Credit cards are more than a convenience. They’re also a valuable tool for establishing and building the credit you’ll need to buy a car or home, and perhaps even qualify for insurance. They can also earn you some nice perks. But a mistake with your credit can have a negative impact on your credit for years to come. Understanding how your credit card payments work can keep your credit and your finances on track.
How Credit Cards Work
Whereas a debit card lets you pay for purchases or withdraw funds directly from your bank account, a credit card is a loan against your credit limit — the maximum amount the credit card issuer allows you to have outstanding at any given time. Because it’s a revolving line of credit, there’s no fixed date by which you need to repay the debt. Rather, the line of credit is available to you as long as your account remains in good standing, and you can pay down or pay off the debt and keep using the card as long as you don’t exceed your credit limit.
Whenever you use the card to make a purchase or withdraw cash, the card issuer gets notice of the transaction information and posts the transaction to your account within a few days. The purchase or withdrawal amount is then added to your account balance, which is the total principal amount you owe. Your available credit — the amount of your credit limit that you’ve not used — is reduced by the same amount.
Credit Card Billing
Credit card issuers prepare statements according to a billing cycle that usually runs for 27 to 30 days, according to CNBC. The statement shows all of the activity on your account during the previous billing cycle. Account activity is any action that increases or decreases your account balance, whether initiated by you or your credit card issuer.
Understanding Your Credit Card Statements
Statements differ slightly from one credit card issuer to the next, but all contain the same essential information about your account, including the following:
- Account activity: An itemized list of every charge and every payment to your account, including purchases and cash advances as well as interest and fees imposed by the card issuer. Payments include payments you’ve made as well as credits to your account, such as refunds from store returns.
- Statement balance: The principal you owe as of the last day of the billing cycle, including new charges and balances you carried over from the previous billing period
- Available credit: Equals your credit limit less your account balance
- Minimum payment: The least amount you can pay to avoid a late fee
- Payment due date: The date by which the credit card issuer must receive your payment before it imposes a late fee
- Minimum payment warning: Shows you how long it’ll take you to repay your balance — and how much interest you’ll pay — if you only make the minimum payment each month. You can explore the consequences of other payment amounts using an online credit card payment calculator.
Credit Card Interest and Fees
Credit card issuers make money by charging you interest and fees for using your card. Although both types of charges can add up fast, interest can cost you more than the items you purchased if you’re not careful.
Credit Card Interest
You’ll incur interest charges on any balance amount you carry over from one billing period to the next. You’ll find your rate in the card member agreement you accept when you open the account. For example, Citi’s agreement discloses that its rate equals the U.S. prime rate plus a margin. So if the prime rate is 2% and the margin is 10%, your annual percentage rate would be 12%.
Many cards charge different interest rates for purchases than they do for cash advances, with the cash-advance rate typically being the more expensive.
Good To Know
Your card issuer might increase your interest rate if you make a late payment. In some cases, the rate reverts back to the regular rate after a certain number of consecutive on-time payments.
Credit Card Fees
Your card issuer might charge any number of credit card fees. Common ones include:
- Annual fee
- Late fee
- Balance transfer fee
- Cash advance fee
- Foreign transaction fee
Making Credit Card Payments
You have several options for paying your credit card bill. If you’d rather not mail in a check with the payment coupon attached to your paper statement, you can set up your account online and have payments drawn directly from your bank account. An online account lets you schedule payments for a specific date or set up autopay to have your payments automatically drawn from your bank account on your credit card due date.
How Your Payments Are Applied
Federal law determines how credit card issuers apply your payments. Your payment first goes to the minimum amount due. If there’s money left after that, it goes to your balance with the highest rate. For example, if you paid late and have one purchase being charged a penalty rate while other purchases are being charged your standard rate, your overpayment goes toward the balance amount being charged the penalty rate.
The exception to this rule is in instances where you have a balance with deferred interest, perhaps from a credit card promotion where you get a certain number of interest-free months to pay for a purchase. In this case, you can request that your payments first be used to offset the balance with deferred interest. Beginning 60 days before the balance due date to avoid interest, the card issuer must apply any overpayment to the deferred-interest balance first.
The Importance of Paying on Time
Your credit card payments can make or break your credit score. First, payment history is the most significant factor determining your credit score, comprising 35% of the score. Whereas on-time payments increase your score over time, late payments might cause your score to plummet.
Credit utilization comprises 30% of your credit score, so your best bet is to pay down your credit card balance to keep it at a low percentage of your credit limit. This also shows lenders that you live within your means — a very good thing if you apply for new credit.