How Do Credit Cards Work?

Whether you’re considering getting a credit card or already have one, you may want to know how credit cards work. While Americans have an average of four credit cards, not everyone understands how they work.

We prepared a guide to explain what a credit card is and how they differ from debit cards to help you choose the best one for your particular circumstances and needs.

What is a credit card?

A credit card is a thin plastic card that allows you to make purchases and pay bills without cash. Also, depending on the card, you may be able to withdraw cash using a credit card.

The front of a credit card includes the following elements:

  • The name of the card issuer;
  • A unique number of the credit card;
  • An expiry date;
  • The name of the cardholder; and
  • The logo of either Mastercard or Visa, a payment processing company that processes all credit card transactions.


On the back of the credit card, you will find:

  • A magnetic strip or chip; and
  • A three- or four-digit CVV number used for online or phone purchases.


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In order to understand how a credit card works, think of it as a short-term loan.

Once you’re approved for a credit card, you’ll get a card with a preset credit limit, which is an amount of money your lender – the credit card issuer – allows you to spend using the card. Interest charges will accrue if you don’t pay your full balance by the due date.



How do credit cards work?

Here’s what happens every time you use a credit card to make a transaction at the point of sale:

  1. Your credit card details are sent electronically to the merchant’s bank, also known as the acquiring bank.
  2. The bank forwards the card information to the credit card network.
  3. The credit card network processes the payment and requests payment authorization from your card issuer.
  4. After verifying your information, your credit card issuer must authorize or decline the payment.
  5. If your credit card company approves the transaction, the merchant will receive the payment.
  6. After the transaction is complete, your card’s available credit is reduced by the amount of the transaction.


That’s how the credit card transaction process works. At the end of the billing cycle, your credit card company will prepare a billing statement displaying the following:

  • All the transactions that were made during the billing cycle
  • Your previous balance
  • Your new balance
  • The minimum payment amount
  • The due date to make a payment on your card


Will your credit card company charge you interest?


No interest charges will accrue if you pay your full balance by the due date during the grace period. The grace period is the period between the end of your billing cycle and the date when your minimum payment is due.


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The Credit CARD Act of 2009 requires credit card companies to give a grace period of at least 21 days.


If the grace period expires and you carry a balance on your credit card, your lender can charge you interest. In order to calculate how much you’ll be charged if your balance isn’t paid in full by the due date, you need to:

  1. Determine what your annual percentage rate (APR) is;
  2. Convert your APR to a daily periodic rate (DPR);
  3. Calculate your average daily balance;
  4. Multiply your DPR by the average daily balance;
  5. Find out what your credit card interest is by multiplying the resulting number by the number of days in your billing cycle.



What’s the difference between credit cards and debit cards?

While many people talk about these two types of cards interchangeably, there are several differences between a debit card and a credit card.

When making purchases or paying bills using a credit card, you’re not spending your own money. Rather, you’re spending the card issuer’s money, which is subtracted from your credit limit.


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However, you still have to pay the full statement balance that you’ve borrowed.

When using a debit card, the money that you use to make a purchase is deducted directly from your savings or checking account. It means that you don’t owe anyone anything because you’re spending your own money.

Also, credit and debit cards have a different impact on your credit score. When using a debit card, your financial transactions aren’t reported to credit bureaus, and thus there is no impact on your credit score.

When using a credit card, your transactions are reported to credit bureaus that calculate your credit score based on your card activity.

Finally, another difference between these two types of cards is that federal law provides greater protections against fraud for credit cards.

How to compare credit cards?

As different lenders offer numerous credit cards to choose from, it’s important to understand how to compare cards to pick the best one for your particular needs.

Before you begin to compare different credit cards, you need to identify why you’re interested in getting a credit card. According to a 2018 survey by Credit Cards Explained, the most common reasons why people open credit cards are:

  1. To build or improve the credit score
  2. To earn cashback
  3. To earn travel or store rewards
  4. A previous maxed-out card
  5. To get a signup bonus


Consider the following factors when comparing credit cards are:

  • APR on purchases and balance transfers
  • Regular APR
  • Annual fees
  • Rewards rate and bonuses
  • Minimum credit requirements


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If you’re currently looking for a credit card, avoid applying for multiple cards at once. Doing so could hurt your credit score because each time you apply for a credit card, the issuer performs a “hard inquiry” on your credit report.


Pros and cons of credit cards

If you’re not sure whether you need a credit card or not, we’ve prepared a list of pros and cons of getting a credit card to help you make an informed decision.


Pros of credit cards
Cons of credit cards
Getting a credit card is easy as long as you meet the card issuer’s approval requirements.
Each time you apply for a new credit card, your credit score takes a short-term hit because of “hard inquiries.”
You can build and rebuild your credit score by using the credit card responsibly.
A missed or late payment can damage your credit score.
Having a credit card may eliminate the need to carry cash.
Since credit card payments are not tangible, people tend to spend more than they would with cash.
You can get rewards by using a credit card, including cashback and airline miles.
There are many fees to consider when using a credit card, including annual and advance fees.
If you don’t have enough money to make a big purchase, a credit card gives you the ability to buy now and pay later.
Compared to other types of loans, including mortgages, credit cards have high interest rates. According to CreditCards.com, the average APR for new credit cards stood at over 16% in December 2020.
You won’t lose any money if your card gets stolen or lost (the same cannot be said about a wallet).
When used irresponsibly or carelessly, credit cards can lead to debt.
A credit card allows you to keep track of your spending over time.
Many people view their credit limit as a form of supplemental income. This can contribute to overspending.
Having a credit card allows you to make online purchases.

Credit cards usually offer cheap and convenient currency conversion when making purchases abroad.


Conclusion

Credit cards have become an essential tool in our everyday life, but many people do not understand how they work. While credit cards have many downsides, they also offer a plethora of benefits. When used responsibly, credit cards can help you build or improve your credit score and get rewards. However, if you don’t pay the full balance by the due date and carry a balance from one month to the next, you will have to pay interest on your credit card.


FAQ

  • How to get a credit card?

    In order to get a credit card, you need to submit an application on the card issuer’s website. When completing the application, you will have to provide your full name, employment status, income, Social Security number, and other necessary information.
  • Can my credit card application be denied?

    Yes, the credit card issuer can deny your application if you have too much existing debt or too many credit cards, you’re unemployed or have unstable income, have a limited credit history, your credit score is lower than what’s required, or you don’t meet other eligibility requirements.





Table of contents
  1. What is a credit card?
  2. How do credit cards work?
  3. Will your credit card company charge you interest?
  4. What’s the difference between credit cards and debit cards?
  5. How to compare credit cards?
  6. Pros and cons of credit cards
  7. Conclusion
  8. FAQ