How do credit cards work?

When it comes to credit cards, many of us have either been tempted to get one, or are scared to use one for fear of debt. However, we are here to explain the ins and outs of credit cards, and how getting one could help you. 

Credit cards are one of the most successful financial products of all time. They’re a convenient tool for making secure payments, they offer you enhanced consumer protection and they can provide a source of cheap borrowing.

However, to get the most from your credit card – and avoid costly mistakes – it’s worth taking a few minutes to learn how credit cards work.

What is a credit card?

Simply put, a credit card is a card that allows you to buy things using ‘credit’. Essentially, you are using a loan from the card issuer to make purchases. You agree to pay back this loan along with any additional charges such as interest. 

How do credit cards work?

Credit cards enable you to access a prearranged loan or credit line from the credit card issuer. So every time you use your credit card, you’re taking out a loan. Unlike most loans, though, credit cards let you avoid paying interest entirely if you manage to clear your balance in full by its due date. If you can’t afford to clear your balance in full, credit cards let you roll-over your balance from month to month, so long as you make the minimum monthly repayment.

In short, credit cards offer greater flexibility for managing your finances than traditional loans. This is because traditional loans require fixed monthly payments regardless of your financial position in a given month.

Credit cards also offer enhanced purchase protection. This ensures that your card issuer will repay you for faulty goods (costing between £100-£30,000) that you purchased with a credit card. A similar scheme (chargeback) also protects debit card users, but the purchase protection offered by credit cards (enshrined in law by Section 75 of the Consumer Credit Act) is a lot stronger.

The flip side, though, is that the interest rate on credit cards is much higher than loans. This means that loans are generally better for long-term debt, where you won’t clear your balance within a few months. With that said, 0% purchase and balance transfer cards with very long interest-free periods (30+ months) can be cheaper than loans – as long as you pay off your balance in time. In a similar vein, using a money transfer credit card to pay off an existing loan or overdraft can be a savvy move.

Understand the fees and terms of credit cards

Although credit cards can be a great vehicle for minimising debt, there are several not-so-obvious fees, charges and potential pitfalls that you should know about before you jump in.

  • Annual fees: Annual fees are not typically charged in the UK, but some, mainly airmile cards, do charge annual membership fees. It’s also worth remembering that some cards which charge fees waive them in the first year, so it can be easy to forget that you’ll be charged once you’ve had your card for a year.

  • Cash advances: Although you can withdraw money at ATMs with your credit card, it’s normally very expensive. Most card issuers will charge a fee on the amount withdrawn immediately. Unlike standard purchases, cash advances attract a high rate of daily interest until they are fully cleared.

  • Credit rating: Your credit score, as determined by credit reference agencies, is probably the most important factor issuers look to when assessing your creditworthiness* and deciding if they will accept you as a customer.

*Due to coronavirus financial worries, some lenders have tightened their acceptance criteria. It’s certainly worth doing an eligibility checker before applying.

  • Late payment fee: Late payment fees will be issued if you fail to make a minimum payment on time. Don’t make the mistake of assuming that the payment date is the date the money must leave your account. You must ensure you leave sufficient time for your payment to clear with your issuer (normally 2-3 days) to avoid a late payment fee.

  • Minimum monthly payment: Although credit cards offer greater payment flexibility than loans, you are still required to make at least one payment within each billing cycle. The amount you must repay varies from issuer to issuer, but it is typically around 1% of the balance (or a minimum of £5), plus any interest charges. If you only pay the monthly minimum amount your debt will take a very long time to clear, so you should plan to pay considerably more.

  • Representative APR: The Representative APR (Annual Percentage Rate) is a figure that illustrates the expected interest rate. At least 51% of people entering into a credit agreement with a particular product will receive this. Representative APRs are necessary since credit card issuers do not have to offer the advertised interest rate to everyone they accept.

Should I apply for a credit card?

Before you consider applying for a credit card, you will need to think about the following:

  • Your debt: if you have any existing debt, it’s worth paying off as much as possible before applying for a credit card. A lot of debt might put card companies off lending to you as your finances may be too tightly stretched.

  • Open accounts: close any unused open credit accounts as lenders might see many open accounts as a reason not to lend. 

  • Credit history: Your credit history is the most important thing that lenders will assess. Use an eligibility checker beforehand to make sure you will be accepted as multiple rejected applications will harm your credit score. If you don’t have a credit history, consider looking at first credit cards.

Getting the most from your credit card

Credit card issuers are businesses, and they need to make money. However, aside from annual fees (which are unavoidable where charged), most charges associated with credit cards can be avoided with good account management. This means you can get all the convenience and enhanced consumer protection without ever paying a penny. You’ll also build up a good credit history, which will help you get advantageous rates on other credit products in the future.

22nd June 2020