Credit Cards: What They Are, How They Work And How To Get One
Sidney Richardson10-minute read
May 05, 2021
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Your credit score impacts many major decisions you’ll make, including getting a mortgage. It’s important to build credit if you want to qualify for some of the perks of having a good credit history, like lower interest rates and access to loans with better terms.
For many, building credit starts with getting a credit card – but how do credit cards work? Knowing what a credit card is and how to use it responsibly is an important part of improving your finances. Here’s what you need to know.
What Is A Credit Card?
A credit card is a card given to you by a bank or other company, also called an issuer, that allows you to make purchases with borrowed funds. Since you aren’t paying with your own money, you must pay back your issuer whatever you borrow, either in full each month or in installments over time. Using a credit card responsibly will increase your credit score, while spending irresponsibly will lower it and potentially burden you with debt you can’t manage.
How Do Credit Cards Work?
When you’re approved for a credit card, you gain access to a line of credit that you can borrow from to make purchases. Your bank or other issuer will set a credit limit for your account, which determines the maximum amount of money you can borrow. This limit is determined by a number of things, including other debts you may have and your personal income. If you’re using a secured credit card, your credit limit might be the same as the security deposit you made.
Once you have your card, you’re free to spend up to your credit limit at your own discretion, paying back what you owe either in full each month or over time. Your credit card transactions are processed by whatever major payment network your card is attached to – Visa, Mastercard, American Express or Discover.
Your payment activity is monitored by your issuer and reported to the three major credit bureaus: Equifax®, Experian™ and TransUnion®. The bureaus use your payment activity and other factors to determine your credit score, a three-digit number that represents how much of a risk it may be to lend you money in the future, based on your history with debts.
How To Use A Credit Card
The four major payment networks, Visa, Mastercard, American Express and Discover, are accepted by most merchants across the U.S. You can use your credit card as a method of payment the same way you would a debit card, swiping it at a register, inputting your card info online or adding it to a digital wallet app like ApplePay to make a contactless payment. For online purchases, input your credit card’s CVV number for additional security.
You can use a credit card to pay for most transactions, including big purchases such as a new appliance, like a refrigerator. You can even use it to pay for some bills, if the company or business you’re paying allows it.
How Do Credit Card Payments Work?
Once you’ve made purchases with your credit card, the amount you currently owe back to your issuer is added to your card’s balance, along with any fees, including annual fees and penalties, you may have accrued depending on what you bought and when.
At the end of your monthly billing cycle, your card issuer will give you a monthly statement that will tell you how much you owe them in total as well as the minimum payment you must make that month on your debt.
You can either make a minimum or otherwise partial payment and allow the rest of your debt to roll over to the next month or pay everything off in full. If you allow your debt to roll over, it will accrue interest for each month you don’t pay it off. While it’s perfectly fine to make multiple payments on a debt rather than pay off everything at once, it can be harmful to your credit score. If the balance on your card is too high, you may have an unfavorable credit utilization ratio, which can lower your credit score.
Paying Back Your Balance
When you make a purchase with your credit card, you have a 30-day grace period to pay off the debt, during which you will accrue no interest on the amount you borrowed. If you don’t fully pay off what you borrowed in that time, the remaining balance will begin to accrue interest based on your card’s annual percentage rate (APR).
The APR of your credit card varies based on your issuer, but the “prime rate” is typically responsible for what your credit card’s APR will look like. The prime rate is an interest rate used by banks and other issuers to determine APR for credit cards. While this rate is decided by banks and issuers, it’s influenced by whatever the federal funds rate is at the time.
Interest can build up quickly if you don’t pay off what you owe promptly enough, so while it is OK to allow your debts to roll over when needed, you should always try to pay off what you borrowed each month in full to avoid damaging your credit score.
Credit Card Vs. Debit Card
As mentioned earlier, you can use a credit card and debit card in virtually the same way. There is a big difference between these two card types, however.
With a debit card, you pay with money that is withdrawn from your own bank account. You don’t have to pay anything back since you’re using your own funds. Debit cards also (usually) have no impact on your credit, so if you pay bills or make purchases with them, the credit bureaus will not make any changes to your credit score.
With a credit card, you pay with money borrowed from your issuer and must repay whatever you spent, sometimes plus interest. Your history of payment and repayment with a credit card will also impact your credit score, unlike using a debit card.
How To Get A Credit Card
Getting a credit card is a fairly straightforward process, though the quality of card you can qualify for depends greatly on your credit score.
If you already have an established credit score, you can apply for a credit card either online or at the physical location of a bank or other credit card issuer. You’ll need to be at least 21 (or 18 with parental permission) and have some source of income to qualify. The interest rates and rewards you might qualify for will differ based on your income and existing credit history.
If you don’t have a credit score, have never had a credit card and don’t know where to start, don’t worry – you can get a credit card with no credit. While your options starting out may be limited, you can get started building credit with a student credit card, store credit cards, or a secured credit card, which requires a security deposit to make up for a lack of (or low) credit.
How To Cancel A Credit Card
If you have multiple credit cards, you probably won’t want to keep them all open forever. Closing a credit card can simplify your finances and cut out annual fees that are weighing you down. To close a line of credit, make sure you’ve paid off your balance or transferred it to another card. Then, simply contact your issuer and request to close the account. You should dispose of your card after the account is closed by cutting it up with scissors or shredding it.
Be aware, however, that closing credit cards can hurt your credit score. Especially if you’ve had that line of credit open for a long time, your credit score may take a hit when the account is closed.
Types Of Credit Cards
There are many different types of credit cards to choose from when building credit, each with their own pros and cons. Here are just a few:
- Secured credit cards: These cards require a security deposit of your own cash, which may also be your spending limit. Since they often have no annual fee and decent interest rates, secured cards are a great option for those just getting started building credit or those looking to rebuild their “bad” credit.
- Unsecured credit cards: Unsecured cards do not require a security deposit to open, but may have higher interest rates and annual fees. This is the most common type of credit card.
- 0% interest credit cards: A 0% interest credit card is the same as a regular unsecured card, except for a period of time after opening the line of credit, you don’t have to pay any interest. Once the period ends, however, it becomes a regular unsecured card with a typical interest rate.
- Store credit cards: These cards are offered at many retail stores and allow you to make purchases in the store at a discount or offer some type of exclusive rewards.
- Student credit cards: These cards help college students build credit, since they are young and likely do not have much credit history.
- Rewards credit cards: These cards are typically available to those with good credit scores and offer various rewards to cardholders, such as cash back and the ability to earn miles you can redeem for airline tickets.
Pros And Cons Of Using A Credit Card
Using a credit card is typically a must if you’re looking to build your credit. Before getting a credit card, however, it’s still useful to be aware of all the pros and cons of using one so that you can be sure to spend responsibly.
- You can make purchases without spending your own money (at the time) and pay back your balance later.
- Using a credit card can help you build credit, which will help you qualify for better loans in the future.
- Some cards offer sign-up bonuses, cash back rewards and other credit card perks.
- You can be charged interest if you don’t pay your balance in full every period.
- Some credit cards may charge an annual fee, and you may be charged for various other fees while using your card as well, such as penalties for late payments, balance transfers and foreign transactions.
- Careless use of a card can lead to credit card debt that can be difficult to pay back.
- Using a card irresponsibly can hurt your credit score, as well, rather than improve it, as using credit should.
FAQs About How Credit Cards Work
How Do Cash-Back Credit Cards Work?
When you use a credit card that offers cash-back rewards, you earn a small portion of what you spent back in cash, usually around 1 – 2%. Some cash-back cards work a little differently and may reward you with gift cards for certain amounts of money that you’ve “earned back” over time by making purchases.
How Do Credit Card Miles Work?
Similar to cash back cards, cards with “miles” reward systems allow you to collect miles that you can eventually trade in for airline tickets while spending. While it differs by card issuer, you might earn 1 mile for every few cents that you spend. Once you’ve earned enough miles, you can trade in those miles for a plane ticket to a destination of your choosing. Depending on the destination, the mile cost of your ticket will differ. You usually have to collect a minimum of 25,000 miles to trade them for a ticket.
How Do Credit Card Balance Transfers Work?
If you’re closing a credit card or looking to move your credit card debt to a more favorable interest rate situation, it’s possible to transfer your card’s balance to another card. There are even some credit cards made to be used for balance transfers that offer incentives such as limited or no interest for a limited time post-transfer. If you’re interested in moving your debt from a card with high APR to a more favorable card, perhaps even one with rewards options, you can apply for that new card and request a transfer.
Despite it being called a “transfer,” moving your funds in this way actually pays off your credit debt using the new card you’re moving the debt to. Before applying for a new line of credit to move debt to, make sure you’re prepared to pay a transfer fee, which is typically around 5% of the transfer total. You should also assure that the balance you’re transferring doesn’t exceed your new card’s credit limit.
The Bottom Line: Will A Credit Card Work For You?
Credit cards are an essential tool if you’re looking to build credit history and increase your credit score. If you aren’t careful, however, you could accrue a great deal of debt using them, so make sure to spend responsibly and stay informed about how your card works and what interest rates and fees you might have to think about.
For more finance tips and resources, check out the Rocket HQSM Financial Learning Center.
Rocket HQSM has partnered with CardRatings for our coverage of credit card products. Rocket HQ and CardRatings may receive a commission from card issuers. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities.
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