Using credit cards is a convenient way to pay for products and services while also building your credit. On top of that, your credit cards can even earn rewards, such as cash back or travel discounts, on purchases you would have made anyway.
Of course, letting your credit card spending get out of control can lead to mounting debt, excessive interest charges, late fees and bad credit.
That’s why it’s so important to understand how credit cards work so you can take advantage of their benefits while minimizing their risks. Here’s everything you need to know about how your credit card actually works.
How credit cards work
A credit card is tied to a revolving credit account, typically at a bank. The card allows you to make purchases by borrowing money from the issuer to pay the merchant for your purchase. You can use your credit card to buy products and services with any merchant that accepts credit cards, or you can use the card to get a cash advance.
When the bank approves your credit card, they 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 purchase items with your credit card, the transaction is processed by one of the four major payment networks: Visa, Mastercard, American Express and Discover. Their role is to ensure the merchant receives money for the transaction and that your card issuer or bank 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 or cash withdrawals.
How do credit card payments work?
You will receive a credit card bill every month, which typically comes with a 21-day grace period during which you can pay for your transactions interest-free. You can avoid paying any interest on your purchases by paying your balance in full by the due date. But, if you cannot 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.
How does credit card interest work?
If you carry a balance into the next billing month, 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.
Credit issuers and banks express APRs as the amount of interest and fees you’ll pay in a year, but your monthly statement may show your monthly interest rate. To determine your monthly interest rate, divide your APR by 12. That means, if your APR is 24.86%, you can divide that number by 12 to get 2.071% as your monthly interest rate.
Note that your bank doesn’t require you to pay your full balance each month. Instead, you must 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.
Your bank or credit card issuer reports your payments to the credit agencies, so it’s in your best interest to pay your bill on time. Ensure your payment is on time by setting up automatic monthly payments for the minimum amount or another amount you determine. Most banks also offer email or mobile notifications to alert you when your due date is near.
Credit cards vs. debit cards
Credit cards and debit cards look nearly identical, but in practice, they are not. Both types of cards are different in how they pay, their impact on your credit score, and the protection they provide against fraud.
How credit cards and debit cards process purchases differently
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, which may include interest.
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.
Credit vs. debit: How each impacts your credit
Creditors report your credit card payments to the three major credit bureaus—Equifax, Experian and TransUnion. Using your credit cards responsibly and paying your bill on time each month can help you build good credit. Conversely, paying your bill late or missing a payment can hurt your credit score.
On the other hand, using a debit card will not impact your credit score either way since card issuers don’t report debit card activity to the credit bureaus.
Credit vs. debit: How fraud protection compares
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, and 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 information, your bank could hold you accountable for all 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.
How to use a credit card wisely
Credit cards are a valuable tool to earn rewards, build credit and pay down debt. But these benefits come with a downside: credit cards are so convenient to use that it’s easy to rack up debt in a hurry.
Become a deadbeat
Only in the world of credit cards is it cool to be a deadbeat. A deadbeat is the name credit card companies use to describe a cardholder who never pays interest. That means they’re not making any money from you except for any fees they charge. Put another way, being a deadbeat means you’re not wasting your money paying interest.
To become a deadbeat, simply pay your entire balance in full by the due date and you’ll avoid accruing interest on your account.
Make payments on time
If you can’t pay your balance in full, pay as much as possible before the due date. Remember, your payment history is the most significant factor impacting your credit. Even one late payment can have a negative impact on your credit score.
Spend within your means
It’s a lot easier to pay your balance in full each month when you only charge as much as you know you can afford to pay when your statement arrives. A credit card can help you build credit or even pay down debt, but you shouldn’t use them to make purchases you won’t be able to repay before your due date.
How to build credit with a credit card
Another way to use your credit card wisely is to build credit by practicing healthy credit card habits. Those with the highest credit scores tend to follow these practices:
Follow your FICO score: While there are many types of credit scores, FICO Score is the one lenders use the most. Your credit card’s online dashboard may have a FICO Score tracker, and there are other ways to check your credit score for free, such as the FICO® Score Open Access Program.
Make payments on time: The best way to build your credit is by paying your bill on time every month, as your payment history accounts for 35 percent of your FICO credit score.
Know your credit utilization ratio: Your credit utilization ratio compares the amount of credit you are using from the credit limits on all your cards and expresses it as a percentage. For example, if you have $10,000 in total available credit and all of your credit card balances add up to $2,000, your credit utilization ratio is 20 percent. Most credit experts advise keeping your credit ratio below 30 percent.
Don’t close your credit card accounts: One way to keep your credit utilization low is to keep your credit accounts open. This preserves the amount of credit available to you. Since banks often close accounts that are inactive for six months or more, make a small purchase every few months to keep the account open, or set up a regular subscription payment, like Netflix.
Do you need a credit card?
If you have sufficient emergency savings and enough cash for a home, car or other large purchases, you may not need a credit card. But if you need to build credit to obtain financing for a home or car, or you want to maximize rewards on your regular spending, responsible use of a credit card is a great option. Here are some other reasons you might want a credit card:
- Pay down debt: You can transfer a balance from a high-interest credit card to a card with a 0 percent APR period. You can then pay down or eliminate your debt during the introductory period and save money in interest.
- Sign-up bonuses: Many credit cards give you cash back or a large number of points to open a credit card. You can use the bonus money to start an emergency fund or the points to go toward a vacation.
- Rewards: Take advantage of various rewards many credit cards offer, including cash back, retail rewards points and hotel or travel points.
- Flexibility: Credit cards give you the flexibility to quickly address an unplanned expense or make a large purchase and pay for it over time. (That said, it’s still best to pay your balance completely each month to avoid paying interest.)
- Build credit: Paying your credit card bill on time each month is one of the best ways to establish good credit.
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. Only use your credit card for purchases you would make anyway and pay your bill in full and on time each month.