Credit and credit cards power the modern world. Whether you’re making payments online, paying with plastic (or contactlessly) at a shop, or looking for cheap sources of borrowing, credit cards have it all. But what are credit cards exactly, how do they work, why are they so popular – and what gotchas do you need to watch out for?
Credit cards are thin slivers of plastic that give you easy access to credit.
Although we associate credit cards with physical cards, it’s the infrastructure underpinning the credit card system that really makes them so useful. Nowadays you can even get virtual credit cards, which don’t exist in the physical world at all.
With credit cards, then, it depends on what’s under the bonnet – so let’s do just that and take a technical deep dive into how credit cards really work.
Credit cards offer you a line of credit – an agreed amount that you can borrow, with almost no caveats. Unlike loans which require you to take a fixed amount of money, and make regular monthly repayments on the debt, credit cardholders are under no obligation to use their credit; if you don’t use your credit card, there is simply nothing to repay at the end of the month. If you do choose to use your credit, you are required to make a payment. However, so long as the amount you pay meets or exceeds the minimum monthly payment, you are free to roll the balance on to the next month, by which time you may have used your card again.
The ability to roll over your debt from month to month is what makes credit cards incredibly flexible. If you have the means to repay in full, you can. If money is particularly tight in any given month, you can roll most of your balance on to the next, or the next. Of course, when a balance is rolled on to the next month it incurs interest, but if you use your card within a billing cycle and clear the balance in full before the date that payment must be made, you can get up to 56 days interest-free with no charges whatsoever.
The other feature of credit cards that makes them so popular is the seamless payment processing they enable.
Credit cards are available from dozens of banks, building societies and standalone card issuers – but, at least in the UK, they universally carry the brand logo of American Express, Mastercard or Visa.
These logos identify the credit card’s payment processor. (There are other payment processors outside the UK, such as China UnionPay, JCB, and Discover.) A credit card payment processor performs a few important tasks, but primarily they authorise and authenticate payments – and then connect your credit card to the merchant’s bank account.
Without these processors, banks would need to establish direct connections to every retailer and service provider in the world. This would not be impossible, but matching the tens of millions of places worldwide that most of these cards are accepted would be highly impractical and hugely expensive. This is why banks defer the processing to these large multinational organisations – which is rather advantageous for you, since it means your cards can be used all over the world.
Every credit card is slightly different, but there are some universal benefits available to all credit card users.
You can always access interest-free purchases on your credit card for up to 56 days. This is the period between when you make a purchase with your credit card, and when you are required to repay your card issuer to avoid interest – the grace period.
This interest-free period can very useful for cash flow, so long as you have a realistic way of the making the full repayment when it’s due. It can also help you keep money in your current account or savings account, where it could be accruing interest.
Every UK credit card user gains purchase protection for goods costing between £100 and £30,000 – protection that isn’t available to debit card users or cash shoppers.
This protection, which is granted via Section 75 of the Consumer Credit Act, is designed to ensure that users of credit are not forced to continue repayments if the purchased product or service is not of sufficient quality.
For example, prior to the Consumer Credit Act, if you bought an expensive refrigerator using credit, and it then stopped working shortly after, you would still be expected to repay the credit supplier. The store might not be willing to replace the product since they would not want your unusable fridge. Even if you could get them to replace the product, that might take many months, during which time you would be fridgeless, but still liable for credit repayments.
Section 75 established a legal link between the product itself and the credit used directly to purchase it (i.e. it does not apply to loans, where the borrowed money could be used for anything). It also ensured that the lender was liable if the goods failed, so borrowers could reclaim the money directly from their lender without have to fight their case in the courts.
This protection afforded to UK credit card holders is amongst the most powerful consumer protections in the world.
If you lose your purse or wallet with money in it, there’s a good chance you’ll never see your money again. However, if you lose your credit card and somebody else uses it, you’ll likely get all of your money back.
So long as you have acted with reasonable care (e.g. not left your card’s PIN in your purse or wallet) and you have informed the bank as soon as you realised the card was missing, you should be fully reimbursed.
Applying for a credit card is a relatively easy process that can be done online or via a mobile app, though you can usually apply on the phone or in-branch as well. Some balance transfer offers can only be applied for online.
After you’ve done your research and picked out your ideal credit card, simply navigate to the application form for that card. Credit cards application forms are designed to be as straightforward as possible, and they tend to ask many of the same questions, including:
They will also ask if you expect your circumstances to change imminently. If you’ve seen a card that you want, it can be tempting to exaggerate your income or omit details (e.g. pending redundancy). This is unwise: lying on a credit card application is fraud – a criminal offence that you could go to prison for.
Once you have completed your credit card application form, you will need to agree to the terms and conditions of the application to proceed. These terms will include your permission for the issuer to complete a credit check on you.
Every credit card issuer will use at least one, normally two, credit reference agency files to understand your current level of indebtedness, your repayment history, and whether you have any CCJs, bankruptcies or IVAs. If you do not meet the specific eligibility criteria for your desired credit card, your application will be declined. This is not necessarily a reflection of you and how you would approach credit. It’s merely a prediction, based on what others in a similar situation have done in the past, so don’t take it personally. Obviously it’s frustrating, but the best thing to do in this situation is to address the reason why your credit record might not be good enough for your desired product.
Assuming you are accepted for credit, your issuer will set up your account and dispatch your physical card and PIN in the mail. As an added security measure (to prevent cards being intercepted in the post), you’ll still need to activate it when it arrives and change your PIN at an ATM to something more memorable. Once that’s done you’re ready to use your card up to your agreed credit limit.
There are different ways you can make payments with your credit card, and each will generally have a different method of authentication – that is, proving that you didn’t just steal or stumble across someone else’s card.
If you’re making a payment at a physical location, there are occasions – usually when the total purchase price is £30 or less – where you can pay by simply tapping your card on a contactless reader. Contactless cards are theoretically slightly less secure than chip-and-PIN, but in reality there’s never been a case in the UK where someone has bumped into people on the Underground and stolen money from contactless cards with a high-tech gizmo. And in any case, you’re still fully protected by the card provider’s anti-fraud measures, and if you are somehow defrauded you will be fully compensated.
Android, Samsung, and Apple Pay – where you pay contactlessly with your mobile phone or smartwatch – also fall into this category. Because these devices are “authenticated” (you have to enter a PIN or pass a facial recognition test) they aren’t restricted to £30 or less per purchase.
Chip and PIN is the most common method of authenticating transactions over £30. Chip-and-PIN cards store your PIN on a secure smart chip (similar to the chip on your phone’s SIM card, incidentally). To make a payment, you have to enter a PIN that matches the stored number. When it was introduced in 2004, chip-and-PIN quickly reduced payment card fraud and is considered a far more secure way of validating transactions than a customer signature.
For many years a customer signature was the only way to authenticate a payment, which is why a space for your signature still exists on every card – and why, in theory, the card isn’t valid until signed. Expert forgers can easily reproduce a signature that would pass a simple inspection by the retailer. Most stores no longer use signatures for day-to-day business – though they are still used occasionally when chip-and-PIN doesn’t work.
In the early days of the internet, online payments were sometimes perceived as insecure. Payment processors quickly responded to those concerns, though, and now almost every online credit (or debit) card transaction is protected by a second level of security – Verified by Visa, MasterCard SecureCode, and Amex SafeKey.
It also used to be the case that online payments only required the long card number and the expiry date, both of which were easily skimmed from the front of a card or from the magnetic strip. This resulted in a lot of fraudulent online payments using stolen credit card numbers. Now you also need the three security digits (the card verification value or CVV) from the rear of the card, which can’t so easily be skimmed.
Before the internet, there was mail order and telephone shopping. You have always been able to complete these ‘card-not-present’ purchases by reading your long card number and expiry date over the phone to the representative processing the order. However, since the internet (and the dark web) has made it easier for criminals to buy and sell credit card data, ‘card-not-present’ now requires the CCV number and usually other information about the cardholder as well. Some retailers have also prohibited the dispatch of goods to any address other than those held on record by the payment card supplier.
Every credit card has unique eligibility criteria, but there are some common requirements applicable to all applicants.
To obtain credit in the UK, you must be an adult in the eyes of law, since a credit agreement is a legally binding contract, and only adults can enter into contracts. Therefore, the minimum age that anyone can be accepted for a credit card is 18.
Credit card issuers will only lend to permanent residents of the UK. This is partly because they will want to see at least three years of address detail from applicants, but also because they need to be sure that they can retrieve any money they are owed through the UK courts.
Aside from these common requirements, issuers will also apply their own rules regarding who is eligible for credit. Sometimes these rules are easy to understand. For example, some issuers might set a minimum age that’s over 18. Others have minimum income requirements that let you see, at a glance, whether you’ll be accepted.
Every card issuer also has its own secretive ‘scorecard’ methodology that you’ll be rated on. These scorecards are shrouded in mystery because they’re effectively the issuer’s business model – it’s how they decide whether you’ll be a good customer or not. Instead of the scorecard methodology, most issuers will simply give you rough guidance on what your credit rating needs to be (excellent, good, etc.)
The UK credit card market has evolved over the last 50 years, from simple payment products to a plethora of cards targeting different interests and financial circumstances. Although these cards are all unique in their own way, they can be broadly split into the following 14 categories.
Airmile cards are a type of reward card, where the issuer incentivises you into spending on the card by offering such goodies as free flights, free upgrades, free or discounted weekends away, and other travel-related freebies and savings. Many airmile cards come with tempting introductory bonuses or offers, usually dependent on a minimum spend, and some incur an annual fee. These cards are perfect if you are a seasoned traveller, or wish to be, and you intend to pay off your credit card balance each month.
These cards are designed for people who either have a poor credit rating or no credit history at all. Typically they have more relaxed eligibility criteria than conventional credit cards, higher APRs and lower credit limits. Used well, they can help to build or rebuild your credit rating, enabling you to access more competitive or rewarding cards in the future.
These are the most popular form of credit card in the UK. They allow you to transfer a balance (or several balances) from other high interest-charging credit cards to the balance transfer card, which you then pay 0% interest on for a fixed promotional period – anywhere from 12 to 36 months.
There is a one-off fee charged by credit card suppliers for transferring balances, which is around 3 to 5% of the amount of the balance. It should also be noted that if you do not adhere to the terms of the credit card agreement – if you don’t make your minimum payments on time and remain within your credit limit – the credit card issuer will retract the offer immediately and you will be charged interest on any remaining balance at the standard APR rate.
As the name suggests, these cards are exclusively available to business owners. They vary greatly in their rewards, with some offering loyalty points for a minimum spend, while others focus more on helping with the budgeting and invoicing process. Business credit cards sometimes come with a fee, so it is worth calculating whether the reward you could reap would outweigh any costs.
Cashback cards offer you the opportunity to earn cashback on purchases. The amount of cashback is offered as a percentage of the spend amount, and varies greatly from card to card, not only in the percentage amount itself, but also on where (and on what goods) the cashback rates can be earned. Some cashback cards charge an annual fee, so be sure to do the maths on how much you will realistically earn from the cashback.
These cards are very different to other cards in the credit card market today, in that they do not allow the cardholder to roll over their balance from month to month. Charge cards do allow the interest-free period between purchases and payment (up to 56 days), but once the full billing cycle is complete, the balance on a charge card must be paid in full. Furthermore, cardholders are not afforded the Section 75 protection on their purchases like conventional credit cardholders (though some do offer some form of alternative protection), and charge cards almost always incur a steep annual fee.
Why would anyone want a charge card? They have no credit limit at all and come with a raft of goodies, such as loyalty points, travel insurance, hotel and flight upgrades, and other travel-related rewards and discounts. In order to be eligible for a charge card, you would need an excellent credit rating and often an impressive regular income.
As the name suggests, these cards charge a lower interest rate than more conventional cards, often as low as 5.5% APR. These cards rarely come with introductory 0% deals (though some do offer a short period) or tempting rewards, but they are useful if you want to spend on your card and pay off a balance at a regular (and low) rate.
These cards are balance transfer cards which offer a zero or low fee for the transfer itself – but that low fee is usually offset by a shorter 0% interest period than the market-leading balance transfer cards. Low transfer fee cards are ideal if you wish to transfer a balance and can comfortably pay off the balance within the 0% promotional period.
Money Transfer cards are the newest type of cards on the UK market. These cards allow you to transfer money from your new credit card to a bank account at 0% interest for a fixed period of time. The money can then be used for any purpose, including paying off other debts held elsewhere, including loans and/or overdrafts. There is a fee payable for transferring the money – typically around 3% – 5% – but if you use it wisely (minimum payments made on time and not spending over your credit limit), money transfer cards can be a very cost-effective way of borrowing.
These cards offer an interest-free period on all purchases made using your card, up to a pre-agreed credit limit. These cards are good if you want to spread the cost of a large purchase, or a number of purchases, over a long’ish period of time (usually 12-36 months). You will still have to pay at least your minimum payment every month, but if you work out a regular repayment plan, and pay off your balance before any interest becomes payable, purchase cards can be one of the cheapest forms of borrowing.
These cards incentivise cardholders to spend on their card by offering rewards. There are a dizzying array of rewards on offer, including loyalty points, cashback, airmiles, discounts and savings. Each reward card has its own method of calculating spend, rewards and redemption of points. If you are contemplating applying for a reward card, it is always advisable to carefully calculate, based on your normal spending habits, which card offers the most for your hard-earned money. Also, watch out: some reward cards are lumbered with an annual fee.
Transfer and purchase cards combine the benefits of the balance transfer card and the purchase card, offering you a 0% interest period on both for a fixed period. The only caveat is that the interest-free duration is usually shorter than if you pick up a specific, market-leading transfer or purchase card. These transfer & purchase cards are perfect if you want to transfer a balance from another card (or cards), but also want to spend on your card too.
Travel credit cards are exactly what they say on the proverbial tin. They are a combination of a conventional credit card, plus a number of travel-related perks such as no fees on overseas purchases, no fees on travel money, free foreign ATM withdrawals, or loyalty scheme points.
The advertised interest rate of a credit card (or ‘Representative APR’) is not always the rate you will be offered. The definition of ‘Representative’ in this context is simply what 51% of any given credit card issuer’s customers will receive, meaning that 49% of their customers are offered a different (and inevitably worse) interest rate.
Rather unfairly, you will not know which rate you will be offered until you apply for the credit card and your particulars are assessed by the credit card issuer. If you are successful in your application, but are offered a rate higher than you were expecting (or can afford), and go on to reject the offer and apply for another card, such multiple applications in quick succession can adversely affect your credit rating.
There are things you can do before you apply for a credit card, to ensure that you obtain the rate you expect. First, before making any application, it is advisable to check your credit rating. That way you will be able to gauge what type of card you are likely to be accepted for. For example, if your rating isn’t good or excellent, you should steer clear of the market-leading cards and instead aim for more ‘middle-of-the-road’ cards. Second, you can check out any alternative rates (also known as ‘downsell’ rates) which credit card issuers are offering alongside their market-leading product, so you know the worst case scenario and whether you would accept these alternatives. Finally, instead of making a formal application for a credit card, you can go through an eligibility checker, to see whether you would be likely to be accepted without leaving a trace on your credit file.
The charges and fees of credit cards are always listed in any terms and conditions or credit agreements you sign when you take out the card, and are also accessible online. While you will hopefully be well aware of the balance transfer fee or annual service charge, there are some other charges that you might not consider until you’re actually hit by them:
Using your credit card to withdraw cash is never advisable, as there is almost always an immediate charge (usually around 3%) and the interest rate on cash tends to be much higher than the standard purchase rate – sometimes up to 10% higher. Furthermore, the interest on cash (and its fee) accrues from the very day you take it out. If you need to access cash, it is always better to apply for a money transfer card with a 0% deal.
There are sometimes quite hefty fees payable when you use your card while travelling outside of the UK, in the form of transaction fees on purchases and ATM fees. Make sure that you are aware of all these charges before you travel, and try to mitigate them wherever you can. If you want to use a card abroad for practicality purposes, there is a swathe of travel prepaid cards available which offer free foreign purchase fees and free foreign ATM fees.
Credit card issuers have the right to withdraw any introductory offer the moment you fail to meet any of the agreed requirements, such as a late payment, failing to make your minimum payment, or exceeding your agreed credit limit. This could mean that the long interest-free balance transfer duration you were granted (and paid a fee for) is withdrawn, and you are suddenly left with a debt which needs to be repaid at a double-digit interest rate. In order to avoid such a disaster, it is best from the outset to set up a direct debit to pay your credit card every month.
The combination of the rolling credit nature of credit cards, where a debt is allowed to accrue month on month, and the tantalising rewards they offer for spending, could form the basis of a convincing argument that credit cards encourage indebtedness and should be avoided.
Even with the best of intentions with your credit card – only spending what you can realistically afford to repay, and making all your payments on time — sometimes your personal circumstances can change dramatically. You could experience the death of a close family member, lose your job, or simply receive an unexpected bill. All of these can have an impact on your ability to repay your credit card debt, which can then spiral out of control very quickly.
Applying for and regularly using a credit card is a serious financial undertaking, and should be considered very carefully. You should bear in mind not only your current financial standing, but your worst case scenario in financial terms.
Ideally, credit cards should be viewed as a convenient form of payment, rather than a form of long-term borrowing. Used sensibly and not frivolously, with the enhanced consumer protection they offer and bonus rewards for everyday spending, credit cards can reap you huge benefits.
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Last updated: 3 June, 2019