How Do Credit Cards Work? (Complete Easy-to-Understand Explanation)
Credit cards are everywhere these days.
In fact, they’re used for 28% of all payments made in the U.S.
If you’re not using a credit card of your own, it’s probably because you’re not sure how they work.
And I get that! It’s never smart to use a financial strategy you don’t fully understand.
But here’s the thing: Credit cards are amazing tools that can make your life easier while improving your finances.
It could be smart to educate yourself and then get on board!
So, how do credit cards work?
I’ll answer that question and more below.
What is a Credit Card and How Do Credit Cards Work?
A credit card is a small, physical card that allows you to make purchases on credit.
The word “credit” just means that you’re borrowing money.
When you pay for something with your credit card, the money doesn’t come from your bank account. Instead, the payment amount is added to your “balance,” which you’ll have to pay off later.
But how do credit cards work – in detail?
The process looks like this:
- Apply for a credit card. This is where you compare your options, then send in an application for a card that meets your needs.
- Receive your card (with a specific credit line). Your credit line is how much money you’re allowed to borrow with the card. So, if your credit line is $3,500 dollars, you can use the card until your balance reaches that limit.
- Make purchases. The money you spend will be added to your balance. This is the total amount you owe.
- Receive (and pay) your monthly bill. When the bill arrives, you’ll see both the minimum payment and your total balance. Making the minimum payment is enough to avoid late fees, but you should try to pay off the balance in full.
- Optional: Pay interest on your balance (try to avoid this step!). If you don’t pay off your entire balance, you’ll have to pay interest on whatever’s left. This part isn’t pleasant since the average APR (annual percentage rate, or interest rate) is a hefty 19.07%.
The process outlined above is the “standard” credit card experience. But not all credit cards operate the exact same way.
Some charge annual fees. Others offer an “introductory period” with 0% interest rates.
And then there are the rewards.
Rewards like cash back on some purchases, travel points, and other perks that work in your favor.
So that question “How do credit cards work?” isn’t as simple as it sounds, but at least now you’ve got the basics!
Why Use a Credit Card?
There are several reasons why using a credit card can be a good idea:
- Convenience. If fumbling in your wallet for crumpled bills sounds like a pain, you’ll love the ease of use that credit cards provide.
- Improve your credit score. Responsible card use allows you to build credit history. This can give you more financial flexibility moving forward.
- Earn rewards. Perks like cashback and travel discounts can save you some serious money.
- Purchase protection. Credit cards usually offer protection against fraud and theft – meaning they could reimburse you if a thief pulls a fast one.
How Do Credit Card Payments Work?
Each month, you’ll receive a credit card statement that includes two key numbers:
- The minimum payment. This is how much you must pay to avoid late fees – and, often, to avoid a nasty hit to your credit score.
- The statement balance. This is where your balance was when the last billing cycle ended.
The statement should arrive at the end of the one-month billing cycle. It could come through snail mail, email, or an online portal, depending on how you’ve set up your account.
The bill will give you a due date for your payments, which is usually three weeks after the end of the billing cycle.
The due date should always be the same day of the month– except for when it falls on a weekend or holiday, in which case it could be pushed back to the next business day.
You may be able to simplify the payment process by setting up autopay, but that will depend on the card you’re using.
*Warning* It’s easy to assume you’re being financially responsible by making just the minimum payment. You did what they asked for, right?
Yes. And that’s enough to keep your account in good standing, but you’re still leaving a balance that will soon be hit with interest!
Here’s a better plan: Pay off your entire balance every time.
That’s what keeps you from paying interest and falling into debt.
How Do You Get a Credit Card?
Asking, “how do credit cards work?” is only half the battle.
Once you understand the basic idea, it’s time for another question to take center stage:
How do I get one of these things, anyway?
Here’s the 5-step process:
- Look into your credit score. Knowing your score will allow you to decide which cards are worth applying for. If a card requires an excellent score and your score is only 600 (considered “fair”), you’re better off looking elsewhere.
- Shop around. You can consider cards from the bank where you already have a checking account, but don’t forget to consider other banks and credit unions, too.
- Compare fees, interest rates, and rewards. These are the variables that determine which card is the best deal.
- Check for pre-approval. Some cards have online tools that let you see ahead of time whether you’re likely to be approved. This helps you avoid applying for too many cards, which can negatively impact your credit score.
- Apply for a card. You’ll enter some personal info, including your income and social security number. Then they’ll dig into your credit history, including running a hard credit check, before making their decision.
What to Look For In a Credit Card
My goal here is to answer your credit card questions.
How do credit cards work? Answered!
How to get one? Answered!
But this next question is even more specific:
With so many credit cards out there, how do I decide which ones to apply for?
You’ll have to look at certain variables, then decide how the cards stack up. Here are the main factors to consider:
- Annual fees. Some credit cards charge an annual fee. That means a lump sum is added to your balance once a year. These cards might still be worth it – especially if you want to earn rewards or you need to build credit – but you’ll have to do some math to find out.
- Other fees. Credit cards sometimes charge for balance transfers, cash advances, credit limit increases, foreign transactions, and other maneuvers. The fees might not matter if you don’t plan on doing any of these things, but it’s still worth knowing what the deal is before you apply for a card.
- Rewards. Airline miles. Cashback. Airport lounge access. Travel protections. These are all rewards that come with some cards but not others. Check out what rewards are on offer, then consider how they’d benefit a consumer with your unique habits and needs.
- Interest rates. Even if you plan to pay off your balance each month, it’s still good to know how much you’ll be charged if you fall behind. And then there are 0% APR cards to look for. These are cards that won’t charge any interest during an initial “introductory” period, making them perfect for financing major purchases.
For each credit card you investigate, look at these potential drawbacks and advantages, then see how they shake out.
One card might be available without an annual fee – but offer practically no rewards. Another could have a hefty annual fee – but offer such fantastic rewards that it’s worth it.
It’s your job as a consumer to compare these options, then make a decision.
Commonly Asked Questions About How Credit Cards Work
How Do Credit Cards Work in Simple Terms?
Credit cards allow you to make payments with money that you’re essentially borrowing. Each time you use the card, the money spent is added to your “balance.” You have to pay some of that balance back every month; this is the “minimum payment.” Then, whatever portion remains is what you’ll be charged interest on.
How To Use a Credit Card for Beginners?
Beginning credit card users should follow two basic rules:
- Only use the card for essentials (so you don’t spend beyond your means).
- Pay off the entire balance each month (so you don’t get charged interest and fall into debt).
How Do Actual Credit Cards Work?
Standard credit cards give you a “line of credit,” meaning you can spend up to a certain amount of money without paying upfront. The cost of your purchases will be added to your balance, which you’re responsible for paying back.
How Much Does a Credit Card Cost Per Month?
There’s no set monthly cost for a credit card. Some credit cards have an annual fee, but this is only charged once a year. The actual “cost” of your card depends on several factors, including whether you pay off your balance in full, the interest rate (APR), and the card-specific fees.
How Do Credit Cards Work for Beginners?
You use a credit card to pay for things on “credit,” meaning you’re borrowing from a financial institution. If you spend $5 with your credit card, you’ll have $5 added to the “balance” of what you owe. You should pay off this balance each month – otherwise, you’ll be charged interest.
How Do Credit Cards Work to Build Credit?
When you use a credit card and then successfully pay off the balance, you demonstrate your ability to meet your financial obligations. Credit bureaus take this payment history into account when determining your credit score.
How Does a Debit Card Work?
A debit card allows you to make purchases by drawing money directly from your checking account. Let’s say you have $500 in the bank, and then you spend $20 with your debit card. The money will come straight from your bank account, which will go down to $480.
What Are The Differences Between a Credit Card and a Debit Card?
Credit cards allow you to make purchases on credit, while debit cards make payments with money that’s already yours. Spend $10 on a credit card, and it goes towards a balance you’ll have to pay off later on. Spend $10 with a debit card, and it comes straight from your checking account.