how using a credit card works

How Using a Credit Card Works

Credit cards are a great way to make purchases easily, borrow money conveniently, and sometimes even earn money when you use them. But how does using a credit card work, and why are credit cards used? Here’s everything you need to know about how to use credit cards for dummies. No, we don’t actually think you’re a “dummy” but, you know, it’s a common expression!

What is a credit card, anyway?

A credit card is a kind of payment card that you can use to make instant purchases, pay bills and, in some cases, make cash withdrawals. Credit cards are thin, plastic or metal, wallet-sized cards. They contain a magnetic stripe and/or tiny radio frequency identification (RFID) chip that communicates the card’s account number and other details to specialized card readers.

How do credit cards work? When you use a credit card to buy something, the money for that transaction does not come out of your bank account as it would if you were using a debit card. Instead, the bank that issued you the credit card—called the credit card issuer or creditor—pays the merchant for the transaction at the time of purchase and then bills you later.

Credit cards provide you with a revolving line of credit. When a bank issues you a credit card, it assigns the card a credit limit based upon factors including your income and creditworthiness. With your credit card, you can spend any amount up to that credit limit. After you repay the bank for some or all of your charges, you may borrow up to your credit limit again, and the cycle repeats.

When were credit cards invented?

Two men named Ralph Schneider and Frank McNerma created credit cards, as we know them today, in 1950. They created a charge card called the Diner’s Club Card that allowed people to use credit to make purchases at any business but required them to repay their debt in full by the end of each month. 

The Diner’s Club Card was the first credit product of its kind that people could use on purchases at associated merchants. However, modern credit cards allow customers to carry balances if they choose to.

How is a credit card different from a debit card?

Credit and debit cards may seem similar because they look alike, and you can use either to make payments, but when it comes down to where the funds come from to pay for the transactions, they are quite different.

How do credit cards work, and how do debit cards work? Credit cards use money from a card issuer to make payments, allowing the credit card holder borrows that money temporarily.

On the other hand, debit cards use the money immediately available in a cardholder’s checking or savings account to cover transactions. If a cardholder does not have enough available money, the bank may decline their transaction or overdraft their account—go into a negative balance—and they will need to pay a fee and deposit more money into their account.

David says:

The fact that paying with a credit card does not immediately withdraw money from your bank account is a more important benefit than many people realize for a few reasons: Fraud, merchant holds and cash flow.

Fraud: If a criminal gets your debit card (or just your debit card number), they can empty your bank account with a few charges — whether you have $10 in your account or $100,000! Most banks will give you your money back as long as you report the theft immediately, but it can take several days. Those are days in which you won’t have access to your money. If a criminal uses your credit card, it’s the bank’s money, not yours.

Merchant holds: When you book a hotel room, reserve a rental car or even buy a tank of gas, the merchant places a hold on your credit or debit card over and above the cost. This hold ensures you have the money to pay for hotel incidentals; rental car damages, fuel or excess mileage; or enough gas to fill your tank. When you pay with a debit card, these holds tie up your money for up to four days.

Cash flow: Credit cards can allow you to spend money you don’t yet have. That can be dangerous, of course. But there are times when this benefit is helpful and can be used responsibly — especially for very short periods of time. Let’s say you’re changing jobs and taking a week off in between in which you won’t paid. On top of that, your new job’s pay cycle is different than your old job, so it will be several weeks before you get a paycheck. But your new job pays more, so you’ll more than enough money to afford your monthly expenses…it’s just going to take a while to get. Even if you’re down to $50 in your bank account, you can use a credit card to buy groceries and gas until your new paycheck comes in, at which point you can pay your credit card bill without ever incurring interest.

The smartest consumers aren’t those who use debit cards for everything, they’re the ones who know how to use credit cards strategically while never going into debt.

Credit card issuers

Credit card issuers are banks and credit unions that offer their customers lines of credit if they deem them responsible enough to use a credit card wisely. Credit is like a loan, in which the credit company advances funds to cover your purchases and then charges you interest for the privilege. Because credit card issuers initially cover your purchases, before they agree to give you credit, they must determine that you do not pose too much of a risk to them.

Each time you use a credit card to make a purchase, your card issuer must approve that purchase. If approved, your bank makes the payment for you, and you owe it the full purchase amount—like a small loan. Credit card issuers partner with third-party networks like Visa and Mastercard that process your payments. That’s why your bank-issued card will usually bear the brand of one of these companies.

A card issuer may choose not to authorize a purchase if a problem exists with your account. For example, it may decline a transaction if you have exceeding your credit limit or failed to make a payment on-time.

The largest credit card issuers in the United States today are Capital One, Chase, Bank of America, Citi, American Express, and Discover.

How to get a credit card

To get a credit card, you must qualify financially. The lender must consider you creditworthy, and it determines this by running a credit check.

You begin by applying for a credit card either online, by phone or by mail. A credit card application is very simple and asks for:

  • Your legal name
  • Your address
  • Your date of birth
  • Your Social Security Number (SSN)
  • Your income

The issuer will either approve the application and mail you the credit card or – if you do not meet the financial qualifications — deny your application. In some cases, they may ask for more information prior to making a decision.

But how do you get a credit card when you don’t have established credit? In this situation, you can apply for a secured credit card. Secured credit cards work just like other credit cards except that you must provide a security deposit in order to open one. The security deposit is usually a few hundred dollars. The bank will refund your deposit when you close the account as long as you have paid your credit card bills in full. Typically, if you pay your credit card bills on time for a year or two, the bank will also upgrade your account to a regular, unsecured credit card and refund the deposit.

Full-time college students may also be eligible to receive a student credit card with reduced credit requirements and no security deposit requirement.

Credit card credit limits

If the lender approves your application, your credit issuer will assign you a credit limit. This limit is not flexible. If you try to make purchases that will exceed your limit, your bank will most likely decline to authorize them. This limit is subject to change at your bank’s discretion and may increase or decrease over time. Your card issuer will notify you of any changes to your limit. 

Available credit and credit limit both relate to how much you may charge to your card. Your available credit refers to how much of your total credit limit remains after subtracting your current balance.

How do credit cards work when your bank gives you a low credit limit? Because borrowers don’t get to choose credit limits for themselves, some are stuck with lower limits than they would like.

If the credit limit you’ve received feels restrictive, the best thing you can do is use your card regularly and do so responsibly, which means paying your bill the same month and not carrying a balance from month to month. This payment pattern will prove that you can manage your credit card well, so your issuer may grant you a credit limit increase after several months (if they don’t, you may request one after six months). 

How do payments on a credit card work?

Making payments is the essential part of responsible credit card ownership.

A few key terms you’ll want to know are:

  • Billing cycles
  • Grace periods
  • Due Dates

A billing cycle is the period of time between when one statement begins and ends. At the end of each monthly cycle, your credit issuer compiles all of your purchases for that period into a credit card statement then bills this to you. Many credit card issuers start a billing cycle on the first day of the month and end on the last day of the month, but exact cycles vary. A typical cycle is between 25 and 31 days.

Repayments are not usually due on the day they are requested. Grace periods refer to the amount of time your card issuer gives you to make a payment before the lender begins charging interest. The period is often about 23 days after a billing period ends. Due dates are when payments are actually due.

Every statement you receive will include a payment due date. Your statement balance reflects total purchases made over a billing cycle, and your current balance reflects the running total on your card since the last time you paid it off. When a payment is due, this refers to the statement balance.

Most credit cards cost nothing to use as long as you repay all of your monthly charges within the grace period and before the due date. If you do not, the issuer will charge you interest on the unpaid balance

Because the interest rates on credit cards are quite high — much higher than on other kinds of credit including mortgages or car loans — I always recommend paying your statement balance in full.

If you do not pay off all of your charges at the end of the month, this is known as carrying a balance.

Each month, the credit card issuer will assess a minimum payment that you must pay by the due date to keep your account in good standing. The minimum payment is usually between 2 and 4 percent of the outstanding balance or a minimum of $10 or $15. 

If you only pay the minimum payment or you pay any amount between the minimum payment and the total balance, the bank will charge interest on the remaining balance.

Credit card interest

Interest is money a bank charges a customer for the service of borrowing money.

The biggest benefit to a credit card is that the bank does not charge interest on charges as long as you pay them off within the grace period. In this way, credit cards provide an interest-free short-term loan.

When you do carry a balance on your card from month to month, you will trigger interest, also called finance charges. The bank will add the finance charges to the balance that you owe. 

Interest is expressed as an annual percentage rate (APR), but credit card issuers typically calculate the interest using a daily rate, which comes from dividing your card’s APR by 365. For example, if your credit card has an APR of 25%, this means you will pay $25 per year in interest for every $100 owed.

Let’s say your due date is February 1st and you have a $1,000 unpaid balance from the prior month. You will likely see a finance charge for that month of about $21.23. That’s the proportion of $250 annual interest owed for each of the 31 days in January. If you make a $100 payment and don’t spend anything more on your card in February, in March you would see a finance charge of about $17.67. It’s less because of your $100 payment the month before but also because February has 28 days, not 31.

Keep in mind that interest compounds. This means that as finance charges are added to your balance, future finance charges are calculated based on the total outstanding balance — including the previous finance charges.

For simplicity, let’s assume you’re not making any payments on your $1,000 card balance. Excluding fees, at the end of the first year you’ll owe $1,250. Buit at the end of the second year you’ll owe $1,562.50 because 25% of $1,250 is $312.50 in interest that’s added to your balance.

This compounding effect, combined with very high interest rates to begin with, is what makes credit cards very hazardous to your finances if you get behind paying your balance.

Credit card fees

The majority of credit card fees are avoidable.

How do credit cards work when you don’t pay them off by their due date? When you are unable to pay off your credit card on time, you will receive a late fee of between $30 and $40. If you make a payment more than 60 days late, a penalty APR may kick in. This means that your already-high APR will get even higher!

Other common types of fees include:

  • Balance transfer fees (when you use your credit card to transfer money)
  • Foreign transaction fees (when you make purchases outside of the country)
  • Over-the-limit fees (when you exceed your credit limit)
  • Annual fees (charged by certain credit cards, but easily avoidable)
  • Cash advance fees (for using your credit card to withdraw cash at an ATM)

Types of credit cards

Many different types of credit cards exist besides the standard type we discussed above. For those who want a safer choice or have poor credit, unsecured credit cards, secured credit cards, and charge cards are good options.

Unsecured credit cards do not require a high credit score or a deposit to open. However, they usually come with annual fees and low credit limits.

Secured credit cards often require a deposit when opening. You get this back when you close your account, but it serves as cash collateral until then and is often equal to your credit limit.

Charge cards work like credit cards except you must pay them in full at the end of each month — there’s no option to carry a balance. For this reason, charge cards do not come with credit limits. You need good credit to qualify, but this kind of card can help you build credit without the risk of accumulating debt.

Credit card rewards

During the 1986 Super Bowl, the Sears Corporation launched a new credit card called Discover. In order to lure customers away from Visa and Mastercard, Discover offered to pay customers a small rebate on certain purchases which they called “cash back”. 

Whereas previously credit cards were seen primarily as a convenient way to pay and an option for short-term financing, the Discover Card gave birth to a new era in which credit card issuers rewarded consumers for using their cards.

Today, credit card users can earn thousands of dollars a year in cash back, free travel, and other incentives just by using certain credit cards for purchases. 

Some credit cards give customers a fixed percentage of their purchases (usually between 1 and 2 percent) back in the form of cash or travel credits. Others offer rebates of higher percentages, but only on certain types of purchases (for example, on dining or travel purchases).

In addition to rewards for each dollar spent, some credit cards offer large up-front rewards known as sign-up bonuses when a new customer opens a card and spends a minimum amount on it.

Merchants pay credit card issuers fees everytime a credit card payment is made. The credit card rewards are simply a percentage of these fees returned to the consumer.

Credit card benefits

Credit cards come with a variety of benefits that many users don’t realize.

For example, most credit cards will refund your money if there is a problem with your purchase that you cannot resolve with the merchant. Let’s say you order something and it either arrives defective, or it doesn’t arrive at all. If the merchant refuses to issue a refund or replace your product, the credit card company will take the charge off your bill. If you paid for that item with cash or a debit card, you’d be out of luck!

Some credit cards also offer insurance for car rentals and, sometimes, travel interruption. 

Every credit card features slightly different benefits that can be real lifesavers when something goes wrong.

Frequently asked questions

Are credit cards good or bad?

Credit cards are a powerful financial tool. Like anything powerful, they can be used for good and bad. 

When used responsibly, credit cards provide a convenient way to pay with many built-in protections. They can also help you save money by returning a portion of your purchases in the form of rewards.

Used recklessly, credit cards can enable you to spend a lot more money than you have. This can result in an insurmountable debt, ruined credit, or even bankruptcy.

Is it worth getting a credit card?

Having credit cards can improve your credit score and enable you to spend funds you otherwise might not have spent, but they carry risks.  You need self-discipline to have a credit card. 

Getting a credit card and misusing it is often much more detrimental than not getting one at all. Instead, you might consider a non-standard option such as a secured card or charge card if you’re worried about misusing a traditional credit card.

How do credit cards work when you make payments on time, spend below your limit, and take advantage of rewards? 

The answer is that they set you up to develop positive spending habits, can help you become more creditworthy for future lines of credit you need, and give you financial security when emergencies come up and you need access to money.