What is a credit card?

A credit card is a financial tool offered by a bank as a type of loan, with a line of revolving credit that you can access with your card account. The loan behind your credit card has a limit — known as a credit limit — that you can use for everyday expenses or large purchases. Like traditional loans, a credit limit is subject to interest, known as APR, which is added to your card bill if you don’t pay off your balance each month.

Credit cards can lead to debt if you spend more than you can afford to pay off every month. But, used wisely, a credit card can be a powerful financial tool and a key part of building credit so you can achieve future goals, like buying a car or a home. You can also use credit cards to get rewards (such as cash back) for purchases, and to access card benefits.

But before you set about choosing a card that’s right for you, it’s worth taking the time to learn exactly what a credit card is, including what the different card-related terms mean.

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.

Important credit card terms

When considering applying for a credit card, there are many terms that may seem unfamiliar or confusing, but understanding what they mean is key to finding the best card for your lifestyle. Here are some of the most common terms you may encounter:

• Interest rate: Interest is a fee that banks charge on the line of credit they extend to their customers. Interest rates vary depending on the card and the credit score of the consumer applying. You will be charged interest if you carry a balance from month to month.
• Annual percentage rate (APR): The APR of a credit card is another name for the interest rate. An APR represents the total cost of financing a financial loan and tends to be the same as its interest rate in the case of credit card financing. APRs typically range from 12 percent to more than 24 percent.
• Credit limit: A credit limit is the spending limit on a credit card. For people with limited or no credit history, an initial credit limit may only be a few hundred dollars. For more veteran card owners, credit limits can be much higher, in the thousands of dollars.
• Credit score: A credit score is a rating that allows banks and credit card issuers to determine your creditworthiness. Ranging from 300 to 850, there are a number of factors that determine your credit score.
• Credit card balance: A credit card balance is the amount of money you have spent on your credit card and what you owe to the credit card company at the end of your billing cycle.
• Cash advance: A cash advance is when you use your credit card to withdraw cash. Cash advances are subject to high fees, have no grace period and are not recommended unless absolutely necessary.

Differences between credit cards and debit cards

You should also know how a credit card differs from a debit card. So, what is the difference? To understand credit versus debit, you need to know what a credit card is and what credit cards can offer that debit cards can’t.

Let’s start with how a debit card works. When you use a debit card to make a purchase, the cost of the item you are buying is deducted — or debited — from a linked bank account. Think of it as a cash-equivalent payment tool. Debit cards may be plastic, but every time you pay with a debit card, you’re actually spending cash you’ve deposited into a bank account.

A credit card is different. Think of it as a card that literally offers you credit — that is, the ability to buy something now and pay for it later. If you can’t pay off your credit card bill in full, you have the option to pay it off over time. Most credit card issuers charge interest on unpaid balances, but for some people, the flexibility of carrying a balance when they need to is more than worth the extra interest charges.

There’s one other big difference between credit cards and debit cards, and that has to do with security. Although both credit cards and debit cards have protective measures in place to help shield you from fraud, credit cards are usually the more secure financial tool. Nearly all major credit cards offer zero fraud liability, which means you won’t be responsible for paying off fraudulent or unauthorized charges.

Debit cards, on the other hand, come with different levels of liability, depending on how quickly you are able to report a lost or stolen debit card. If it takes you more than two business days to report a missing debit card or let your bank know about fraudulent charges, for example, you could be on the hook for as much as $500.

This is why many financial experts recommend using credit cards over debit cards, especially when making purchases online, at gas stations or anywhere else that might be a potential fraud risk.

Pros and cons of using credit cards

Credit cards come with a lot of advantages, but there are a few drawbacks to using credit that you should keep in mind.

In most cases, the negative aspects of credit cards can be avoided by practicing responsible credit habits. If you always make your credit card payments on time, for example, you never have to worry about how a late payment can affect your credit score. If you keep your credit card purchases within your budget, you won’t have to worry about going into credit card debt — or getting out of credit card debt in the future.

Here are some of the biggest pros and cons of using credit:

The bottom line

Used responsibly, a credit card can be a powerful financial tool. Once you understand the basics of how they work and how they can help you build credit, you can begin to explore the various types of credit cards.

Then, you can begin the process of choosing the best credit card for your financial needs and learning to use credit to achieve your long-term goals.