Credit cards are convenient for consumers who want to make purchases without cash. However, there can be hidden costs to using credit cards. Cardholders must understand how credit cards function beyond making purchases and payments. For all of their benefits and privileges, not knowing how credit cards work can result in financial difficulties. Understanding how do credit cards work can help current and potential cardholders avoid pitfalls resulting in crushing debt and a damaged credit score.
What Is a Credit Card?
A credit card is a physical card made of plastic or metal that connects to a revolving line of credit provided by a bank or other company that issues credit. A revolving line of credit is like a loan that does not have an end date. It remains open as long as the account is in good standing by making on-time payments on any balance owed.
When using a credit card, it is the same as borrowing money from the bank or company that issues the card to pay for purchases. The bank sets a credit limit on how much is available to spend. When using a credit card for purchases, the amount of that transaction adds to the card’s total balance.
Credit cards have to be repaid either in whole or in monthly installment payments. Making credit card payments lowers the total balance owed, which frees up the amount of credit that is available to use.
How Do Credit Cards Work?
The question of how credit cards work is a common one, especially for anyone new to using them. A credit card is used to purchase items in a physical store or online and can also be used to pay bills. Credit cards are used at the holder’s discretion as long as a merchant accepts them.
When the credit card is in use, the card’s information is sent to the merchant’s bank. Their bank receives authorization from a credit card payment network for processing. Next, the lender confirms the credit card holder’s information and approves or declines the purchase.
Credit card payment networks include companies like Mastercard, Visa, American Express, Discover, and STAR. They are responsible for processing all credit card purchases. These networks ensure the merchant receives payment for credit card transactions and that they bill the correct cardholder’s account.
How Do Credit Card Payments Work?
Credit card users receive a monthly statement detailing the total balance owed. Users can either pay the outstanding balance in full, pay the minimum amount set by the lender, or pay more than the minimum amount due.
Paying the total balance in full each month by the due date saves money by avoiding interest charges. Making minimum payments or less than the total balance costs more over time because interest accrues on any outstanding balance. Making late payments or no payments at all may result in higher interest rates and the addition of late fees to the total balance.
The bank issuing the credit card reports those payments to the three major credit bureaus that compile credit reports: Experian, Equifax, and TransUnion. An individual’s payment history accounts for 35% of their credit score. To avoid having a reduced credit score, it is essential that cardholders at least make the minimum monthly payments on time each month.
How Do Credit Cards Work Differently From Debit and Prepaid Debit Cards?
Another aspect of knowing how do credit cards work is being aware of the distinctions between credit, debit, and prepaid debit cards. Credit and debit cards may look similar in appearance, but they function quite differently.
Credit cards work by borrowing money from an approved line of credit. Paying the outstanding total balance directly impacts the cardholder’s credit score. Making on-time payments can boost a credit score, while making late or missing payments altogether can lower a credit score.
Debit cards connect to the cardholder’s checking account. When using a debit card to make a purchase or pay a bill, the money is deducted from the checking account right away as long as there is enough money in the account to cover the transaction amount. Since there isn’t a line of credit involved, there are no outstanding balances owed, and there are no minimum payments owed, which does not impact credit scores.
Prepaid debit cards do not connect to a checking account. Cardholders add money to the card and can only spend the amount that is on the card. Prepaid debit cards may not offer mobile banking, usually charge a monthly maintenance fee, may have high ATM usage fees, and may not be accepted by some merchants. As with debit cards, since they do not connect to a line of credit, they do not affect credit scores.
How Do Credit Cards Work Differently Than Secured Credit Cards?
Unsecured credit cards are granted based on the applicant’s creditworthiness. Applicants with higher credit scores have a better chance of being approved for an unsecured credit card. Consumers with adverse or bad credit can apply for a secured credit card to rebuild their credit history. This rebuild allows cardholders to learn how do credit cards work.
Secured credit cards require a deposit that equals the credit limit for the card. Cardholders receive a monthly statement with a total balance that is payable in full or in monthly installments. The security deposit is typically refunded if the account is closed in good standing or the cardholder upgrades to an unsecured credit card.
Other Types of Credit Cards
No matter which payment network processes the transaction, unsecured credit cards function similarly. However, there are different kinds of credit cards, either for specific cardholders or particular purposes. Some examples of specialized cards include:
Balance Transfer Cards
Unsecured credit card holders seeking to minimize their interest rates can transfer their existing card debt to a balance transfer credit card to get a lower interest rate. Numerous balance transfer cards offer a zero percent introductory rate to reduce the amount of interest paid.
Business Credit Cards
Owners of smaller businesses use business credit cards. These credit cards frequently offer fringe benefits that support the needs of the particular company, such as earning rewards, mileage, travel points, and cash back.
Corporate Credit Cards
Also called commercial credit cards, these are lines of credit for larger, more established companies that allow their employees to charge work-related expenses without using their own money or personal credit cards. Corporate credit cards offer benefits such as travel rewards and gift cards.
Rewards Credit Cards
Rewards-based credit cards provide cardholders with various rewards as incentives for using their cards, such as points, airline mileage, and cash back. The types of benefits offered can vary and provide a specific perk, like hotels, airlines, and car services offering rewards for travel-related expenses and restaurant rewards for dining purchases.
Store Credit Cards
Many retail stores and sites have unsecured store credit cards, frequently offering perks for shopping at that merchant and using their card. These perks can include loyalty program points and additional discounts. There are two kinds of store credit cards: closed loop and open loop. Closed-loop store cards are for use at specific merchants and related brands, and open-loop cards are unsecured credit cards used anywhere.
Student Credit Cards
Student credit cards are unsecured credit cards for students who tend to have lower incomes and limited credit histories. Students are more likely to be approved for a student credit card than a traditional unsecured card, but the credit limits are usually lower.
The Costs of Credit Cards
Having an unsecured line of credit in your wallet is highly beneficial, especially knowing how credit cards work. Credit cards can have various costs and fees attached to them that can increase how much cardholders pay to card issuers. Excess fees to look out for include:
Annual Fees
Some banks charge annual fees that range from the moderate (less than $100) to the excessive (more than $100). If the card offers benefits that exceed the annual fee, it may be worth keeping. Contacting the credit card issuer may help get these fees minimized or waived.
Balance Transfer Fees
Transferring existing credit card debt to a balance transfer credit card can result in a transfer fee amounting to a percentage of the obligation moving to the new card. Some banks offer promotional periods where they waive the transfer fee.
Foreign Transaction Fees
When cardholders travel outside the United States and use their credit cards, some banks charge a fee for any purchases from foreign merchants. These fees typically are not imposed when using their travel credit cards.
Interest Payments
When cardholders pay their credit card balances in full, the total monthly balances do not have interest charges added. However, credit card issuers may levy different interest rates for various transactions, such as purchases, balance transfers, and cash advances.
Late Payment Fees
One of the benefits of making credit card payments on time is the avoidance of late payment fees. Specific late fee amounts vary by bank, but the federal government limits how much credit card issuers can charge, and credit card issuers cannot impose a late fee that is higher than the minimum payment that is due.
Manage Credit Card Use Wisely
When used and managed appropriately, credit cards can be helpful to consumers who wish to have non-cash purchasing options. Knowing how credit cards work can save cardholders money from excess fees and interest rates, as well as prevent negative actions against consumer credit reports.