A Complete Guide to How Credit Cards Work

• Credit cards allow you to borrow money from a lender and pay it back later.
• Using a credit card comes with several advantages, including convenience, security and the potential to earn rewards.
• Responsibly managing your credit is important to avoid the downsides of credit cards, like interest charges or credit card debt.

When it comes to managing your finances, a credit card can be a beneficial tool for accessing and establishing credit. A credit card allows you to borrow money, up to the credit limit on the card, to cover transactions. Borrowed money is paid back in part or in full by the end of each statement period. 

Using a credit card responsibly starts with understanding how credit cards work. Here, we’ll discuss the basics on how to use a credit card, the different types of credit cards and the benefits of having a credit card. 

How credit cards work 

When an individual is approved for a credit card, they’ll receive the card itself, as well as key information about their credit account. Creditors will set a credit limit, the maximum amount that can be charged to the card, as well as the interest rate on the card. 

Any purchase made using the credit card counts against the total credit limit. Conversely, any payment made reduces the balance owed and frees up more available credit on the card. 

If the card is paid in full at the end of each statement period, the borrower can avoid paying interest. If they pay only a fraction of the balance due, such as making only the minimum payment, they will typically begin to accumulate interest charges on the remaining balance. 

How do credit card payments work?

Each month, cardholders receive a credit card statement listing the purchases they made with their credit card that month, as well as the minimum monthly payment required and the payment due date. 

Cardholders need to make at least the minimum payment on the credit card by the due date to keep their account in good standing. Paying too little or making a late payment may negatively affect your credit score, and you might also incur late payment fees or other penalties.

However, paying more than the minimum amount owed can be beneficial, because paying off your card in full each month allows you to avoid credit card interest. This is because credit card issuers allow a “grace period” on each purchase: a time frame during which you can pay back the lender without incurring interest charges. If you pay your card balance in full each month, you’ll always make your payment within the grace period, meaning you can avoid paying interest on the card entirely. 

Note that while credit card issuers often allow grace periods for purchases made on the card, they may not offer a grace period for other types of transactions, such as cash advances. It's important to understand the terms and conditions your card offers. 

How does credit card interest work?

Credit card interest is the cost of borrowing money from a lender — in this case, the credit card issuer. Once the grace period elapses, your purchases accumulate interest. This means that, if you have an outstanding credit card balance that rolls over into the next billing cycle, you will likely notice interest charges appear on your next statement. You’ll continue to be charged interest until the purchase is repaid.

The amount of interest charged on a credit card balance is based on the card’s annual percentage rate (APR). The higher the APR, the more interest you’ll pay, and the more costly it becomes to carry a balance. Generally speaking, credit card APR is higher than other forms of debt. However, you may encounter cards with low or 0% APR offers. 

Types of credit cards

Several options are available to those shopping for a new credit card. Some types of credit cards you might encounter include:

• Secured credit cards: Backed by a cash deposit from the cardholder. They may be suited to credit beginners or those who want to rebuild their credit.
• Low-interest credit cards: Have lower-than-average APRs. They may be a more affordable option for borrowers that carry a balance on their credit cards.
• Rewards credit cards: Offer perks for using the card, including cash back or travel rewards.
• Balance transfer credit cards: Typically come with low or 0% balance transfer APR offers. The cardholder can transfer the balance from a higher-APR card to the balance transfer credit card and potentially use the savings on interest to pay down their debt.
• Student credit cards: Designed with credit beginners in mind. They often have smaller balances and may come with student-centric rewards.
• Store or retail credit cards: Typically only work at one or a handful of retailers and allow shoppers to make purchases on credit, rather than with debit or cash.

Benefits of using a credit card

Credit cards have a number of benefits for cardholders, including:

• Convenience: Credit cards are accepted at a wide variety of retailers, in person and online, which makes them convenient for day-to-day transactions. 
• Greater cash flow: Credit cards allow cardholders to manage their cash flow. Unlike debit cards, credit cards do not deduct money from your bank account. A payment does not need to be made until the due date. 
• Rewards: Rewards cards offer perks for using the card, including points rewards, travel mileage and cash back. 
• Card benefits: Credit card companies may partner with other organizations to offer additional rewards, like free hotel stays, exclusive discounts and more. 
• Builds credit history: Credit reporting agencies collect information on credit card accounts, and having a credit card contributes to your credit history. 
• Boosts credit score: Managing your credit card well — for example, by making your payments on time, every time — can help increase your credit score. 
• Security: Credit cards often have enhanced security compared to debit cards, including added layers of fraud protection. Some credit cards may also extend the warranty on some purchases made on the card.

Risks of using a credit card

Despite their many benefits, credit cards come with potential downsides, including:

• Temptation to overspend: Because credit cards do not withdraw money from your bank account with each purchase, like a debit card does, cardholders need to monitor how much they use the card to prevent overspending. 
• Potential for credit card debt: Charging more to the card than you’re able to pay off at the end of the statement cycle can result in carrying a balance on the card and going into credit card debt. 
• Interest charges: Carrying a balance on a credit card or paying only the minimum amount each month means cardholders are charged interest on their account balance. Because credit cards tend to have a high APR, debt can accumulate quickly. 
• Missing a credit card payment: Missed or late payments can negatively affect your credit score and may result in late payment fees. Depending on the agreement with your lender, missing payments may also increase the APR on the card. 

How to get a credit card

Applying for a credit card is often a simple process that can be completed in person or online. 

During a credit card application, you’ll need to supply the lender with personal information they can use to validate your identity, and you may be asked for additional information, such as your annual income. The lender will then run a hard credit inquiry, which will allow them to assess your credit history and decide whether to approve your application. 

If you’re new to credit and have no prior credit history, look for cards tailored to credit beginners, such as secured credit cards. As you build your credit history, you can seek out cards for more experienced borrowers, such as rewards cards or low-APR cards. 

No matter what type of credit card you get, responsibly managing your credit is essential. Make all of your payments on time to help increase your credit score and to avoid going into debt by not charging more to the card than you can pay back by the payment due date. Being savvy with credit helps ensure you’ll enjoy the many benefits of a credit card while avoiding or minimizing risk.