How Do Credit Cards Work?

It seems like everyone has an opinion when it comes to credit cards. Some people love them, touting them as amazing financial tools. Others despise them, believing that they were designed to tempt fiscal novices into spending money that they don’t have. Few financial topics get people as riled up as the merits and risks of credit cards.

But passions aside, what are credit cards, really—and how do they work?

We answer those questions—and more—so that you can make an informed decision about whether or not owning a credit card makes sense for your personal financial situation and goals.

What is a credit card?

At its most basic, a credit card is a financial product that you use to borrow money from a bank or other lender in order to make a purchase, which can be completed by swiping the card in person or electronically using your card number. They are most commonly made out of plastic, though some premium cards consist of metal.

While that’s it in a nutshell, to truly understand credit cards there are a number of other concepts and terms that you should know. The most important of these include:

Credit Score

Your credit score is a three-digit number that lenders (and potential lenders) use to determine your risk as a borrower, and which is used to set the interest rate and credit limit for your credit card. Individuals with higher credit scores are generally seen as being less risky, so they qualify for lower interest rates and higher credit limits compared to those with lower credit scores. Your exact score is determined by a number of factors, including your payment history, your total debt levels, the length of your credit history, the types of debt you carry and whether or not you have recently applied for new credit.

Interest Rate

The interest rate is the cost of borrowing money, which you are charged if you do not pay off your credit card balance in full within your grace period. This grace period typically consists of 25 to 30 days, and often coincides with your typical statement period. As of this writing, the average new credit card carries an interest rate of 17.80 percent, though rates can vary significantly depending on your credit score and other factors, and may reach as high as 25 or even 30 percent. Depending on your card, your interest rate may either be fixed (it never changes) or variable. A variable credit card interest rate is pegged to an index—typically the prime rate, which in turn follows the interest rate set by the Federal Reserve, our country’s central bank.

Credit Limit

Your credit limit is the total amount of money that you can access with your credit card. Credit cards which offer the ability to withdraw cash in the form of an advance often have a separate, lower limit when used for those purposes.

How do credit cards work?

Generally speaking, a credit card works like this: First, you make a purchase using your available credit, either by swiping your card or by using it to make a purchase online or over the phone.

You must then pay your balance off in full during your grace period, or else your balance will accrue interest, which you must also then pay back. Because interest rates on credit cards are typically pretty high, it is generally recommended that you pay off your balance in full each month, though you can choose to make only the minimum monthly payment instead.

Although you can access up to your credit limit at any given time, maxing out a credit card can have serious negative repercussions on your credit score—which is partly determined by how much credit you’re using compared to how much is available to you—so experts recommend avoiding it.

Credit card fees

In addition to charging interest on any balance that you carry on your card, most credit card companies charge users a range of fees. The exact fees that you can expect will depend on your lender and your specific agreement with them, but some of the most common include:

Annual Fees

This is the fee you pay to be able to use your card. It is typically charged as a lump sum once a year. Some credit card companies will waive their annual fee to encourage signups or in an attempt to retain a customer who is threatening to leave for a competitor. (It’s worth asking.)

Late Payment Fees

If you are late making your monthly credit card payments, your lender has the ability to charge you a late payment fee. The amount of these fees is typically defined in your credit card policy. By law, the maximum first-time late fee that a credit card company can charge is $28, and the maximum they can charge each time you are late thereafter is $39.

Over-limit Fee

If your credit card balance ever exceeds your credit limit (which can happen in some cases if you make a purchase when you are at or near your limit) you can be charged an additional fee.

Cash Advance Fee

If you use your credit card to withdraw cash (known as a cash advance), you may be charged a cash advance fee, which is typically a percentage of the amount of cash withdrawn.

Foreign Transaction Fee

If you use your credit card to make a purchase outside the US, your credit card company may charge a foreign transaction fee. This is typically a percentage of the total purchase price, but can sometimes be a flat fee. Some cards, like travel cards, may waive these fees.

Balance Transfer Fee

If you choose to transfer your balance from one credit card to another, you can be charged a balance transfer fee. This is typically a percentage of the amount transferred, though it can sometimes be a flat fee. Some cards will offer new customers a period of time (often 12 to 18 months) during which the balance transfer fee is waived, in order to encourage the customer to open an account and consolidate their debts.

Types of credit cards

When credit cards were first invented, they were simply lines of credit which customers could use to make purchases as necessary. But as time has gone on, credit cards have evolved into many different varieties, each with unique features that make them better suited to different individuals.

Some of the most common types of credit cards include:

Standard Credit Cards

Standard credit cards do not have much in terms of fancy features; they are simply lines of credit that a user can access at will. Many standard credit cards will carry some kind of promotional offering in order to entice signups. For example, some may feature no or low interest rates for a certain period of time, which then increase after the period has ended; others may offer a zero percent interest rate specifically for balance transfers in order to encourage users to consolidate their debt onto a new card.

Rewards Cards

Rewards cards offer users rewards which are earned when the card is used to make purchases. There are many different types of rewards programs, each of which may be suited to different types of customers. You may, for instance, earn cash back (a percentage of each purchase made), miles that can be used to purchase cheap (or free) airplane tickets, or points that can be converted into items, experiences, or credits on your account.

Secured Cards

Secured credit cards are specifically designed for users who have no credit history or a poor credit score. They are backed by some type of collateral—commonly in the form of a security deposit, but sometimes in the form of another type of collateral like a car or home—and are used by individuals who are trying to build or improve their scores.

Other Types

There are many other types of credit cards. Retail-specific credit cards may offer store-specific perks; business cards may offer benefits designed to appeal to business owners; and student cards will typically offer lower credit limits for college students with no (or a limited) credit history.

How to open a credit card

Before you try to open a credit card, it’s important that you understand what your personal credit history looks like. The easiest way to do this is by checking your credit report. You can request a free credit report for free once each year by using AnnualCreditReport.com. Credit Karma and Credit Sesame also both offer free credit reports.

If, upon reviewing your credit report, you realize that your score is less than favorable, there are steps that you can take to increase your score.

Once you are certain of your credit report, you must choose the type of card that you want to apply for. Online marketplaces like Nerdwallet, Bankrate or Creditcards.com can all help you compare your options and make a decision.

When you have identified a card that you want, you will submit a full application. This application gives the credit card company explicit permission to conduct a hard pull on your credit report in order to analyze the risk that you present as a borrower. This information will determine a.) whether you meet the company’s minimum requirements, b.) what your credit limit should be and c.) the interest rate you will be charged on balances.

If you are approved and accept the terms of the agreement, you will sign the contract and will be issued a card. If you are denied, or don’t like the terms of the policy, you may be able to take steps to improve your credit score and try again at a later date.

How to make credit cards work for you

While credit cards are often vilified, the truth of the matter is that they can be powerful tools if they are used responsibly. With that in mind, here are a few tips to help you get the most out of your credit card if you choose to open one:

Be wary of interest

If you carry a balance on your credit card from month to month, interest charges can easily cause your debt to balloon out of control. Do your best to pay off your balance in full each and every month, and if you must carry a balance, be sure to pay it off as quickly as you can.

Do not mistake credit cards for an emergency fund

Though people often believe that it is fine to tap a credit card to cover an emergency, you would be much better served by saving an emergency fund to cover unexpected expenses.

Don’t be overly tempted by rewards

Rewards programs are a big reason that many of us choose to open a credit card. But when interest rates and annual fees are taken into account, a lot of the value of these programs can be eaten away. If a rewards program is one of the reasons you’re considering a card, be sure to crunch the numbers to truly understand whether or not the rewards are worth the costs.

Think twice about canceling an old card

Closing an old credit card can have a serious negative impact on your credit score, because in addition to lowering your total credit limit, it can also lower the length of your credit history. You’re much better off keeping your account open, but simply not using it. That being said, if you find yourself unable to control your credit card spending, or you’re paying an annual fee, it may make sense to close your card in order to prevent yourself from getting into trouble. (Or to call the lender to see if the annual fee can be waived.)