How Does a Credit Card Work?
If you’re thinking about getting a credit card, you may be wondering “How does a credit card work?” Applying for credit cards can open up a world of possibilities for you by helping you build credit and maintain a respectable credit score.
Using a Credit Card
When you use a credit card responsibly, you can create a credit history that will help you later in life. Lenders look at how you handle credit when you apply for an auto or home loan and base their decision in part on whether you have good credit or poor credit.
When you have a credit card, you have an agreement with the financial institution that issues your card. The card issuer agrees to advance credit to you up to the card limit, and in return, you promise to pay at least a minimum payment every month. The minimum payment is calculated based on the interest rate you’ve agreed on with the card issuer.
You’ll have to pay the interest owed on the balance of what you have spent as of the most recent statement, plus a small principal payment to be applied to the balance itself.
This means that if you have a balance, unless you are in a special interest-free grace period, you’re being charged interest monthly. If you pay the balance in full before your statement each month, you can typically avoid interest being charged.
The priority when using credit cards is to be responsible and not overextend yourself. The best way to use your credit card wisely is to use the card only for the amounts you could easily cover in cash and to pay off your balance in full each month.
How Do Card Issuers Make Money?
It’s important to be aware of how credit card companies make their money, so you can avoid making the kinds of mistakes that will cost you down the line.
Credit cards come with interest, which benefits the card issuer. Lenders will typically charge you a fee if you fall behind on your monthly credit card payment, so it’s important to stay up to date with your payment. Use direct deposit to automatically pay off your credit card debt every month. Some lenders may increase the interest rate if you fall behind on one or multiple payments.
As you continue making payments, you will free up additional credit that can go towards future purchases. Many credit cards come with rewards or point systems that encourage you to buy things on credit. These points can help you save money but avoiding spending more than you can afford.
Some cards may also come with annual fees, foreign transaction fees, cash advance fees, and other costs that can add up over time. Knowing exactly what your credit card agreement says can help you avoid or negotiate away some of these fees.
Credit Cards vs. Debit Cards
Debit cards often look like credit cards and work in the same payment systems as credit cards, such as Mastercard and Visa. However, instead of being connected to a credit line, they are connected to your checking account. When you use a debit card, you are spending money you have in your account, not a line of credit. Your financial institution might allow you to exceed your available balance on your debit card with overdraft protection up to a certain limit.
If you need more money than what’s available in your account, some lenders may give the option of adding a line of credit to your debit card, which is usually much cheaper than paying overdraft fees.
When you use debit cards, you’re less likely to overspend, since you can see your checking account balance going down in real-time (or close to real-time.) You won’t build credit using debit cards, but you also won’t have to pay interest on your spending.
Unsecured vs. Secured Credit Cards
If you don’t have a good credit score or have a limited credit history, it can be hard to get a credit card. However, you may be able to get a secured credit card. While an unsecured card requires the card issuer to advance you credit on the assumption that you will pay it back, a secured credit card requires a deposit. The amount you deposit is your credit limit.
This secured amount is usually small, as it’s assumed you’re trying to learn how to handle your credit wisely and are still learning or relearning how credit cards work. For example, you may deposit $300. This allows you to obtain a credit line of $300. If you default, the card issuer can use the deposit to pay off your balance.
Over time, your card issuer may slowly increase your credit limit if you have a history of paying your bills on time by allowing you to make a larger deposit. Eventually, if you develop a good payment history, they may offer you an unsecured line of credit that is much larger than your secured line. Secured credit cards can be an important part of learning how to handle credit, and it is a great way to build up a good credit history to raise your credit score.
The Credit Card Transaction Process
So, how do credit cards work physically? When you use a credit card at a store or give your credit card number for an online or over-the-phone transaction, the payment system asks for authorization from the credit card network to process the payment.
The network contacts your financial institution so your card issuer can verify your information. Your card issuer will either approve or decline the transaction. Thanks to the speed of electronic communication, this whole process only takes a few seconds.
When your transaction is approved, the payment is completed and the appropriate amount is debited against your credit limit. At the end of the billing cycle, your card issuer sends you a statement. Your statement shows every transaction you made during the month, including all purchases and any payments made on your account.
Your statement also shows your previous balance from the end of the last statement, your new balance, your minimum payment due, and your due date. If you carry the balance from month to month, you’ll see the interest rate and amount listed on your statement. As long as you make your payment by the due date, your credit remains in good standing. If you pay off your balance, you can avoid interest charges.
Credit Card Fraud
You need to keep your credit card details secure and secret. Keep your statements in a safe place. If your credit card is lost or stolen, call the number on your statement to report it so they can cancel the card.
If someone used your card to make unauthorized purchases, you usually have some protection as long as you report the loss as soon as possible. Most credit card issuers offer zero-liability fraud protection so you won’t be on the hook if someone steals your card and spends a lot of money with it.
Be smart with your credit card, especially if this is your first time buying things on credit. Use it for amounts that you can cover in cash to get started and pay off your balance in full every month.