Credit Card Basics: What They Are and How They Work

What is a Credit Card?

A credit card is a rectangular card made out of plastic or metal, which is often given to consumers by a financial services company or bank. The solution allows cardholders to access cash from a line of credit, on a temporary basis, so they can pay for goods and services. Every time you borrow money from a credit card, you agree to pay back what you use, within a specific time period, alongside any agreed charges or interest. 

In order to be issued with a credit card, you will need to satisfy certain criteria from banks or other financial organizations. For instance, you may need to show evidence of your identity and pass a credit check before you’re allowed to use a card. 

Credit cards are accepted in millions of ATMs and stores around the globe and are a convenient and hassle-free way of making purchases abroad as well as online. 

Each credit card issued is unique and non-transferable and each cardholder will be asked to sign a credit card agreement at the time of issuing.

There are two core “types” of credit cards available. The first is a “secured credit card” which requires users to pay an upfront security deposit, as collateral in the case they end up missing a payment. Unsecured credit cards, on the other hand, require no security deposit, and typically offer better terms. People with poor credit histories may not always qualify for an unsecured card.

Most major credit cards are affiliated with Visa, Mastercard, American Express or Discover and are issued by banks or credit unions. Additionally, many credit cards also offer incentives for using that card ranging from airline miles to hotel points to cash back. This can increase consumer interest in using a specific reward card.

Another type of credit card is the store credit card, which is intended specifically to increase customer loyalty. Typically offered by major retailers such as Sears or JC Penney, this type of credit card is often easier to qualify for, but can only be used at the retailer who issues the card. However, that loyalty can pay off when the retailer offers special sales and discounts to their cardholders.

How Do Credit Cards Work? The Basics

Credit cards are a relatively simple financial tool, but it’s worth making sure you fully understand how these resources work before you consider using one. Credit cards typically require users to “apply” for approval before they’re issued with credit. If you’re approved for a credit card, the issuer will open a credit account for you, which comes with a specific limit on how much you can spend before paying back whatever you owe. The issuer also sets an “interest” rate and establish any specific fees which need to be paid when using the credit card. 

The limits and fees connected to a credit card will often depend on the kind of card being used. A credit limit on a secured credit card is often equal to the “security deposit” the user pays. Alternatively, on an unsecured card, the issuer bases the line of credit on factors like income, credit score, and similar factors. 

The interest rate, on the other hand, is the price the user pays when borrowing money on a credit card. This is usually expressed as an “annual percentage rate” or APR. Each month, the card issuer you choose will send you a statement with your credit card balance, and insights into the transactions made over the month. Additionally, you’ll receive a due date for a payment.

Credit card users need to ensure they’re paying at least part of the balance due each month (the minimum payment). However, it’s best to pay off the full balance before the due date, when possible, as this will reduce fees and interest rates. 

Failing to pay any of the balance on a credit card before the due date will often lead to additional charges. 

Credit Card Pros and Cons

Credit cards are a convenient tool for making transactions. They can assist with building a user’s credit score, when used correctly. Plus, these tools make it easier to make purchases and spread the costs out over an extended period of time. However, credit cards can often have substantially higher interest rates when compared with other forms of consumer credit.

Additionally, it’s possible for users of credit cards to end up in debt if they’re not careful about their spending. Some of the common pros and cons of credit cards include:

Pros:

How Do You Choose a Credit Card?

There are various different types of credit card available. The option you choose will depend on a number of factors, including what kind of services and finances you’re looking for. The first thing you’ll need to consider is how you’re going to be using your credit card. 

If you’re paying your credit card balance in full each month, you can reduce your risk of paying interest. In this case, it’s often a good idea to look for a credit card that allows you to earn rewards (provided you have the right credit score). Rewards can give you points, airline miles, and cash, every time you use your credit card. 

On the other hand, if you don’t know whether you’re going to be able to pay your balance in full each month, you may need to look into a card which allows you to keep your interest rates as low as possible. Make sure you consider all of your options carefully, and look at the fees you can expect to encounter when using your card, such as:

• Interest payments: The amount of interest you pay when you don’t pay your balance in full
• Fees: Such as late payments and annual fees

Notably, credit cards can charge a number of fees, depending on the situation. Most cards won’t have an annual fee unless you’re using a card with a high number of available rewards. If you have a rewards card, the interest on your card will quickly consume any rewards you earn if you don’t pay your entire balance on time. 

Before you choose a company to start your credit line with, it’s worth doing plenty of research into the best options for lower interest rates and higher perks. 

Understanding Fees for Credit Cards

If you’re not sure how to calculate the fees you’re likely to pay for your credit card, it’s worth looking for the “Schumer box” on your credit card application. This is essentially a chart which tells users as much as possible about how the card works. Here are some of the fees you may see represented here:

• APR for purchases: The APR rate for purchases is the interest rate charged on anything that wasn’t paid the month before. The rate is charged on a daily basis. This means if the APR is 15%, you’ll be charged around 0.041% per day. Some cards come with an introductory 0% interest rate which can last for around 6 months or more. If the “APR” is variable, this means it’s tied to a base rate called the “prime rate” managed by the federal reserve. If the prime rate raises, the interest on your credit card will increase too. 
• APR for balance transfers: If users have credit card debt, they can sometimes shift that debt onto a new card through a balance transfer. Some cards allow users to move their balance without paying any interest on their balance for up to 12 months. However, some cards also charge a balance transfer fee, or a specific interest rate. 
• APR for cash advances: Users who take out a cash advance (using a credit card to take money from a bank or ATM), they’ll be charged a specific fee. The APR for cash advances is usually more expensive. Additionally, unlike regular purchases, wherein credit card users have a grace period for paying off their debt, with a cash advance, users start accumulating interest on cash advances immediately. 
• Penalty APR: A penalty APR is the fee users pay when they miss a balance payment. This is a higher interest rate which can remain on your card for a specific amount of time. Usually, your credit card application will provide you with insights into how to avoid paying extra interest and fees, as well as offering overviews into your minimum interest charge. 
• Annual fees: Annual fees are fees paid to the credit card company in order to use the product. While many cards don’t have an annual fee, there are some, such as cards with hefty rewards, which can have a significant fee. Cards for people with less than ideal credit may also be more likely to have a fee attached to them.

Other fees included with credit cards usually fall into the realms of transaction and penalty fees. Transaction fees may include a “foreign transaction fee” which is an extra price you pay to use your credit card when shopping overseas. Penalty fees usually include fees for late payments, when you don’t pay the minimum balance on your card by a specific date. 

You may also have to pay “over the limit fees” when you go over the limit set by your credit card provider, and returned payment fees, when you try to pay a balance on your credit card, and it doesn’t work for some reason. Keep a close eye on your billing cycle, and make sure your bank account has enough cash in it to pay each credit card bill as it arrives. 

An unpaid balance can quickly damage your finances, so make sure your outstanding balance doesn’t get too high either. 

How Can You Get a Credit Card?

If you’re just starting out in your financial journey, applying for a credit card can be a little more challenging than it seems. Most of the time, all you need to do is fill out an application. However, if you don’t have a good credit score already, merchants and banks may be less likely to give you a line of credit, because you’re seen as a riskier borrower. 

If you’re new to credit, it’s a good idea to start building your credit as quickly as possible. You can start working on your credit by:

• Getting a secured credit card: Secured credit cards require you to make a cash deposit into your card which will be used if you’re unable to pay your bill. This reduces the risk to the issuer, making it more likely you’ll be able to apply for credit.
• Getting student credit cards: Student credit cards are a specific kind of card designed for younger people who might not have much credit history. You’ll need to demonstrate you have an independent source of income before you can apply for one of these cards. You may also need to provide evidence of your age and background.
• Becoming an authorized user: If your parents or partner has a credit card, you may be able to piggy-back on their credit card account, which helps to develop your credit. In this instance, the primary credit card user is still responsible for making the payment. In some cases, you may also be able to ask someone to “co-sign” your credit card, and take responsibility for your debts if you can’t pay them. 

Keep in mind, the rules involved in getting a credit card will depend on your credit card issuer. While most brands will check your credit report, some will require more from consumers than others. For instance, if you want to apply for rewards credit cards, rather than just build credit, you may need to be a certain age, and have a regular source of income. 

If you’re not sure of your credit score, it’s worth checking with the credit bureaus before you start applying for credit cards with companies like Visa, Capital One, or Mastercard.  

Should You have a Credit Card?

A credit card can have a lot of perks for the average consumer. The best credit card can make it easier to access the products and services you want easily. You can use your credit card to buy everything from groceries to gift cards, while improving your credit score, and keeping your spending in check. However, it’s important to make sure you’re using these products correctly. 

Explore a range of credit card offers before you make your decision of what kind of card you need, and always keep a close eye on your credit card statement. Ensure you’re making your credit card payments on time, to avoid late fees, and where possible, try to opt for interest-free cards which don’t have any monthly payment requirements to worry about.