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Credit cards offer convenience, consumer protections and a quick way to build good credit, assuming you use them responsibly. Use them unwisely, and your credit can suffer, which affects your ability to borrow money in the future. Understanding how credit cards work will help you choose the right cards for you, manage them well and save money.
Credit card basics
What is a credit card?
A credit card is a plastic or metal card that allows you to access a line of credit offered by the bank that issued the card. Every time you pay for something with a credit card, you’re borrowing money from the card issuer to cover the purchase. You then have to pay that money back, either in full at the end of the month or over time.
How do credit cards work?
When you’re approved for a credit card, the bank authorizes a credit limit — the maximum amount you can borrow — to be used at your discretion. Your credit limit will depend on such factors as your income, your other debts and how much available credit you have on other cards.
Payment networks — Visa, Mastercard, Discover and American Express — process credit card transactions. They make sure that the money for the purchase gets to the merchant and that the correct cardholder gets billed.
When your bill comes, you have the option of paying a certain minimum amount, paying the whole balance in full, or paying some amount in between. Paying just the minimum every month is ultimately the most expensive option, since it will cost you the most in interest. Paying in full is the best option; when you pay in full each month, you get a grace period that allows you to avoid paying any interest on purchases at all.
Your credit card issuer reports your payments to the credit bureaus, the companies that prepare credit reports. Your payment history counts for 35% of your credit score — a three-digit number that indicates how risky it would be to lend you money. You must pay at least the minimum by the due date every month to avoid late fees and potential damage to your credit score.
How do credit cards differ from other cards?
A debit card is linked to your checking account; debit card purchases automatically pull money out of your account. You're using your own money to pay for things rather than borrowing it. Some debit cards earn rewards, but they generally pale in comparison to credit card rewards. Debit cards also have weaker fraud protections.
A prepaid debit card isn't linked to a checking account; instead, you "load" money onto the card, and you can only spend as much as you've loaded. These cards often charge many fees you wouldn’t pay with a regular debit card. Prepaid debit cards offer some protections, and they come with limitations. For example, some prepaid debit cards don’t offer ATM access or mobile banking. Also, not all merchants accept them.
Neither debit cards nor prepaid cards will affect your credit scores, because using them does not involve borrowing money. Only a credit card will affect your credit score.
Types of credit cards
Rewards credit cards give you something back for each purchase you make. Generally, these cards require good credit. They come in different types:
Cash back cards give you money back. You can usually get that money as a check or a deposit into a bank account, or you can use it to reduce your balance.
General travel cards give you points that you can use to pay for any travel expense. They're more flexible than branded airline or hotel cards.
Store credit cards reward you for loyalty by giving you discounts or other benefits for shopping at the store that provided the card.
Rewards cards are ideal for cardholders who pay their bill in full every month. When you carry a balance, interest charges nip away at the value of rewards.
Low-interest cards don't give you rewards; instead, they provide value with a lower interest rate, making it less expensive to carry a balance. Many times, these cards will come with a 0% introductory APR period, giving you time to pay off a large purchase without interest. You usually need good credit to qualify.
A balance transfer credit card lets you move your debt from another issuer to take advantage of a lower interest rate. Generally, these cards require good or excellent credit.
CARDS FOR AVERAGE OR BAD CREDIT
Credit card options for those with less-than-good credit are more limited. Rewards are more scarce, and interest rates are higher. Use these cards to improve your credit so you can qualify for better offers down the road:
A good card for average credit won't charge an annual fee, or it might offer rewards with a fee.
For bad credit, your best option is usually a secured credit card. These cards require a security deposit that you get back after closing the account or upgrading to a regular, unsecured card. In the long run, a secured card is less expensive than unsecured credit cards for bad credit, which tend to charge high fees that, unlike a security deposit, you never get back.
Being a college student doesn’t automatically qualify someone for a student credit card. The Credit Card Act of 2009 prohibits issuers from giving cards to people under 21 unless they have proof of income or a co-signer, someone willing to put their credit on the line to help the applicant build theirs. When that’s not an option, a secured credit card is a way to establish credit.
Reasons to get a credit card
Debit cards are appealing because they don’t involve borrowing money and won't rack up debt — but they also don't help you establish a credit history. Building credit is one of the key benefits of using a credit card. Others include:
Sign-up bonuses. The bonus could help you start an emergency fund (in the case of a cash back card) or take a trip.
Ongoing rewards: Rewards give you back some of the money you spend.
Building credit: Establishing a good payment history can help you borrow money in the future at lower rates.
A 0% introductory APR period: This lets you avoid interest on purchases or balance transfers during a promotional period.
Flexibility: Though it's best to always pay your balance in full each month, a credit card allows you to pay for things over time, which helps when you have a major purchase to make or a financial emergency.
Costs of carrying a credit card
Credit cards can come with costs, but you can avoid most of them with responsible use. They include:
Interest payments: Credit cards can have different interest rates, or APRs, for purchases, cash advances and balance transfers. When you pay in full every month, your purchases don't accrue interest.
Annual fees: Some cards charge annual fees, from around $20 to hundreds of dollars. An annual fee can be worth paying if the card gives you rewards and perks that make up for the cost, but in most cases, you shouldn't pay a fee just for the privilege of having the card in your wallet.
Late payment fees: The cost varies by issuer, but federal regulations limit how much late fees can be. As of 2018, first-time late fees were capped at $27; and fees for a second late payment within six months were limited to $38. Late fees also can’t cost more than the minimum payment due.
Balance transfer fees: Generally, balance transfer credit cards charge 3% to 5% of the amount of debt transferred. Some cards waive the fee when you transfer debt within a certain time frame.
Foreign transaction fees: Most cards add a surcharge of 1% to 3% on transactions made with non-U.S. merchants. Travel credit cards generally don't charge these fees, and some issuers don't charge them on any of their cards.
Tips for effective credit card use
The benefits of using a credit card responsibly outweigh the costs. Here are some good practices to adopt:
Pay your bill on time and in full every month
Keep your balance below 30% of your available credit
Wait at least six months between credit card applications
Review your account online weekly to track spending and avoid fraud
Keep no-annual-fee credit cards open and active to avoid hurting your credit score
Using a credit card responsibly is an easy and efficient way to establish healthy credit. You’ll be thankful that you did so when you're able to borrow affordably in the future.