How Do Credit Cards Work?

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Using a credit card is a convenient way to make purchases online and in person. In addition to that, you can earn rewards like cash back, points and miles on purchases you make every day. Plus, good spending habits can help you build your credit profile.

If you’re new to credit cards, you probably have some questions about how they work. While credit cards can be very convenient and come with several perks, they can cost you money if you don’t have enough knowledge about them and don’t use them properly.

In this post, you’ll learn how credit cards work, how they compare with debit cards and whether taking out a credit card is worth it.

What Is a Credit Card?

A credit card is a physical card that you can use to make everyday purchases without using money from your bank account. Instead, the credit card company pays the merchant whenever you make a purchase. Your credit card company then sends you a bill at the end of the month. Think of a credit card as a short-term loan.

Get Credit Card Perks

The credit card company gives you a credit limit — the amount you can spend per month — and every time you charge a bill to your credit card, your available limit reduces. As a cardholder, you need to pay off the borrowed money each month, plus any applicable interest.

Apart from that, the credit card issuer also may give you a separate line of credit that lets you borrow cash advances that you can access through ATMs, bank tellers or credit card convenience checks. However, such cash advances have different terms to transactions made with the main line of credit (LOC).

How Do Credit Cards Work?

A credit card is linked to a credit account in the bank or any other financial institution. When you use your credit card to make purchases or pay bills, you’re essentially borrowing money from the issuing bank to pay merchants.

Credit card networks such as Visa, Mastercard, American Express and Discover will process the transactions. Their role is to ensure that the merchant receives the payment and your credit card issuer bills you for the transaction.

Get Credit Card Perks

If the bank approves your transaction, it pays the merchant and your available credit card limit is reduced by the transaction amount. Your card issuer will send you a credit card bill showing all the transactions at the end of the month.

You can pay your bill in full by the due date to avoid paying interest on your purchases. Your card issuer will provide a grace period, which is typically 21 days or more, from the end of the billing cycle to when the bill is due. If you don’t pay your bill in full, any balance will roll over to the next month’s billing cycle and begin to accrue interest.

The amount of interest you’ll pay depends on the Annual Percentage Rate (APR) your credit issuer gives you. The bank determines your credit account by looking at your credit history, income, debt and other factors.

Credit Cards vs. Debit Cards

Credit cards and debit cards may look similar, but they’re different in many ways — including how purchases are processed, the impact they can have on your credit score and liability when it comes to fraud.

How They Process Purchases

A credit card allows you to make purchases without having to spend your own money at the time of purchase. The credit card company will pay the merchant for your purchases and later send you a credit card bill, which you’ll need to pay along with any applicable interest.

Get Credit Card Perks

Conversely, debit cards are physical cards linked to your checking account. For debit card purchases, the transaction amount is automatically deducted from your account balance. You don’t incur any debt or interest later since you’ve already paid for your purchases.

Credit Score Impact

Credit cards and debit cards also can differ based on the impact they can have on your credit score.

Creditors report your card activity each month to three major credit bureaus — Equifax, Experian and TransUnion. Making your credit card payments on time will help you improve your credit score, while late payments could damage it. Also, keeping your credit utilization ratio low can impact your credit score positively, while maxing out your card can hurt your score.

On the flip side, using debit cards does not have any impact on your credit score because debit issuers don’t report your card activity to credit bureaus.

Fraud Protection

How credit cards and debit cards protect you from fraud differs significantly.

According to federal law, if your debit card gets lost or stolen, your maximum liability stands at $50, provided that you report it within two business days. If you don’t report it within 60 days, you may be liable for up to $500.

However, if you report after 60 days, you may be liable for all unauthorized transactions. In a case where your card isn’t lost or stolen but there are unauthorized transactions, you’re not liable as long as you report within 60 days of receiving your statement.

When it comes to credit cards, the most you can be responsible for unauthorized use of your card is $50. However, many card issuers often offer $0 liability protection against fraudulent charges, provided you report it within a specific timeframe. This can vary by issuer.

Takeaway

Credit cards are helpful tools when you don’t have enough cash to cover your expenses or want to earn rewards and build your credit profile. However, it’s vital to know how credit cards work — especially when it comes to how they process purchases, the impact it can have on your credit score and fraud protection. This will help you minimize costs or avoid them altogether.

Credit Card Fees

As previously mentioned, when you use your credit card, you are borrowing money. You’ll have a grace period, usually 21 to 30 days, to repay the amount in full. If you don’t pay off your balance within that period, the remaining amount will start accruing interest. The amount of interest is often based on the APR given and varies by issuer.

Things To Consider Before Getting a Credit Card

When shopping for a credit card, here are some of the things you want to consider.

Fees

Credit cards come with various fees that can add up to more charges — including annual fees, late payment fees, foreign transaction fees, balance transfer fees and others. Card issuers often will have you sign some paperwork outlining all the fees you may be charged for using your credit. Ensure that you understand all the fees you may incur so you can minimize or avoid them altogether.

Rewards Offered

Many credit cards offer rewards in the form of cash back, points or miles for every dollar spent. Some offer a welcome bonus if you reach a certain spending limit within a specified period of time. Keep in mind that reward cards can be particularly helpful if you plan to pay off your balance in full each month.

Interest Rate

Credit cards charge interest if you don’t pay your balance in full each month. The amount of interest charged is often based on the APR and varies by issuer. Although some cards might lure you with an introductory interest rate of 0% APR, be sure to pay off your balance before the promotional period ends. Otherwise you’ll end up paying higher interest.

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About the Author

Lydia Kibet is a freelance writer specializing in personal finance and investing. She's passionate about explaining complex topics in easy-to-understand language. Her work has appeared on GOBankingRates, Investopedia, Business Insider, The Motley Fool and Investor Junkie. She currently writes about investing, banking, insurance, real estate, mortgages, credit cards, loans and more. Connect with her on Twitter or moneycredible.com.

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