How do credit cards work?

Credit cards offer a convenient way to pay for purchases, whether it’s for bills, groceries, gas, online shopping or more.

A credit card account is basically an ongoing loan issued by a bank. You have a credit limit you can spend against before the card must be paid off. If you carry a balance from one month to the next, you have to pay interest on that amount. Once you pay down your balance, you can spend with the credit card again up to that limit (although it’s best to stay well below your max).

How credit cards can financially help or hurt you depends on how you use them, which requires understanding how they work.

How do credit cards work?

Unlike debit cards, which draw from the money you already have banked, or charge cards you’re obligated to pay off in full every month, credit cards work by giving you a revolving line of credit. This means your available credit replenishes as you pay your debt.

For example, if you had a credit card with a $1,000 limit and spent $500, you would only have $500 available credit on your card. If you paid the $500 balance your available credit would bounce back to $1,000 again. If you chose to only pay off $300 of that balance, you would only get back to $800 available credit until you paid the remaining balance.

Every billing cycle, your credit card issuer sends you a statement of all the transactions made on your credit card and a minimum payment amount that must be paid for your account to stay in good standing. If you don’t pay your credit card minimum payment by the due date, you may face penalties and fees.

Furthermore, every month that you carry over a balance on your account from the previous month, the credit card issuer applies interest charges. Issuers charge a percentage of the carried balance and apply it to your account. Expressed as a percentage, credit card interest is also known as APR or annual percentage rate and is the cost of keeping a balance from month to month.

Credit card interest isn’t applied immediately when a transaction is made — there is a grace period between the transaction date and the end of the billing cycle where no interest is charged.

How credit card APR works

A credit card APR is the cost of using a credit card and carrying a balance between billing cycles. Most credit cards are variable-rate cards, meaning their APRs are tied to a benchmark interest rate called the prime rate, set by the Federal Reserve. However, some cards are fixed-rate credit cards and so their APRs are unaffected by the prime rate.

If you rely too heavily on credit cards, interest will rack up on your balance and keep accruing every month that you don’t completely pay off the card. Plus, you’ll also be charged interest on the interest that’s added to the account.

It’s crucial to pay as much of your credit card bill as possible to avoid a cycle of debt in the form of interest charges.

Here are the four main types of credit card APRs:

1. Standard APR: Your APR determines the amount of interest you’ll pay if you carry a balance from one month to the next.
2. Balance transfer APR: If you transfer an old balance to your new credit card, your balance transfer APR will determine how much interest you’re charged on your transferred balance.
3. Cash advance APR: If you borrow cash from your credit card — for example, by writing a credit card check or taking out cash from an ATM — you’ll be charged a special cash advance APR that’s often higher than your regular APR and has no grace period.
4. Penalty APR: Your credit card issuer may also charge a higher APR, called a penalty APR, if you fall behind on payments.

Common credit card fees

Most credit cards charge a variety of fees. However, the fees are typically tied to optional services, such as balance transfers, cash advances and revolving balances. As a result, you may not have to pay any fees at all if you use a no-annual-fee credit card, pay off your purchases in full each month and only use your card to make new purchases.

Here are some common charges you might encounter on your credit card:

• Annual fee: Some credit cards charge a fee just for having the card. For example, if you open a rewards card with premium benefits or get a secured card for consumers with bad credit, you may be charged an annual fee.
• Balance transfer fee: If you transfer debt onto your new credit card, your card issuer may charge you a percentage of the total amount you transferred. Balance transfer fees are usually $5 to $10 or 3 percent to 5 percent of the transferred balance (whichever is higher).
• Cash advance fee: Your card issuer may also charge you a percentage of the amount you borrowed if you take out a cash advance.
• Foreign transaction fee: Some credit card issuers also charge a percentage of any transaction you make abroad or in a foreign currency. Foreign transaction fees tend to be 3 percent of the purchase. If you’re going to be traveling overseas, a card with no foreign transaction fees can help you save.
• Late payment fee: Your credit card issuer may also charge you a fee each time you pay your bill after your payment due date. Under federal law, a late payment fee can’t exceed $40.

Pros and cons of credit cards

While credit cards are convenient and can even come with rewards, there are pros and cons to how credit cards work that you need to know before you use them:

Credit cards vs. debit cards

How credit cards work is slightly different from debit cards. While both look the same and you can swipe, insert or tap both a credit card and debit card at a register, the accounts are managed differently:

Different types of credit cards

There’s a slew of different types of credit cards. Some are designed for beginners. Some let you earn a percentage of your purchase back as cash, and others help business owners charge business expenses. The categories of credit cards include:

• Rewards and cash back cards
• Business credit cards
• Starter credit cards
• Secured credit cards
• Student cards
• Balance transfer credit cards
• Travel, airline and hotel credit cards

Each category has its advantages, drawbacks and requirements, so it’s important to shop around to find the best credit card for you. You can use a tool like CardMatch to see which credit cards you might qualify for.

Bottom line

How credit cards work isn’t as daunting as it initially seems. As long as you practice responsible credit card habits, maximize rewards or use the card to build your credit score, they can be invaluable financial tools to keep in your wallet. Understanding how they work is the first step to better managing credit cards and avoiding credit card debt.