How do credit cards work?

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Using a credit card is as easy as swiping or dipping the card in a card reader. Credit card payments go through quickly and seamlessly because much of the process happens behind the scenes. As a result, credit cards may appear mysterious to first-time cardholders.

Learning how credit cards work can demystify this payment method and help you become a confident credit user.

How do credit cards work?

When you take out a credit card, you get access to a line of credit. You can borrow up to that limit set by your credit card company. You may be charged interest right away, or you may have a limited time to pay what you owe before interest starts adding up.

Each month, you get a bill. You can choose to pay your balance all at once or make payments over time but you’ll have to make at least a minimum payment each month. You can use the card for as many purchases as you like, as long as the balance of your charges doesn’t exceed your limit.

When you apply for a credit card, you provide personal information, including information on your income, and you give the credit card issuer permission to look up your credit. The credit card issuer makes a hard inquiry on your credit and decides whether you qualify for the card. If you’re approved, the credit card issuer lets you know what APR (annual percentage rate) you’ll be charged for different uses of the card and your credit limit.

You can use a credit card to transfer a balance from another card, to get a cash advance or to make purchases from merchants.

How credit card payments work

You can use your credit card for purchases both in-person and online. To make a purchase in a brick-and-mortar store you either swipe the card or, if you have a chip card, insert it into a payment terminal. When shopping with a credit card online, you enter your name, card number, card expiry date and your card’s security code into a payment form during checkout.

Next, the merchant’s bank that’s collecting payment from you automatically contacts your credit card company and checks if you can borrow enough to cover the transaction. If the transaction won’t put you over your credit limit, it’s approved.

Next, the credit card network (Visa, Mastercard, American Express or Discover) gets the money from your credit card company, subtracts processing fees, and deposits the remaining amount into the merchant’s bank account.

Once a transaction is approved, your available credit goes down by that amount, and the purchase may appear as a pending transaction in your account activity for a few days. It becomes a posted transaction when the amount is officially added to your balance.

Paying your credit card bill

At least 21 days before your payment is due, your credit card company gives you a statement showing your activity from the most recent billing cycle. This statement includes all purchases you charged to your card as well as any interest and fees you’ve incurred.

Most credit card companies offer a grace period, during which you aren’t charged interest on purchases if you pay your entire balance by the due date. If you don’t pay your balance in full within this time, you lose the grace period and interest applies to new purchases right away.

Although you can choose not to pay your full balance, you must make at least the minimum payment stated on your bill by the due date, or you may be charged late fees.

If you don’t pay your balance in full, you carry a balance over to the next billing cycle. The credit card company charges you interest on this balance each day with a daily rate that’s based on your APR.

Types of credit cards

Many credit cards are general-purpose cards that are intended for everyday spending. But there are also more specialized cards that are designed for specific uses or that offer particular kinds of rewards.

Balance transfer cards

A balance transfer card comes with promotional terms, like a 0 percent APR for the first 12 to 18 months after opening the account, or no fees for transferring a balance during a specific window. The idea of a balance transfer card is to immediately use it to pay off the balance on another card. You can then pay off the balance during the intro APR period without added interest.

Cash back cards

A cash back card is a card with a rewards program that gives you back a small percentage of the amount you spend. You might receive this reward as a statement credit, as a deposit in your bank account or by check. Some cash back cards offer the same flat-rate rewards on all purchases, while others give more cash back on certain categories of spending.

Travel cards

Travel cards reward spending with points that can be applied toward hotel loyalty programs or redeemed as airline miles. They may offer higher rewards on airfare and restaurant spending and perks like access to exclusive airport lounges. They often don’t charge foreign transaction fees, but there’s typically an annual fee involved.

Retail cards

Retail cards are issued by stores to their customers. These cards may offer perks like free shipping when you order from the store, as well as cash back, store credit or other rewards for making purchases there. It may be easier to qualify for a retail card than for other rewards cards, but the interest rates are often high.

Secured cards

Secured cards are generally intended to help people build credit or to provide an option for consumers who don’t qualify for conventional cards. When you open a secured card, you must deposit some money with the credit card company, and this deposit serves as collateral for your credit account. You may be limited at first to borrowing a portion of the amount you deposited but you may be allowed to borrow up to a higher limit once you’ve established a good payment record. Secured cards often have higher fees and interest rates than other types of cards.

Credit cards vs. debit cards

Credit cards and debit cards usually look the same, but they work very differently. When you charge a purchase to a credit card, you are borrowing money from the credit card issuer. You then pay the money back, and you may be charged interest on the purchase immediately or after a grace period.

A debit card is linked to your bank account. When you use it, you are taking money out of your own account. You can use a debit card to buy something at a store, to get cash back at a store or to get cash from an ATM. Each time you use a debit card, you need to enter a PIN to verify your identity. You aren’t charged interest for using a debit card but your bank might charge fees.

You have more legal protections if someone steals your credit card information than if someone uses your debit card without permission. You may be liable for up to $50 if someone fraudulently makes purchases with your credit card. And if your debit card is stolen and you contact your bank within two business days, you aren’t liable for more than $50. But if you tell your bank about a fraudulent debit transaction after that time frame, you could be out $500 or more.

How credit cards help you build credit

Using a credit card responsibly can help you build credit in several ways.

Establishing responsible credit use

First, if you’ve never borrowed money or used a credit card before, you might not have a credit report. This could make it harder to be approved for a loan or to qualify to rent an apartment. In order to have a credit score, it’s necessary to have used credit recently. If you aren’t actively borrowing money through other accounts, like a student loan or car loan, for example, routinely using a credit card ensures that you always have enough recent history to produce a credit score.

When you take out your first credit card, your new account information is relayed to the credit bureaus and they establish a report for you. If you use your credit card for six months, your credit score will be calculated based on your account activity.

Building a positive payment record

Paying at least the minimum on your credit card by the due date each month builds your payment history, which makes up 35 percent of your FICO score. Making regular, on-time payments shows lenders that you’re able to consistently meet your obligations and repay what you borrow.

Balancing credit utilization

The amount you borrow with your credit card affects your credit utilization ratio, which is another factor that contributes to your credit score. Your credit utilization ratio is the balance on your revolving accounts, such as credit card accounts or a home equity line of credit, divided by your credit limit. It’s recommended that borrowers maintain a credit utilization ratio below 30 percent, as a higher ratio might suggest that you’re close to maxing out your credit or in danger of falling behind on payments. That said, using your credit card to borrow a small percentage of your credit limit can actually be better for your score than not borrowing anything.

Starting a credit history

Having a long credit history is also good for your score. Credit scoring companies look at how long ago you opened each of your accounts and the average age of all of your accounts. Keeping a credit card account open for a while can contribute to the length of your credit history, and this is one reason that closing a credit card account can sometimes lower your score.

Diversifying your credit mix

Using a variety of types of credit accounts—installment accounts like student or auto loans as well as revolving accounts like credit cards—is better for your score than using only one type of credit. Thus, if you don’t have other revolving accounts open, getting a credit card can improve your credit mix and help your score.

Tips for using credit cards

When using credit cards it’s important to monitor your card activity and keep up with your bills. These guidelines can be helpful as you manage your credit cards.

  • Pay your balance in full each month: Make a budget, and charge purchases to your credit card only if you have the money on hand to pay them off right away. Paying your entire bill each month allows you to keep your grace period and avoid paying interest on the things you buy.
  • Use your online account or issuer app to monitor your account: Be aware of your current balance and stay on top of your spending. Review your recent transactions to make sure they’re correct. If you see a transaction you don’t recognize, call your credit card issuer to report it.
  • Sign up for notifications: You can opt-in to email or text message reminders for when your bill is due as well as for different activity on your account.
  • Optimize your cards for different categories: If you have multiple credit cards that offer rewards, find out which spending categories earn points for each card. Keep rewards in mind when you choose to pay with a card. For instance, you may want to use one card for travel and another for groceries and gas to maximize the rewards you earn with each card.
  • Avoid applying for lots of cards at the same time: If several card issuers pull your credit information at once, your credit score could go down. Try to wait at least a few months between credit card applications, and don’t apply for more cards than you need.
  • Check your credit score: Several credit card issuers including American Express, Barclays, Bank of America and Chase make FICO scores available to cardholders through online accounts or on statements. If you notice a drop in your score, find out if you’ve missed payments or if you’re using a large share of your available credit.
  • Protect your account information: Practice safe online shopping habits to keep your information secure. Don’t access your credit card account or enter payment details on a public computer or over public Wi-Fi.
  • Tell your credit card issuer if you’re going to travel: Using your card in a different state or country could look like fraud to your credit card company’s security systems, so call the number on your card before heading out on a trip.