Finance

How Do Credit Cards Work? | Payments, Interest, & More

Credit cards are a way to pay for things without using cash. Basically, you get approved for a line of credit with a limit, and then you can use that amount for whatever purchases you need. However, you’ll need to make payments every month and there are some drawbacks to credit cards like paying interest and fees.

Credit cards are basically small, short-term, revolving loans. They make paying for things online and in stores quick and easy, and allow you to avoid carrying large amounts of cash around. They’re also useful for building credit, an essential part of financial wellbeing that’s important when it comes to buying a new car or a home. 

If you’re considering getting a credit card, you might be wondering how they work. Good job! It’s important to know how any financial tool works before investing time and money into it. In this post, we’ll walk you through the basics that you need to know in order to feel confident about getting a credit card—whether this is your first, or you’d just like a refresher on the most important things to know. 

How do credit cards work technically? We’ll start by defining credit cards in more depth. 

What Is a Credit Card & How Does it Work?

A credit card is a form of revolving credit. Unlike a traditional loan, in which a borrower takes out a certain amount and then pays that back over time, revolving credit allows a borrower to continually take out money up to a certain point—known as a credit limit—pay it back, and then do the same thing again. This is how credit cards work. It’s a line of credit (i.e. a certain amount of money) that you can purchase things against that must be paid back at the end of each cycle (usually, the end of the month). 

Credit cards serve a few different purposes. First, they’re convenient. Rather than carrying cash all the time, a card allows you to quickly make purchases, even expensive purchases, with just a swipe or tap. This also adds security. If you lose a big bundle of cash, that’s it—you’re out of luck. But if someone steals your credit card, many card companies will detect the fraud and pause transactions, as well as potentially even refunding you for fraudulent transactions. 

Credit cards can also be used to finance purchases that you don’t have the cash for immediately. For example, if there is an emergency and you need to travel, you could buy plane tickets with a credit card even if you don’t have the necessary cash in your bank account at the time you’re buying the tickets. People also use credit cards to finance other, non-emergency purchases, but this has some drawbacks, as credit cards tend to have very high interest rates, which we’ll discuss more below. 

Credit cards are a popular way to conduct transactions. As of August of 2021, there are 1,103 billion credit cards in the U.S. As more and more commerce has moved online, credit cards have also become much more convenient than cash, which can’t be used to purchase things on the internet. However, as popular as credit cards are, they can also get you into trouble if used irresponsibly. Next, we’ll review a few of the finer details on how credit cards work. 

How Do Credit Card Interest Rates Work?

Credit cards charge interest on your balance if you don’t pay it off before the end of a billing cycle. Interest is an amount that you owe that’s added onto the amount you borrowed—it’s basically the cost of using the credit card (in addition to possible fees, discussed more below). If you have a balance on your card for multiple billing cycles, you’ll owe interest on the money you’ve borrowed. And credit card interest tends to be pretty high, which means that debt can begin to accrue quickly if you don’t pay off your balance completely. According to the Federal Reserve, the average credit card interest rate in Q3 of 2021 was 17.13%—you can see why it’s usually best to avoid paying interest

Here’s an example of how interest works. Let’s say you’ve put $500 on your credit card. Many cards have a “minimum payment” option—rather than paying the full $500, for example, you could just pay $40 and not be charged a late fee. If you pay that $40, however, the remaining $460 will still be on your balance accruing interest. If your interest rate is 20%, your new balance will be $552, including the new $92 in interest.

Another common term you’ll see when shopping for a credit card is APR, or annual percentage rate. This refers to your card’s interest rate. For some financial products, APR is different from the interest rate, but this is not the case with credit cards. 

How Do Credit Card Fees Work?

In addition to interest rates, many credit cards also have fees. There are a few different kinds of fees you may encounter, such as late payment fees and annual fees for owning a credit card. Fees can increase the total cost of using a card. While late fees can be high, they’re also easy to avoid: just be sure that you pay your credit card bill on time each month. 

It’s possible, and often preferable, to get a credit card that does not charge an annual fee. However, some cards that have desirable rewards (like airline miles or cash back) may charge an annual fee that’s worth it—it’s ultimately up to the consumer to decide. Other credit cards may be available to people with lower credit scores because they charge an annual fee. 

Other common fees include foreign transaction fees, fees for spending past your credit limit, and balance transfer fees (when you transfer your credit card balance from one card to another). 

How Do Credit Card Payments Work?

Credit card billing cycles typically run from 28 to 31 days—so you can expect to pay your credit card bill monthly. Payments are usually straightforward: you log onto your account online and pay with an e-check or debit card; or, if you prefer to conduct business by mail, you can mail a check to your credit card company after they male you a copy of your statement and bill. 

Credit cards often have the option to make a minimum payment, as mentioned above. While this can be useful if you’re tight on cash and want to avoid a late fee, it’s usually a good idea to pay your full balance, or at least a higher portion of your balance than just your minimum. 

How Does Credit Card Debt Work?

You’re effectively taking out a modest short-term loan when you use a credit card. That loan’s conditions state that it must be paid off every month by the end of the month. When you don’t pay off your credit card bill each month, debt builds up. Even if you pay the minimum payment—typically a percentage of the total amount owed, such as $30 or $50—interest will begin to accumulate on the remaining debt. Approximately 35% of millennials have some type of credit card debt, which can start to seriously affect your finances after a while. 

Consider this example. Let’s assume you owe $500 on your credit card and have made a $100 payment. The interest on the remaining $400 will continue to accumulate. If your interest rate is 20%, you’ll owe $480 from your remaining balance plus interest on your next statement. The fact that interest compounds makes it considerably more difficult for many credit card users to pay off their debt once they’ve already accrued a lot of it.  Compounding means the next time interest is calculated on your account, it will be charged to the new $480 total, not the $400 principle.

That’s why it’s a good idea to pay off more than just your minimum when paying your bill each month—you’ll avoid the punishing compound interest that could accrue otherwise. 

How Do Credit Card Balance Transfers Work?

Balance transfers are a way to consolidate debt, or pay a lower interest rate. For example, if you have a credit card with a 20% interest rate and a $2000 balance you’re paying off, you might look for a new card with a lower rate that you can transfer your balance to and begin paying your balance off without accruing as much interest. 

Note that in many cases, cards will charge a fee for balance transfers. If you are transferring your balance as a way to pay down your debt, be sure that you check whether the balance transfer fee is low enough to make the swap worth it. 

Key Takeaways

How do credit cards work? Credit cards can be a useful financial tool for many reasons: convenience, security, and building personal credit. Once you get the hang of using them, they allow you to shop online, earn rewards, and build up a strong credit profile as you cover your day-to-day and even larger expenses. 

It’s also good to keep in mind that credit cards have some drawbacks. They have high interest rates, and sometimes charge high fees for continued use. If you want to learn more about how to apply for a credit card, or you need help with credit card debt, check out the Mint blog for tips, tricks, and insights! 

Source: Consumerfinance.gov

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