variable rate cards. That means the APR is tied to an index — for credit cards, the prime rate is the one most commonly used. When the prime rate goes up or down, the card’s interest rate will go up or down as well. Since the prime rate is tied to the Federal Reserve’s federal funds rate, when the Fed hikes or cuts rates, you can probably expect your card’s APR to change too.

How to use a credit card responsibly

Used wisely, credit cards can help you boost your credit score, earn rewards, finance a big purchase or pay down debt. Used improperly, credit cards can tank your credit score, hit you with expensive interest charges and allow you to dig yourself deep into debt.

Here are a few ways to be smart about your credit card usage:

Pay on time every time. This is crucial to maintaining a good credit score and staying out of debt. If you pay late, your credit score will drop like a rock — and many credit cards will jack up your interest rate to what’s called a penalty APR. If keeping track of payment due dates turns out to be difficult, you can set up autopay, so as to never miss a payment.

Keep your balances low. Running up a high balance is another way to damage your credit score. It’s best practice to never spend more than 30% of your limit. For example, if you have a card with an $8,000 credit limit, you shouldn’t charge more than $2,400 to it at any time.

Don’t apply for too many cards too quickly. Applying for too many cards in a short span of time makes it look to issuers like you’re desperate for credit, which means you’re more likely to get turned down. Plus, applying for new cards can ding your score in two ways — by putting a hard inquiry on your credit history and, if you’re approved, by reducing your average age of accounts. Once you get a new card, it’s best to practice responsible behavior with it and build credit history with it, rather than immediately applying for another one.

Don’t charge more than you can afford to pay off. By putting regular expenses such as gas, groceries and restaurant purchases on a credit card, you’re protecting your finances from fraud. You also have the opportunity to earn rewards such as cash back, points or miles. However, it’s crucial not to spend above and beyond what you can pay off at the end of the month. Pay off your credit card in full at least monthly — perhaps sooner. For example, consumers with jobs that pay on a bi-weekly basis might decide to pay off their card balances every two weeks.

Use a credit card to finance a big purchase. When you need to make a big purchase and spread out the payments over time, a credit card offering an intro 0% APR deal on purchases can help you avoid interest charges for a certain period of time. During such an intro period, all of your payments go to the principal of the debt — you don’t have to worry about interest charges on top of that. It’s possible to find cards offering 12, 15 or 18 months of no interest on new purchases.

Do a balance transfer and pay off high-interest debt. If you have debt on a credit card with a high APR, transferring it to a card offering intro 0% APR on balance transfers can be a way to get control of it. Just like we described for cards offering intro APR on purchases, when you take advantage of an intro 0% APR offer with a balance transfer, all your payments will go to the principal of the debt. There are cards offering up to 21 months of no interest on balance transfers.

Be aware, however, that you may have to pay a balance transfer fee, which usually ranges from 3% to 5% of the amount transferred. There are also cards with no balance transfer fee.

Use our balance transfer calculator to see if a balance transfer is worth it for you.

Can you pay your credit card early?

Yes. Most issuers will allow you to pay off what you charge before the bill arrives through your card’s online account. The only possible restriction you may face is opting to pay off a balance more than once a day, as some issuers don’t allow multiple daily payments. Paying off your card before the bill comes due can work to your advantage in two ways: it will help you keep your utilization low, which is good for your credit score, as well as keep you from having to pay a large chunk of cash when the bill is due.

And don’t believe the myth that you have to carry a balance to boost your credit score — as long as you use your card and make on-time payments, that information gets reported to the credit bureaus.

Credit card FAQs

How much can you spend on a credit card?

The credit card issuer will decide your credit limit when approving your application. Though you can spend up to the amount of your credit limit, you shouldn’t do so, as maxing out your card will hurt your credit score. The best practice is to keep utilization (the ratio of how much you charge to the card versus your credit limit) at less than 30% of your limit. For example, with a $4,500 credit limit, you shouldn’t put more than $1,350 on the card. Also note that if your card charges an annual fee, that will also reduce your available credit until you pay it off. The best way to combat high utilization if you use your card a lot is to make multiple payments during the month to keep your balance low.

Can a debit card be used as a credit card?

You may have been asked when checking out whether you’d like to use your debit card as debit or credit. However, while this does result in the transaction being processed in different ways, it doesn’t mean your debit card can act as a credit card. The transaction is still going to result in money being pulled from your checking account. Plus, a debit card won’t help build your credit score, even when processed as credit.

Read: How to Dispute a Debit Card Transaction

How do prepaid cards work?

Prepaid cards use funds that you load onto the card through various means. For example, many prepaid cards allow you to add funds via direct deposit or at the register at certain stores. Though prepaid cards can be a useful tool for money management in some cases, it should be noted that prepaid cards do not report to the big three credit bureaus (Equifax, Experian and TransUnion) and therefore do not impact your credit score. For more details, read our guide on what you should know about prepaid cards.

How do credit card chips work?

The chips in credit and debit cards are called EMV chips, and are able to generate a unique transaction code for each purchase. The goal of introducing EMV chips was to protect consumers against certain types of fraud that cards are vulnerable to when payments were processed using magnetic stripes.

How do credit card skimmers work?

Skimmers are devices used to steal your card information when you swipe your card at gas stations and ATMs. When skimmers first appeared, criminals had to place them on the outside of card readers — but newer skimmers can be placed inside and transmit info by Bluetooth technology or integrated cellphone components.

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