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How Do Credit Cards Work?

How Do Credit Cards Work?

*Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any credit card issuer. This site may be compensated through a credit card issuer partnership.

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. Credit cards are issued by a financial institution, such as a bank of credit union, that can be used to make payments.

Because you borrow and repay what you borrow with a credit card, that’s called “revolving credit.” And your usage and payment history with the card is typically reported to the three major credit bureaus (Equifax, Experian and TransUnion), which is then fed into an algorithm that makes up your  credit score.

Read: Why it’s Smart to Use Credit for Purchases

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 or credit union branch. Some of the information you’ll need to provide includes:

  • Name
  • Social Security number
  • Address
  • Annual income

Before applying, take these steps to increase your chances of approval:

  • Check your credit score so you know where you stand.
  • See if you’re prequalified. While prequalification doesn’t guarantee approval, it means you’ve got a good chance, and it doesn’t hurt your credit to check.
  • Use our card comparison tool to make sure you’re applying for the right card.

Types of credit cards

Cash back, travel, balance transfer, secured — these are a few of the terms you’ll encounter as you learn more about the world of credit cards. Each type of card offers different things, and works best for consumers with different needs. Here are a few you should be aware of:

Cards for building credit. These are aimed at consumers who are new to credit or who are looking to rebuild their credit. They may be secured, meaning you’re required to submit a deposit in the amount of your credit limit, or they may be unsecured (requiring no deposit). Popular cards for building credit include the Discover it Secured and the Capital One Platinum

  • 2% cash back at Gas Stations and Restaurants on up to $1,000 in combined purchases each quarter. 1% unlimited cash back on all other purchases - automatically

  • Credit line will equal your security deposit of $200 or more*

  • No annual fee, no late fee on your first late payment. No penalty APR*

Highlights
  • No Annual Fee, earn cash back, and build your credit with responsible use.
  • It's a real credit card. You can build a credit history with the three major credit bureaus. Generally, debit and prepaid cards can't help you build a credit history.
  • Establish your credit line by providing a refundable security deposit of at least $200 after being approved. Bank information must be provided when submitting your deposit.
  • Automatic reviews starting at 8 months to see if we can transition you to an unsecured line of credit and return your deposit.
  • Earn 2% cash back at Gas Stations and Restaurants on up to $1,000 in combined purchases each quarter. Plus, earn unlimited 1% cash back on all other purchases – automatically.
  • Get 100% U.S. based customer service & get your free Credit Scorecard with your FICO® Credit Score
  • INTRO OFFER: Unlimited Cashback Match – only from Discover. Discover will automatically match all the cash back you’ve earned at the end of your first year! There’s no minimum spending or maximum rewards. Just a dollar-for-dollar match.
  • Get an alert if we find your Social Security number on any of thousands of Dark Web sites.* Activate for free.
  • See Rates & Fees

See additional details for Discover it® Secured

More Info

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Cards for earning rewards. Some cards allow you to earn cash back on purchases made with the card and some allow you to earn miles or points. Card rewards can be redeemed in a variety of ways, such as statement credits, deposits to a checking account, paper checks, booking travel or transferring them to popular travel loyalty programs.

Read: Best Rewards Credit Cards

There are rewards credit cards that charge an annual fee and cards with no annual fee. Those with an annual fee may offer more robust benefits — such as trip delay and cancellation insurance, or annual travel credits for expenses like incidental airline fees.

Cards for paying off debt. Balance transfer credit cards offer an introductory no-interest period where cardholders can transfer debt from another card to their new card, and all payments will go toward the principal of the debt rather than interest plus principal. There’s often a balance transfer fee of 3% to 5% of the amount transferred, though no-balance-transfer-fee cards do exist. After the intro period is over, any remaining debt will accrue interest at the regular APR.

Read: Best Balance Transfer Credit Cards

How does credit card interest work?

Calculating credit card interest

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 charges, unless your card is offering an intro 0% APR period.

Here’s how interest is calculated:

Note that 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 compound interest can make paying off a card hard

Credit card interest charges can make it difficult to pay off a large balance as 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. Thus, your interest is being calculated based on higher balances each day. However, interest is generally waived if you pay off the card before the due date, which is why it’s important to keep credit card balances from getting out of control.

Minimum payments

Each billing cycle when you’ve charged something to your card, or when you’ve carried a balance over from previous months, you’ll have to make at least a minimum payment. This is typically calculated with 1% of your principal debt along with interest charges and any fees. Because minimum payments only chip away at a tiny portion of the principal, it can take an excessively long time to pay off a credit card balance when only making the minimum payment due, as well as inflate the cost of what you purchased as interest charges are added to the balance.

To avoid falling into a cycle of debt, the best practice is to pay the balance off in full each month rather than making only the minimum payment.

Cards with intro 0% APR

As mentioned earlier, some cards offer an introductory 0% APR period on purchases and balance transfers.

With an intro 0% APR promotion for purchases or a balance transfer, you can avoid interest charges during the promotional timeframe. These offers can range anywhere from 6 to 21 months. However, any balance that remains unpaid past the promotion period will start accruing interest at the APR the card issuer gives you.

Read: Which Credit Card Has the Longest Intro APR Period?

It’s also important to know the difference between an intro 0% APR card offer and deferred interest. Some store cards, for example, offer financing deals (e.g., “no interest for 6 months!”) involving deferred interest, and if you don’t pay your purchase off within the promotional period, you’ll owe interest on the full purchase amount from the date of the transaction.

By contrast, with a standard intro 0% APR card promotion, you’ll accrue interest only on any balance that remains (and, of course, on any new purchases you make with the card).

Using 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 sink you into debt.

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

Pay on time every time. 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. The best way to never miss a payment is to set up autopay on your credit or through your bank.

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 credit limit. For example, if you have a card with an $8,000 credit limit, you shouldn’t charge more than $2,400 at any time.

Don’t apply for too many cards too quickly. Applying for too many cards in a short span of time makes you look risky to lenders, which means you’re more likely to get turned down. Plus, applying for new cards will 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.

Don’t charge more than you can afford to pay off. By using your credit card for purchases you’ll be making anyway, such as gas or groceries or travel, you’re not only protecting your finances from fraud, but you also have the opportunity to earn rewards such as cash back, points or miles. However, it’s very easy to get carried away and spend more than you can pay off at the end of the month. Don’t fall into that debt trap by always having a repayment plan in place

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. However, know that some card issuers restrict you from making 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 must carry a balance to boost your credit score — as long as you use your card and pay on time, 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 they 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.

Are charge cards the same as credit cards?

Charge cards operate similarly to credit cards in many ways, but there are some key differences. Probably the most important one is that while credit cards allow you to revolve a balance, charge cards require that you pay in full each billing cycle.

American Express is the only major issuer of charge cards in the U.S.

Read: What is a Charge Card?

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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