Credit cards work on a buy-now-pay-later basis. When you use a credit card to make a purchase, you borrow money from the credit card’s issuer to complete the transaction, then pay what you owe at the end of the billing cycle, either in part or in full. If you pay a credit card’s bill in full each month, you can essentially borrow money for free because you will avoid interest charges. Interest will apply if you do not pay the bill in full, and your credit score will suffer if you don’t make at least the minimum payments due.
Credit cards are a great tool for paying bills, and they also work for transactions other than purchases, including balance transfers and cash advances. Balance transfers give people the chance to repay existing debt with a lower interest rate, for a fee – usually 3% to 5% of the transferred amount. Cash advances let you withdraw cash from your credit line, but a high fee and interest rate apply right away.
Key Things to Know About How Credit Cards Work
- Credit cards allow you to buy now and pay later, even over the course of months.
- Credit cards enable you to build credit, unlike debit cards.
- Some credit cards reward you for making purchases.
- Some cards charge annual membership fees.
- If you don’t pay your full balance by the due date each month, interest charges are added to your balance each day.
- When you pay off part or all of your balance, an equivalent amount of your credit limit becomes usable for new purchases. This is a process known as “revolving credit.”
- Credit card approval depends on your overall creditworthiness. Credit history, income and debt obligations are important factors.
Below, we’ll discuss how different aspects of credit cards work, from building credit and making payments to interest and rewards.
What Is a Credit Card?
In order to really understand how a credit card works, you naturally have to understand what a credit card is. A credit card is a plastic or metal payment card that allows you to make purchases without having the money upfront and then pay them off over time. Depending on how quickly you pay off your balance, you may owe interest, and credit cards also may charge various fees, such as an annual fee for keeping the account open.
Credit cards are the best way to build credit because they report account information to the credit bureaus every month, even if you don’t use them at all. If you do choose to use your card, you can make purchases with it, pay bills, transfer balances from other debts, or even get cash (although that last option is extremely expensive).
There are many different types of credit cards, including:
- Secured cards
- Unsecured cards
- Rewards cards
- Student cards
- Business cards
- Store cards
- 0% intro APR cards
- Balance transfer cards
You can learn more about all the different types of credit cards here on WalletHub.
How Getting a Credit Card Works
To get a credit card, you must first fill out an application. Then, the bank or credit union issuing the card can evaluate your credit history, income, debts and other factors to determine whether you are an eligible borrower.
You can apply for most credit cards online, it’s also often possible to apply by phone, in-person at a branch or by mail. Applying online usually leads to the fastest decision.
It's possible to get approved for a credit card instantly if you apply online, though it can take up to 30 days to get a decision in some cases. After being approved for a credit card, it generally takes 7-10 business days to get the card in the mail. You may be able to request expedited delivery for free or a small fee, however.
Learn more about how to get a credit card.
How Building Credit with a Credit Card Works
Using a credit card responsibly is the easiest way to build credit. If you use only a portion of your card’s spending limit (ideally less than 30%) and pay the bill on time every month, or never make purchases with the card at all, the issuer will report positive information to the credit bureaus each month. This allows you to build a good credit score.
Plus, it’s very easy for someone with no credit or even bad credit to get a credit card, especially a secured card where your credit limit is based on how much you put down as a security deposit. The same cannot be said for loans, for example.
Learn more about how to build credit with a credit card.
How a Credit Card Transaction Works
A credit card transaction involves either using a card reader at a merchant or providing your card details over the phone. There are four parties involved in every credit card transaction:
- You
- The merchant
- The bank or credit union that issued your credit card
- The network that services your credit card (Visa, Mastercard, American Express, or Discover)
You can use your credit card at any merchant that accepts the credit card network whose logo is on your card, as the network is the company that actually processes the transaction. The exception is with store credit cards, where you can only use the card at the merchant it’s partnered with.
When you make a purchase in-person, there are three different ways you can use your card:
- The first is swiping the magnetic stripe on the back, which is the least secure method, but might be the only one available at certain merchants that haven’t upgraded their payment terminals.
- The second is inserting the EMV chip embedded in the end of your card into the card reader.
- The third is tapping your card on the reader for a contactless transaction. Some cards and some merchants may not have the capability for this yet, but it is the most secure way to pay.
When paying online or over the phone, you’ll have to provide the merchant with all of the information written on your credit card. That includes your name, your card number, the card’s expiration date, and the 3- to 4-digit security code.
Learn more about how credit card transactions work.
How Credit Card Payments Work
Credit card payments are due monthly, roughly 21-25 days after the end of each billing period. Cardholders can choose to pay the minimum amount due, the full balance listed on their monthly statement, or another amount.
Paying at least the minimum amount due is required to keep a credit card account in good standing and avoid potential credit-score damage.
Paying the full statement balance each month is required to avoid interest, unless a card has a 0% introductory APR in effect.
Most credit cards allow you to make payments online, over the phone or by mail. Some cards allow in-person payments at one of the issuer’s branch locations, too. The best approach to credit card payments is to set up automatic monthly payments from a linked checking account. That way, you will never miss a due date because of forgetfulness.
Learn more about how to pay credit card bills.
How Credit Card Interest Works
Credit card interest is charged daily on accounts with a revolving balance – one that carries over from month to month. Credit card interest also compounds on a daily basis, which means the interest charged one day becomes part of the balance that accrues interest the next day.
The combination of daily compounding and the high interest rates that credit cards are known for results in very expensive finance charges for cardholders who are not careful enough. The average credit card APR is 22.76% for new offers, according to WalletHub research.
Fortunately, you can avoid credit card interest by paying the full balance listed on your account statement each month. This will keep your credit card’s grace period intact.
Learn more about how credit card interest works.
How Credit Card Fees Work
There are a lot of different types of credit card fees that you might encounter. However, most of them are easy to avoid – either by applying for cards that don’t charge them or by avoiding certain situations that trigger fees. Common fees include:
- Annual fee: This is a fee just to keep your account open each year. Many cards have no annual fee, but this type of fee can be worth paying if the rewards and supplemental benefits offered by the card provide more value. The average annual fee is $26.75, according to WalletHub research.
- Foreign transaction fee: You can get charged a fee of 1% to 3% of your transaction whenever you buy something from a foreign merchant, either online or in person. Get a card with no foreign transaction fee to avoid this charge.
- Balance transfer fee: Moving a balance from another debt to your credit card usually comes with a fee of 3% to 5% of the amount transferred. This fee is only worth paying if your card has a long introductory 0% APR on balance transfers.
- Late fee: If you pay late or miss a payment altogether, you’ll owe an average of $33.78. If it’s your first time paying late or it’s been a long time since it last happened, you may find success calling your issuer and asking for the fee to be waived.
- Cash advance fee: You can use your credit card like a debit card to get cash from an ATM or bank, but it’ll come with an expensive fee, which is an average of 4.02%. Plus, interest will start accruing on this balance immediately at a high APR.
Learn more about credit card fees.
How Credit Card Rewards Work
Many credit cards reward cardholders with cash back, points or miles for every purchase made. Plus, the best credit cards often come with signup bonuses that cardholders can earn after meeting a minimum spending requirement in the first few months.
Credit card rewards can be redeemed for statement credits to help pay the account balance, travel expenses, gift cards and more, depending on the specific credit card. Generally, the credit cards with the best rewards go to people with high credit scores, a lot of income, and little-to-no debt. But rewards credit card offers are available to people of all credit levels.
Learn more about how credit card rewards work.
How to Use a Credit Card Responsibly
The keys to using a credit card responsibly are paying on time and keeping your credit utilization low. But there are a few other guidelines that are important to follow as well.
Always Pay on Time
On-time payments are the biggest component of your credit score, so it’s absolutely crucial for you to pay at least the minimum by your monthly due date.
Pay in Full, if Possible
You don’t have to pay your balance in full every month, but doing so allows you to avoid interest, and it’s better for your credit score.
Keep Your Credit Utilization Low
Your credit utilization ratio, or the share of your credit limit that you actually use at one time, is a big part of your credit score. Going over 30% can cause damage to your credit score. Anything under that – even 0%, is fine. The best utilization ratio is around 1% to 10%.
Don’t Spend More Than You Can Afford
Overspending can quickly get you into unsustainable credit card debt. Credit card interest is expensive, and the average APR on new offers is 22.76%. Learning how to budget properly can help you avoid spending beyond your means.
Ask for Credit Limit Increases
After six months of consecutive on-time payments, you may want to ask your credit card issuer for a credit limit increase. This may trigger a hard credit pull that can lead to a small, temporary decrease in your credit score. However, it can help your credit long-term because it can decrease your credit utilization ratio if you keep your spending the same, or allow you to spend more without increasing your utilization.
Monitor Your Credit Reports
Checking your credit reports allows you to catch errors and signs of potential fraud that may be bringing down your credit score. If you find anything out of place, you should immediately dispute it with the credit bureaus. You can check your credit report and credit score for free here on WalletHub and get daily updates.
Credit Cards vs. Debit Cards
The biggest differences between credit cards and debit cards are that only credit cards enable you to build credit and borrow money. Credit card rewards are also much more abundant and lucrative than debit card rewards, and credit cards have better fraud protections.
A debit card is tied to a checking account, so the money you can spend is limited to what you have in that account. Credit card spending limits are based on the issuer’s assessment of the cardholder’s overall creditworthiness, as the issuer is lending money to the cardholder.
Learn more about the differences between credit cards and debit cards.
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