The first general-use credit card dates all the way back to 1950. Hence, it may seem surprising that so many people still keep asking, “how do credit cards work.” Yet, it makes perfect sense when you consider that the rules and regulations governing credit cards are in constant flux. In this guide, we hope to remove many of the misconceptions about credit cards and show you why they can be an important financial tool.
Let’s start with some of the fundamentals.
How Do Credit Cards Work “For Dummies”
A credit card account essentially provides you a short-term loan that cannot exceed your spending limit. When you get a credit card, the issuing company will open an account tied to the physical card you receive.
The spending limit is the amount of money you can “borrow” from the credit card company at any one time.
In other words, this is how it goes.
When you use your card to pay for a purchase, the financial organization pays for it and loans you the money. If you repay that loan within an established credit card grace period (usually a month), it doesn’t generate interest. Voila.
How Do Refunds Work on Credit Cards?
As you can imagine, credit cards set up a unique situation when you make returns on an item. Since the credit card company paid for the item, the merchant will refund money to your account in the form of credit.
This credit doesn’t constitute a payment, so it won’t reduce the minimum payment you need to make to avoid missing payment deadlines.
We’ll get into reward structures further down, but know that you’ll typically lose the rewards you earn from a purchase following a successful refund.
How Does a Credit Card Balance Transfer Work?
As the name implies, a balance transfer involves taking debt from one credit card and transferring it to another one with better terms. It’s a common strategy for people who have a large balance on a high-interest credit card.
Some credit cards even offer an introductory period of 0% interest.
Generally, all you need to do is apply for a card and indicate that you want to execute a balance transfer. If the credit card allows transfers, and you’re approved for the card with a credit limit exceeding or matching the balance, the issuing credit card company will perform the transfer.
In effect, the company “buys” your debt from the previous credit card company.
How Does a Credit Card Work Example
Here’s an example of a typical credit card transaction:
Jane comes into a store and uses her credit card to pay for her purchase.
The cashier swipes her card, and her card issuer checks if the purchase is within her credit limit. If it is within the limit, the company approves the purchase and pays for it, essentially loaning Jane the money to buy her items.
3 Types of Credit Cards and How They Work
In the broadest sense, credit cards can be divided into three types — unsecured, secured, and charge cards. Each type has a different kind of credit model, and they each appeal to users with different circumstances and underwriting requirements.
How Do Credit Cards Work: Unsecured Credit Cards
Unsecured cards are the most common kind and the type of credit model that most people think of when they think of credit cards. For this type of card, you apply for an account and supply the credit card company with your credit information.
Based on that information, the credit card company chooses to approve your application or not.
In addition, the company uses your credit information to set your spending limit.
How Do Credit Cards Work — Underwriting Requirements
Underwriting in this context is the process credit card companies use to determine your credit limit. Some of its key elements are:
- Your credit score — This one is huge. Usually, credit card companies set a minimum credit score and don’t consider applications that fail to meet that minimum. Many cards specialize in catering to low credit scores.
- Length of your credit report — The more information a company can get about you, the more confident it will be about your credit limit.
- Annual income — Even if your credit score is low, a steadily high annual income can help make up for it.
- Debt-to-income ratio — If your monthly payments take up a large portion of your income, that’s a bad sign.
How Do Credit Cards Work: Secured Credit Cards
The other major type of credit card is secured cards. These cards are “secured” by an amount that you pay upfront. That is to say, instead of using your creditworthiness to set a credit limit, you put down a security deposit that determines what your limit is.
In most other respects, these cards work like unsecured cards, and payments made to their account affect your credit. They’re commonly used by people who want to build or repair their credit since they’re so easy to qualify for.
How Does a Prepaid Credit Card Work
Prepaid credit cards are a bit of a misnomer since these cards don’t provide any credit. People sometimes confuse them with secured credit cards, but they’re different in several key ways.
With a prepaid card, you have to deposit money to your account that you can then spend. Once you spend it, the card is depleted and needs to be recharged.
Importantly, these cards’ activity isn’t reported to credit bureaus. Consequently, it does nothing to impact your credit score.
How Do Credit Cards Work — Charge Cards
The third and less widely used type of card are charge cards. Charge cards are like credit cards that you have to pay off every month. Thus, you don’t have the option of letting debt accrue and generate interest.
Charge cards are useful because credit card companies report their activity to credit bureaus. Also, many have a lot of the same rewards and perks as standard unsecured cards.
How Does Interest on a Credit Card Work
Like any loan, credit card debt accrues interest over time. It’s the primary way that credit cards generate income for the issuer.
But, as previously mentioned, that interest is only assessed after a grace period.
If you pay off your total credit card balance within every grace period, you will not be charged any interest on purchases.
Any unpaid credit card balance starts to generate interest after the grace period at an annual percentage rate (APR). This rate can be variable or fixed.
- Variable APR changes according to an index interest rate, so it can go up or down during your cardholder agreement.
- Fixed APR stays the same during your agreement, and it’s set when the agreement is executed.
How Does Interest Work on a Credit Card
It’s important to note that most credit cards use compounding interest.
That means that interest is added to your balance on a regular schedule. So you’ll end up paying interest on your interest, and it typically compounds daily. In other words, you end up paying more than the advertised APR.
How Do Credit Card Payment Work?
Credit card companies usually have a minimum payment you have to make every month. The minimum payment almost always contains the interest your balance generates plus a portion of the balance.
You’re always paying off the interest first with minimum payments, which is why they have such a small effect on your remaining balance.
How Do Credit Cards Work For Your Benefit
Many credit cards have reward structures to incentivize spending on a specific category of goods, such as gas credit cards.
There are three primary credit card rewards programs: points, cashback, and miles.
Points Credit Card Rewards
With a points reward system, you earn points issued by the credit card company for every dollar you spend. Then, you can redeem credit card points for merchandise, gift cards, travel, and even cashback.
How many points per dollar you earn and what you can redeem them for depends on the credit card issuer. The Chase Sapphire Preferred® card is a good example of a points reward card that has an excellent redemption system in the form of Chase Ultimate Rewards.
How Does Cash Back on a Credit Card Work
Cashback is the most versatile kind of reward program. Cashback credit cards work by essentially giving you a rebate when you make qualified purchases with the card.
In other words, whenever you spend money with a cashback card on a qualifying purchase, you get a percent of the purchase price back in the form of a credit on your statement.
The amount you get back and when and how you can redeem it depend on the card. One of the best examples of a cashback card is the Citi® Double Cash card, which lets you earn 2% cashback with no restrictions on the purchase category.
How Do Credit Cards Miles Work?
Credit card miles reward you when you spend money on travel and usually when you spend money at specific travel companies. They’re frequently co-branded with a travel company, so you receive miles whenever you make travel purchases with that company.
An example of this type of card is the CitiBusiness® / AAdvantage® Platinum Select® World Elite Mastercard®.
You can typically redeem miles on travel spending, so it’s a way to reward people who travel frequently.
How Do Credit Cards Work Technically?
Credit card companies constantly incorporate new ways to make it more appealing for customers, such as yourself. A lot of those features are small perks and benefits, but some are physical changes that make it easier to use the cards.
How Do Store Credit Cards Work?
Store credit cards work just like regular credit cards, but you can only use them at one retailer or group of retailers. The benefit of using store-branded credit cards is the associated discounts they tend to offer.
However, they also frequently have very high-interest rates, so it’s advisable only to use them if you’re sure you can pay off the total balance every billing period.
How Do Chip Credit Cards Work?
A chip card is the same as a standard-sized credit card, and it incorporates a microchip in addition to the magnetic stripe credit cards have. The chip has information that adds a layer of security to your transactions at point-of-sale terminals, ATMs, etc.
The chip doesn’t change any other function of the card.
How Do Travel Credit Cards Work?
Travel credit card is an industry term that simply means a credit card that has excellent travel-oriented rewards. These cards aren’t restricted to any specific loyalty program. Rather, the term only refers to the card’s intended user category (frequent travelers).
American Express has a long-standing reputation for having the best travel cards, and the American Express® Gold Card remains one of the best in the industry.
How Do Credit Cards Work — Perks and Warnings
Here’s a short list of ancillary benefits that you should keep an eye out for when you’re choosing a credit card.
- Sign-up bonuses — Fairly self-explanatory. This is a bonus you get just for signing on. They’re usually tied to the card’s rewards program but can be valued at hundreds of dollars when redeemed.
- Additional fees — Some cards have such profitable loyalty programs that they charge an annual fee just to own the card. How does a credit card work in this way? With such cards, you have to make sure that the rewards outpace the fee or you need to cancel the account.
- Introductory APR — Often, cards have an introductory period with a reduced APR. This is an excellent offer to take advantage of if you want to make a big purchase since it acts as a low- or no-interest loan for the introductory period.
Always remember that credit card companies have to abide by general disclosure requirements. If you’re in doubt about anything, contact the issuer, and you’ll get answers to all your questions.
How do credit cards work for beginners?
When you make a purchase with a credit card, the card issuer pays for that purchase and you pay them back later. If you pay the rest within an established grace period, that’s where the story ends.
Credit cards also allow you to pay only a small part of the debt and carry the rest forward. If you do so, the card issuer will charge you interest on the amount you didn’t pay.
How do payments on a credit card work?
Every billing cycle, your credit card issuer will send you a statement detailing how much you owe. It will include the total balance and the minimum payment you’re required to make.
The minimum payment consists of the interest accrued over the billing cycle and a percentage of your total balance.
Interest is only assessed if you carry any balance over to the next billing cycle, so the company won’t charge any interest if you pay in full every period.
Will my credit cards work in Europe?
It depends on the card, but most major credit card companies are accepted throughout Europe. Smaller issuers are accepted in some places, and that will depend on the merchant.
If you intend to use your card overseas, it’s important to check the associated foreign transaction fees. These can be pretty high, so it might be better to pay with cash in some cases.
How do credit cards work in the Philippines?
Credit cards in the Philippines work much the same as anywhere else in the world. However, they have a slight added benefit in that significantly more merchants accept credit cards than they do debit cards.
Is it worth getting a credit card?
Yes, credit cards can be great if you are careful enough. Credit cards can be an excellent tool to help you build credit and manage your finances while extracting valuable rewards.
However, they can also put you on the fast track to bad credit scores and a difficult debt cycle. The way to avoid the former is knowing your card and knowing yourself.
In the guide above, you’ll learn everything you need to know about how do credit cards work, so use that knowledge to your advantage and be honest about your ability to manage debt to decide whether a credit card is the right thing for you.
How do credit cards work and what benefits do they provide? They work like a charm and can have loads of benefits. Hopefully, this introductory guide is enough to give you a practical overview and help you understand the basics of credit cards.