How Do Credit Cards Work?

Photo to accompany story about how credit cards work. Getty Images

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$84 a month. 

That’s how much a typical credit card balance will cost you in interest payments, according to the Federal Reserve’s most recent Survey of Consumer Finances. The average credit card balance is $6,300, with an average APR, or annual percentage rate, of about 16%.

But if you follow the golden rule of credit cards, you won’t be on the hook for anything. In fact, the most responsible credit card holders never pay any interest at all.  

“I think it’s grossly unfair to vilify credit cards. It’s the only extension of credit where interest is optional,” says John Ulzheimer, a credit expert formerly of FICO, Equifax and Credit.com. “If I don’t ever carry a balance, I’m never gonna pay interest,” he says.

Paying off your card balance in full, each and every month, is the secret to credit card success. This approach will let the cards work for you—without hurting your finances. But new cards don’t typically come with a handbook explaining how to properly manage a credit card. So it’s easy to end up learning the hard way, and find yourself in a situation where you have to work your way out of a mountain of high-interest credit card debt. 

Here’s what we think you should know.

Credit Card Basics

Credit cards are issued mainly by banks and credit unions. There are four major payment networks that credit cards operate on: American Express, Discover,  Mastercard, and Visa.

Companies often partner with banks to issue their own credit cards; these are known as co-branded credit cards. Most airlines, hotels, and major retail stores have co-branded cards.

What’s a Credit Card?

With a credit card, you can make purchases now and pay for them later. You’ll usually have a credit limit, limiting how much you can spend. When you don’t pay off your card in full each month, the bank charges you interest on the remainder of the balance. “There is lots of money to be made by the credit card companies by charging this interest,” says Ira Rheingold, executive director with the National Association of Consumer Advocates.

“Using a credit card is essentially getting a loan from the bank,” he says. It’s sort of a short-term loan, and you can pay for it in two ways, he says: fees and interest charges. 

What’s the Difference Between a Credit Card and a Debit Card?

When you pay with a credit card, you’re borrowing money from a financial institution, so it can be easy to spend more than you have. But a debit card works differently.

With a debit card, you’re paying with money you have in your account. So a debit card will never leave you with debt — or paying interest charges if you don’t pay back the bank — since you can’t spend more than you have.

However, depending on your bank there could be fees associated with a debit card. You may pay ATM or overdraft fees. But these are easily avoidable, and are usually small compared to the credit card interest you’d pay on a big balance.

Reasons to Get a Credit Card

Getting a credit card to buy something you can’t pay for outright is never a good idea. But there are plenty of reasons to sign up for one. For one, it can help build your credit, and credit cards offer much more generous rewards than debit cards.

Building Credit

Having a credit card will help build your credit in a few ways. When you pay your credit card bill on time each month this shows up on your credit report. Your payment history accounts for 35% of your FICO score, so paying your credit card bill on time is one of the best things you can do to improve your credit. 

But if you miss payments, that will have a significant and negative impact on your credit score. And carrying a balance on your card will increase your credit utilization ratio, which will decrease your credit score.

Sign-Up Bonus Offers

The quickest way to earn rewards with a credit card is to take advantage of a generous sign-up bonus if it offers one. The best bonuses range in value from a few hundred dollars to $1,000 or more.

When you apply for a credit card be sure to carefully read the terms because you’ll need to meet certain criteria in order to qualify for the sign-up bonus. Typically, you’ll have to spend a certain amount (using the card) within a specific time period before you earn the bonus rewards. And bigger bonuses usually have higher minimum spending requirements.

Rewards

There are many different types of credit cards, with each offering varying types of rewards, from cash back to airline miles, or points. So when you’re comparing credit cards, make sure to consider what you’re looking to get out of a credit card. Some credit cards charge annual fees as well, so make sure to do the math and make sure you’d be earning enough rewards to outweigh it. 

You’ll also want to pay attention to not just the type of rewards, but also the bonus spending categories. Some cards earn bonus rewards for specific categories of purchases, like travel, dining, or groceries. So you should consider applying for the card that will earn extra points on what you normally spend the most on.

Introductory 0% APR Offers

In addition to sign-up bonuses, some cards will offer an introductory 0% APR on purchases or balance transfers. If you currently have a balance on a credit card, taking advantage of a 0% APR offer is a potentially great way to save on interest charges.

Just keep in mind that the 0% APR period will only last anywhere between six to 18 months — depending on the card. After that, you’ll be paying the usual APR — usually variable — that comes with most credit cards.

Flexibility

While credit card debt can be expensive, if you have an emergency, they can provide some financial flexibility. It’s better to have an emergency fund, but being able to pay over time with a credit card can allow you to stay on your feet when you have unexpected bills pop up. 

Types of Credit Cards

The type of credit card that is best for you depends on your financial goals, budget, spending habits, and how you prefer to earn and use credit card rewards. Cash back credit cards are ideal if you prefer simpler rewards-earning structure. Travel credit cards are great for anyone who travels a lot — or anyone looking to upgrade their next vacation with a posh business-class flight or luxury hotel. Understanding the different types of rewards makes it easier to choose the right credit card for you.

Cash Back Cards

Cash back credit cards are the most straightforward type of credit card. You’ll always know the exact value you’re getting for every purchase, and you can use cash back for anything. The one exception here would be credit cards with rotating cash back categories — which can be a pain to keep track of.

Since travel isn’t on the table for most people right now, a cash back card may be the perfect choice for you. You can earn rewards to use for immediate needs, or save your cash back to book your next vacation once travel opens up.

Travel Credit Cards

Travel credit cards can be the most lucrative type of credit card, but they can also be the most complicated. Travel cards that offer flexible rewards are the most valuable because many (not all) allow you to transfer the points you earn to different airline and hotel loyalty programs.

This gives you more options for using your points, but it also means you may need to navigate the rules of multiple rewards programs. But having the option to redeem a reasonable number of travel points to book an international business-class flight or $500-a-night hotel room is usually the most rewarding way to use credit card rewards.

Rewards Credit Cards

Many companies issue rewards credit cards that offer specific benefits when you make purchases. Most major airlines and hotels have co-branded cards that not only allow you to earn rewards with their loyalty program, but also come with additional perks. An airline credit card may have a free, checked-bag benefit and certain hotel credit cards grant you automatic elite status with that specific hotel chain.

Rewards cards are a good option if you’re highly loyal to a specific brand. But if you prefer to shop around for the best deal, the ongoing benefits of a brand-specific rewards card may not be worth it for you.

When you pay with a credit card, you’re using someone else’s money, so it can be easy to spend more than you have. 

How to Use a Credit Card

Credit cards can be a great way to build your credit score, when used properly. Consistently paying off your credit card in full and on time each month will help improve your credit score over time, Ulzheimer says. 

That really is the best way to use a credit card – as an extension of your bank account. Ulzheimer believes a card’s annual percentage rate (APR) should be irrelevant. “If the most important metric you’re looking at when you compare credit cards is interest rate, I would almost suggest you’re looking at the wrong product,” he says. You shouldn’t go into a relationship with a card issuer expecting to carry a balance. In that case, he suggests a debit card or charge card that must be paid off each month as better options.

Once you’ve built a healthy relationship with credit cards, you can also take advantage of rewards programs. As long as you’re paying your bill each month in full and on time, rewards credit cards can be a great way to get cash back for travel or other expenses. Many credit cards also come with hidden perks, like extended warranty benefits or built-in rental car insurance. So your credit card could save you money in more ways than you may realize.

How to Be Smart With Your Credit Card When Times Are Tough

The pandemic and ensuing recession has many people struggling to make ends meet right now. This means more people are dependent on credit cards, says Rheingold. This is very dangerous because people may not have the income to pay back that debt, he says. 

Pro Tip

Never pay only the minimum amount of your credit card balance each month. If you do that, you’ll end up paying much more in interest charges than the original balance.

In this case, credit cards are not a long-term solution, even if they aren’t as bad as payday loans or payday loan apps. But there are steps you can take to minimize the cost of using a credit card to get by.

You should do everything possible to at least meet the minimum payment requirement each month. If you’re just one day late on a payment, you’ll usually get hit with late fees and may trigger a penalty APR. A penalty APR is a much higher APR that typically applies for at least six months.

Most credit cards have a cash advance feature which allows you to use your credit card to get cash, but it’s an expensive option. Cash advance fees are typically $10 or 5% of what you withdraw, whichever is higher. A credit card cash advance typically comes with a higher APR than a standard purchase.

If you’ve missed a payment or are carrying a balance, it’s worth calling the bank and explaining your situation. Better yet, if you think you might miss a payment, call your credit card issuer to discuss the situation in advance. Many credit card issuers are offering coronavirus relief by waiving or reducing fees and interest rates.

What to Watch Out For With Credit Cards

Credit cards come with an assortment of fees you should be aware of, because most of them are completely avoidable if you understand when they’ll apply.

The first thing to look at is a credit card’s annual fee. This is a flat fee you pay each year just to have the card. In some cases, the value of rewards and other perks can make the annual fee worth paying. 

Let’s say your annual fee is $129. If your spending yields more than $129 in rewards, then the annual fee is worth it, Ulzheimer says. However, if you’re at all unsure about whether or not it’s worth it to pay an annual fee, then just keep it simple with a no-annual-fee card. This is especially true if it’s your first credit card.

Once you have a card, the cost that can end up being the most expensive is interest. You’ll typically only be charged interest if you don’t pay off your balance in full each month. Credit cards usually only require small minimum payments to avoid late fees, but paying only the minimum payment means carrying over a balance that will incur interest charges. The minimum payment is often a small amount, like $25 or 1%-2% of your total balance, so if you only pay the minimum amount due each month, you could end up paying much more in interest than the amount of your original balance.

A basic credit card calculator illustrates just how much you can end up paying in interest by only making minimum payments:

BalanceInterest RateMinimum Monthly PaymentInterest PaidTotal PaymentsTime to Pay Off
Credit Card$2,000.0015%$30.00$5,900.76$7,900.7630+ years

There are other fees that may apply in specific situations. Some cards charge foreign transaction fees when you’re making purchases in a foreign currency. Credit cards also charge cash advance fees, and unlike with a regular purchase, interest is charged on a cash advance from the day the transaction was made.