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How do credit cards work?

Young woman uses credit card to make online purchase
Damir Khabirov/Shutterstock.com
Young woman uses credit card to make online purchase
Damir Khabirov/Shutterstock.com
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Using credit cards is a convenient way to pay for products and services in person and online. On top of that, your credit cards can earn rewards—such as cash back, points or miles—on purchases you would have made anyway. Responsible spending will also help you to build your credit along the way.

Of course, letting your credit card spending get out of control can lead to mounting debt, excessive interest charges, late fees and bad credit.

Here’s everything you need to know about how your credit card actually works so you can take advantage of its benefits while minimizing the risks.

How do credit cards actually work?

Simply put, a credit card is essentially a small loan from an issuing bank. While some may look at credit cards as “free money,” in actuality your credit limit is a loan that is subject to an APR (otherwise known as interest) that will be charged to you as the cardholder if you don’t pay off your balance at the end of a billing cycle.

When the bank approves your credit card application, it will cap your account with a credit limit, which is the maximum amount of money the bank will allow you to spend with the card. Your credit card limit is based on your income, debts, credit history and other criteria.

When you make a purchase with your credit card, the transaction is processed by one of the four major payment networks: Visa, Mastercard, American Express or Discover. Their role is to ensure the merchant receives money for the transaction and that your card issuer bills you for the purchase.

Once you purchase goods or services with a credit card, the purchase amount is deducted from your available balance. Conversely, when you make a payment on your credit card account, you will have more available credit to use for future purchases.

How do credit card payments work?

After you make purchases with your credit card, you will receive a credit card bill every month. It’s important to know that you won’t be required to pay your full balance each month, although it’s in your best interest to do so. Instead, you only have to make a minimum payment, which usually ranges from 1 percent to 3 percent of your outstanding balance (plus any interest and fees from the previous month).

When possible, it’s best to pay your balance in full. While it may seem appealing to only make a minimum payment, this is when it’s important to remember that the money you have spent is not free. Any outstanding balance on your credit card is subject to added interest that compounds monthly. Only paying your minimum balance is okay if you’re in a pinch, but doing this over a long period of time could get you into credit card debt that only seems to grow.

Once you have made a payment, your bank or credit card issuer reports your payments to the credit agencies. Ensure your payment is on time by setting up automatic monthly payments for the minimum amount or another amount of your choosing. Most banks also offer email or mobile notifications to alert you when your due date is near.

How does credit card interest work?

You can avoid paying interest by paying off the entirety of your credit card balance each month. If you pay in full each month, your issuer is required to provide a grace period, usually 21 days or more from the end of your billing cycle to your payment due date, during which you can pay for your transactions interest-free.

If you don’t pay the entire balance, any balance that remains will roll over into the next monthly billing cycle and start to accrue interest. Since you generally lose your grace period when you carry a balance, you’ll start accruing interest on new purchases, too.

The amount of interest you’ll pay is based on the annual percentage rate (APR) your credit issuer assigns to your account. The bank establishes the APR for your credit card account by reviewing your income, credit history and other factors.

Differences between credit cards and debit cards

Credit cards and debit cards look nearly identical, but in practice, they are not. The major differences between them include how purchases are processed, the impact (or not) on your credit score, your liability when it comes to fraud and the potential to earn rewards on everyday purchases.

A debit card uses your money, a credit card uses the issuer’s

When you make a purchase with your credit card, you are borrowing money from your card issuer. You don’t have to use your own money until you pay your credit card bill.

By contrast, debit cards are linked to your checking account. When you purchase goods or services with your debit card, money is automatically transferred from your bank account the moment you complete the transaction. You don’t have a bill to pay later because your account already paid for the transaction.

Using credit impacts your credit score; using debit won’t

Creditors report your credit card payments to the three major credit bureaus—Equifax, Experian and TransUnion. Using your credit card responsibly and paying your bill on time each month can help you build good credit. On the other hand, paying your bill late or missing a payment can hurt your credit score.

Debit cards have no impact on your credit score (positive or negative) because you pay for your purchases when the transaction is processed. Card issuers never report debit card activity to the credit bureaus. Debit cards do come with their own fee structures, however, such as overdraft fees.

Credit cards offer better protection against fraud

While both credit and debit cards limit your liability for fraudulent purchases, there are subtle differences between the protection you’ll get from each card type.

If someone uses your credit card information to make purchases, your maximum liability is $50 by law. What’s more, many issuers (as well as the four major credit card networks) provide $0 liability protection against fraudulent charges. That means a thief can ring up thousands of dollars of unauthorized charges on your credit card, but as long as you report it within a certain time frame—which varies by issuer—you won’t be on the hook for any of it.

However, if someone makes fraudulent purchases using your debit card, your bank could hold you accountable for all of their unauthorized charges if you don’t report the fraud within 60 days of receiving your statement. Although most banks monitor for suspicious debit card activity, their fraud protection is inferior to the $0 liability protection you receive from most credit card issuers.

You can earn rewards with credit cards

Another big difference between credit cards and debit cards is the potential to earn rewards. Many of the best credit cards incentivize cardholders to use their cards by offering rewards on purchases. Rewards rates vary by card, and some cards offer no rewards at all, but they come in a variety of forms including cash back, airline miles, statement credits and more.

When it comes to debit cards, you don’t run the risk of added interest, but you also don’t earn rewards for the purchases you make.

The bottom line

Credit cards can be a helpful tool when you use them strategically to establish credit, earn rewards, obtain 0 percent interest financing or pay off high-interest debt. But in order to maximize the benefits, only use your credit card for purchases you would make anyway and pay your bill in full and on time each month.

Written by
Tim Maxwell
Contributor
Tim is a freelance personal finance writer and blogger with a particular focus on credit cards and consumer lending. In 2002, he stumbled upon a copy of "The Millionaire Next Door," by Thomas J. Stanley and William D. Danko, which ignited a passion for learning and sharing fact-based money principles. Tim has a passion for demystifying personal finance and helping people live their best lives.
Edited by
Associate Editor