How do credit cards work?

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Credit cards provide a line of credit you can borrow against, but you don’t have to pay back your entire balance all at once. You can use your credit card to make purchases, take out a cash advance or set up a balance transfer, and you get the option to make payments in any amount that is more than the minimum monthly payment your credit card requires.

When you pay your balance in full by your statement due date, you won’t pay any interest on your charges. If you spread your payments out over a period of time, interest charges will accrue on owed amounts, causing your purchases to cost more than they originally did.

How do credit cards work?

When you are approved for a credit card, you are essentially qualifying for a line of credit you can use if you want to. When you use your credit card for purchases, balance transfers and other transactions, the money you borrow is taken from this line of credit.

In contrast, when you pay with a debit card, the money comes right out of your bank account when you make the purchase.

With a credit card, you can choose to pay all your credit card purchases in full when your credit card bill arrives, but you can also choose to spread your payments out over time. If you decide to carry a balance on your credit card, interest will begin accruing on purchases after your statement due date. With cash advances and balance transfers, on the other hand, interest will begin accruing from the date the transaction is made.

Before you sign up for a credit card, you should know about all the pros and cons, as well as the potential pitfalls you should strive to avoid.

Benefits of credit cards

There are plenty of incentives for consumers to use credit cards instead of cash or debit. Here are the main perks you should be aware of as you compare card options:

Earn rewards

Many of the top rewards credit cards let you rack up cash back, points or miles that you can redeem for a check in the mail, gift cards, travel and more. If you pay your credit card bill in full each month and avoid all credit card fees, these rewards can leave you “ahead.”

Qualify for a zero percent intro APR

Select credit cards offer zero percent APR on purchases, balance transfers or both. These offers can help you save money on interest and consolidate debt.

Help build your credit score

Your credit card movements will be reported to the three credit bureaus: Experian, Equifax and TransUnion. This can help you build credit over time with responsible usage, such as paying your credit card bill on time each month.

Receive important consumer benefits

Credit cards can offer a range of protections that can help you save money or stress. Common benefits include purchase protection against damage or theft, extended warranties and travel insurance.

Conduct safer online purchases

Most credit cards come with zero fraud liability, yet you can only be legally liable for up to $50 in fraudulent charges with a credit card due to rules in the Fair Credit Billing Act (FCBA). With a debit card, on the other hand, you can be liable for an endless amount of fraudulent charges, including all the money taken from your bank account and possibly more if you don’t report the fraud within 60 days of your bank statement being sent to you.

Drawbacks of credit cards

Credit cards also come with some major downsides, which is why plenty of consumers never use them. Here are some of the drawbacks to consider:

You’ll pay interest if you carry a balance

The main disadvantage of credit cards is the fact they charge interest on your purchases and cash advances, as well as balance transfers that don’t take place during a zero percent intro APR period. Since the average credit card interest rate is currently over 16 percent, using credit can be a costly endeavor in the long-term.

There are various fees

Credit cards with the most perks charge annual fees that typically range from $95 to $550. However, all credit cards have the potential to charge foreign transaction fees on purchases you make abroad, late payment fees when you pay your bill late, fees for cash advances, fees for balance transfers and plenty more.

Your credit score can be affected

The second most important factor that makes up your FICO score is the amount of debt you owe in relation to your credit limits, otherwise known as your credit utilization. If you max out your credit cards and show high utilization rates on revolving debt accounts, your credit score could drop—even if you pay your bill on time each month.

Easy to rack up long-term debt

Paying for your purchases with plastic can almost be too convenient. Credit cards make it easy to rack up balances you can’t pay off each month, which can lead to a lifetime of costly debt.

How credit card transactions work

Credit card transactions involve a series of steps that can vary slightly depending on the type of credit card you have as well as whether you’re making a purchase in-person or online. However, you should note that there are five main parties involved in each transaction that takes place:

  • You, the credit card customer
  • The merchant where the transaction takes place (store, restaurant, etc.)
  • Your merchant’s bank
  • The bank that issues your credit card
  • The credit card network that facilitates the transaction

Each party to the transaction has its role to play when you use your credit card to make a purchase, and the following steps describe how a credit card purchase works from start to finish.

Step 1

If you have a chip and pin credit card, you’ll dip your credit card into a payment terminal to get the transaction started. If your card does not have chip technology, you may swipe your card instead. In the event of an online transaction, you’ll manually enter your credit card numbers and information to make a purchase.

Step 2

Once your credit card information has been entered, your merchant’s bank requests information from your bank to determine if your line of credit is sufficient to make the purchase.

Step 3

Once your purchase is approved, your credit card issuer sends the funds to your merchant’s bank, by way of the credit card network the transaction takes place on (i.e. Visa, Mastercard, American Express or Discover).

Step 4

The merchant’s bank deposits the funds in the merchant’s account, minus any credit card processing fees.

Step 5

Your purchase is recorded on your credit card statement, and you now owe your credit card issuer the amount you charged. You can choose to pay your credit card statement in full, or you can spread your payments out over time.

Bottom line

Credit cards come with a range of benefits you cannot get with other forms of payment. For example, you’ll never earn travel rewards points if you pay with cash or debit cards, nor will you secure important perks like travel insurance or extended warranties without paying extra for them.

Still, you’ll only benefit from credit cards if you use them responsibly and with a plan. That means using credit cards for rewards and perks but avoiding credit card interest and minimizing fees. If you don’t think you can manage a credit card without racking up debt, you should probably avoid them.