Credit Cards 101: How Do Credit Cards Work?

APR, interest rates and all the basics about credit cards.

Credit cards are a way you can pay for purchases without using cash. In addition to the convenience factor, many credit cards offer incentives to get you to choose a card. If you’re looking at getting a credit card, you should understand how they work, which purchases to use credit cards for and the benefits that they provide.

How Credit Cards Work

Credit cards can improve your financial life if you know how to use them responsibly. Here’s a brief overview of how credit cards work:

Credit Cards vs. Debit Cards

Unlike credit cards, which trigger a revolving line of credit from a bank or credit card issuer, a debit card actually withdraws money from your bank account when you use it. Most debit cards don’t have annual fees or interest charges, so they aren’t as profitable for banks. Credit cards, on the other hand, can be very profitable for banks.

In addition to fees they earn, credit card issuers also earn higher interchange fees from merchants with credit cards as opposed to debit cards. To generate customers, many cards offer attractive rewards to entice you to choose one card over another. For example, many credit cards offer points or miles that you can use to book free hotel rooms or flights. Others offer cash back on your purchases or pay higher rewards for certain categories of spending, such as gasoline or office supplies.

Related: Cash vs. Credit Card — The Original Paper or Plastic Debate

Using Credit Cards to Manage Your Finances

With a variety of rewards cards available, it makes sense to research the cards that offer the greatest benefits for the way you spend. If you use your card responsibly, you can avoid most, if not all, of the fees and interest charges that many cards carry. Research the benefits and the cost of cards that interest you, and you’ll soon understand how credit cards work.

A credit card carries important financial information about you in a magnetic stripe on the back of the card. Many cards also have an embedded chip, containing information just like magnetic strips. Card issuers use cryptography to keep your information safe. When you swipe a card or insert it into a chip reader, your account information is transferred between the merchant and your credit card company.

Credit Card Fees

Although having a credit card might seem like free money, in reality, a credit card is your access point to a line of credit offered to you by a bank. Every time you use your card, you’re borrowing money. Most credit card companies offer grace periods of 21 to 30 days before you start accruing interest. If you don’t pay off your charges in that time, you’ll face a finance charge, just like with any other loan.

Interest rates can vary wildly, but the average credit card annual percentage rate, or APR, on accounts that charge interest is about 13.5% APR, according to the Federal Reserve. Some cards also charge annual fees, which can be as high as $450 per year or more.

Other fees to look out for include:

  • Balance transfer fee: Fee for moving a credit card balance from one card to another
  • Foreign transaction fee: Fee for using your card overseas or in a different currency
  • Cash advance fee: Fee for withdrawing cash using your card
  • Late payment fee: Fee assessed if you don’t make your minimum payment in time
  • Over-limit fee: Fee for going over your credit limit

See: Best Credit Card Offers, Deals and Bonuses

Improving Your Credit Score

A credit card is an unsecured loan, meaning you don’t have to put up any collateral to back it up. This creates more risk for the credit card company, which is why you have to apply to get a credit card. The issuing bank will review your credit history to determine if you’re an acceptable risk, based on its own standards. The higher your credit score, the more likely you are to be approved for a card.

One universal standard for credit scoring is the FICO score, which runs from 300 to 850. Most credit card companies consider customers with scores of 700 or above to be lower risk. The FICO credit score is based on five variables:

  • Payment history
  • Amounts owed
  • Length of credit history
  • Credit mix
  • New credit

The first two categories comprise 35 and 30 percent of your overall score, respectively, so they’re the most important. If your score is too low for you to qualify for a credit card, here are some strategies to improve your credit score:

  • Make all payments on time.
  • Reduce the amount of your outstanding debt.
  • Don’t close old accounts — so you can lengthen your credit history.
  • Only apply for the credit you need.
  • Try to have diverse lines of credit — for example, a car loan or home mortgage.

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