Learn how credit cards work before charging ahead

2 min read

Credit cards are an extremely popular financial tool, and it’s easy to understand why. They’re convenient and practical, and—when used responsibly—they offer advantages you don’t have when paying with a debit card.

But to get the most out of your credit card—and avoid potential pitfalls—take a few minutes to learn how credit cards work.

Use it right—and reap the benefits

Sign-up bonuses and rewards like cash back on purchases are some of the most obvious perks of credit cards. But many also come with added protections like product warranties and travel insurance.

What’s more, there are safeguards in place if your card is lost or stolen. As long as you report a card missing in a timely manner, your maximum liability for unauthorized purchases is $50. In contrast, if someone steals your debit card, the thief can drain your account, and it can take time to recover your cash

Looking for a great deal on a new credit card? Check out the best credit card offers here.

How do credit cards work?

When you buy something with your credit card, you’re essentially taking out a loan. If you pay the money back in full each month, you won’t owe any interest on the loan. If you don’t pay it all back, you’ll owe finance charges on the amount you don’t pay.

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

Learn the terms and fees

To use your card wisely and avoid paying unexpected fees, it’s important to understand the terms of your credit card agreement.

  • Annual fee: Some credit card companies charge every customer a yearly “membership fee” to use the card.
  • Annual percentage rate (APR): This is the annual interest rate, or cost of borrowing money. An APR can be a fixed rate, which doesn’t change, or variable, meaning it goes up and down based on economic indicators. Sometimes there is a lower, promotional APR for a limited period of time, followed by a higher, long-term APR.
  • Finance charges: If you don’t pay your bill in full, most lenders calculate your finance charge based on your average daily balance during the billing cycle. If you tend to carry a balance on your card, pay extra attention to how interest is charged.
  • Other fees: Most lenders charge additional fees if you make a late payment, go over your credit limit or get a cash advance.
  • Grace period: This is the number of days—typically 25—you have to pay your bill in full before you begin paying interest, or finance charges.
  • Credit limit/available credit: Your credit limit is the total amount you can charge and your available credit reflects how much you have left of that total.
  • Minimum payment: This is the amount you must pay to avoid a late fee and other potential penalties, such as having your interest rate raised.

Use your card responsibly

While you must make the minimum payment every month, it’s wise to pay more if you can. Here’s why: Let’s say you charge $1,000 on a card with an 18 percent interest rate and make the minimum payment of $25 (in this case, 2.5 percent of the total) each month. It would take you more than two years to pay off your bill, and you’d wind up forking over $923 in interest charges. That’s good reason to pay careful attention to how your card works.