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Whether you’re just about to apply for your first credit card or have had one for some time without knowing the details, you’re in the right place to learn how credit cards work.
The world of credit can be a confusing one, so we’ll break down the basics of how a credit card works, and answer some of the most common questions to help get a better understanding of credit cards.
First things first: How do credit cards work?
At their most basic, credit cards offer cardholders a short-term loan on purchases they make. Each month, you can spend up to a pre-set maximum (your credit limit) without having to pay for any of those purchases out of your own bank account.
At the end of the month, you’ll receive a credit card bill with a balance that reflects the purchases you’ve made throughout the month (plus any outstanding balance from months past as well as applicable fees), at which point you can pay anything between the minimum payment and your entire balance.
If you pay only the minimum, the remainder of your credit card balance will start accruing interest. But if you pay your entire balance each month, you won’t have to pay any interest; meaning, you’ve effectively been given a 0-interest loan for that billing cycle-which is a great deal!
To incentivize people to get a credit card in the first place, many card issuers offer some sort of rewards—commonly cash back or travel rewards. Some cards offer 0% interest for a set period of time, balance transfers from a different credit card account, or the opportunity to build their credit through “secured” credit cards.Whether you’ll get approved for a card depends on the card issuer’s eligibility criteria as compared to your responses to the credit card issuer’s application and your credit history; the better your credit history the more likely you will qualify for a card and, typically, at better rates.
Whether you’ll get approved when you apply for a card depends on the card issuer’s eligibility criteria as compared to your responses to the credit card issuer’s application and your credit history; the better your credit history the more likely you will qualify for a card and, typically, at better rates.
What is a credit card balance?
Your credit card balance is the amount of money you owe to a credit card company at a specific time. This can include any purchases you’ve made in the last billing cycle, as well as purchases from previous billing cycles that haven’t yet been paid off, as well as interest that has accrued from those purchases.
Even if you pay off your credit card balance in full each month, keep in mind that your balance may never go to 0—but that does not cause for alarm.
Think about it this way: When your credit card company generates and sends your monthly bill, what’s captured is a snapshot of the amount you owe on that date. Any purchases you make after that date will add to your balance, so unless you pay more than what you’re billed for, you balance will still be positive—even after making a full payment.
Learn More: How to Pay Your Mortgage with a Credit Card
What is credit card interest?
You can think of credit card interest as the amount of money you have to pay for the privilege of using a bank’s money to fund your purchases. Just like with a personal loan or student loan, credit card interest accrues based on the APR you agree to when you open your account. Credit card interest compounds daily, so it can add up quickly—so it’s a good idea to pay your full balance as often as possible.
How do credit card payments work?
Credit card bills are generally sent to cardholders once per month, but keep in mind that you can make payments at any time. When you make a payment, it will be applied to your account balance—whether that includes just purchases, or purchases and interest.
How can I figure out my minimum credit card payment?
While minimum payments are not standardized throughout the credit card industry, the minimum payment is typically highlighted on each credit card bill, making it hard to miss. Companies usually calculate the minimum payment as either a percent of your total balance or as that percentage plus interest accrued from the prior month plus fees.
For more specifics, review your card’s terms and conditions to see exactly how the minimum payment is calculated for your account.
How is credit card interest calculated?
Credit card interest is charged and compounded daily, making the calculation more complicated than it would be for simple interest.
To calculate your daily interest, your credit card company divides your APR by the number of days in a year (some use 360, other 365), then multiplies that percentage by your unpaid balance (though how that’s determined is a complicated process in itself).
This interest is then added to your unpaid balance, so the interest for the following day will be calculated on an even higher balance (this is what compounding means).
It’s not necessary to understand every detail of how credit card interest is calculated—just know that the longer a balance goes unpaid, the more interest accrues.
In addition, because of interest compounds daily, each additional day you carry a balance on your credit card account, the amount of interest you pay increases incrementally, which can quickly add up to a significant amount of money.
What are some best practices for monitoring my credit card account?
There are a few ways to stay on top of your credit card account.
- Always check your bill: It’s a good idea to scan through your purchases on each bill to make sure there are no fraudulent charges, and that any credits you’re owed (if you’ve returned an item, for example), have been made. Most credit cards come with advanced fraud monitoring, but there’s always a chance something can sneak through, and you should submit a fraud claim as soon as possible after the charge has been made.
- Make sure you’re not being charged interest unnecessarily: If you pay off your balance in full, make sure you aren’t being charged any interest (this will show up on your monthly statements).
- Double check your autopay accounts: If you’ve connected a bank account for autopay, double check that this payment has been made each month to avoid incurring unexpected charges.
- Monitor your credit score: In the last few years, it’s become increasingly easier to monitor your credit score. Many companies offer free credit score monitoring, and most credit card companies are even expanding this offering to their cardholders. This can help you keep tabs on drops or improvements in your score, as well as understand how various factors impact your score and how you can improve it. (Tip: as your credit score goes up, this may be the perfect time to check out other credit cards that may be better suited to your needs; the higher your credit score, the more options that are available to you, such as rewards cards with greater rewards value to you based on your spending habits)
What are the typical fees associated with credit cards?
Some of the most common credit card fees include the following:
- Annual fee: Annual fees tend to be for cards that offer rewards of some sort, but it’s always worth checking. Credit card companies are able to charge an annual fee for rewards cards because, in many cases, cardholders can more than make up for that fee in the rewards they redeem, so the net result is that the card doesn’t actually end up costing the cardholder. Make sure to calculate your expected rewards based on your spending habits to see if the benefits you are likely to receive from the card outweigh the annual fee.
- Balance transfer: If you’re looking to transfer a balance from an old credit card account to a new one, most cards will charge some sort of balance transfer fee—typically a percentage of the transfer (often around 3-5%) or a flat fee, whichever is greater. Some cards will waive the fee for an introductory period, so if you’re planning a balance transfer, read through the terms on each card you’re thinking of applying for
- Cash advance: Accessing cash with a credit card isn’t quite the same as it is with a debit card. While you can do it, credit cards will charge a cash advance fee (usually close to 5% of the amount withdrawn or a flat fee), so it’s usually better to withdraw cash with a debit card unless you’re in a pinch
- Foreign transaction: Most (but not all!) non-travel cards charge for foreign transactions—typically at a rate of around 3% of the transaction. But some travel cards also charge for foreign transactions, so be sure to read your terms before using any credit card abroad. If you are planning on traveling abroad it never hurts to call up the credit card company and ask if they will waive the foreign transaction fee. (Tip: Before traveling abroad, call up your credit card company and let them know where and when you are planning to travel. If you don’t, there is a chance that the purchases in a foreign country will be caught by the credit card company’s fraud filters, and for your protection, the company might put a hold on your credit card until they can confirm your card has not been stolen. To avoid this inconvenience, make the call before you go.)
- Late and returned payments: Most credit card companies will charge a fee for late or returned payments, and some will also levy a penalty APR (which is higher than the standard APR). Some cards waive late fees for your first infraction but make a habit of getting your payments in on time to avoid these fees.
What are the different types of credit cards?
- Rewards cards: These cards allow you to earn points, miles, cash back, and more on everyday purchases, then redeem them for cash back, travel, and other rewards options depending on the card. Make sure to consider the rewards rates for each card, the categories the card rewards, and compare that to your monthly spend to understand if it’s the right card for you (you can use our rewards calculator to do the math for you)
- Balance transfer cards: Some cards offer 0% APR for a specific period of time on balance transfers, which can be a great option if you have high-interest debt on a different card and could use some time to get your financial footing again without racking up tons of interest
- Low-interest cards: These are cards with a 0% APR offer on purchases or cards with low fees and no bells and whistles; They can be useful for those looking to finance a big purchase interest-free for a period of time or if you’re just looking for a simple low fee card
- Travel cards: Travel cards offered come in two flavors: general purpose cards, and specific airline and hotel cards. These cards reward travel, whether is higher rewards bonuses for travel spend, perks such as Global Entry or TSA Pre-Check, or no foreign transaction fees, if you’re a frequent traveler, these types of cards are something you should consider
- Cash Back cards: Straightforward rewards cards, you receive a percentage of what you spend as cash back to your account. The cash back you earn is usually based on certain categories such as gas and groceries
- Student cards: As the name suggest, these cards are made for students. These allow students to start building their credit while also providing some perks such as cash back or rewards points
- Secured cards: These cards require you to put down a deposit so your credit line is “secured” by the deposit you put down. The transactions on this card affect your credit history and the deposit is used as collateral in case you cannot make payments on your account.
How to find the best credit card
Now that you understand how credit cards work, you’re better prepared to apply for a new card that will allow you to build your credit, earn rewards, or take advantage or introductory offers. But with hundreds of credit cards on the market, choosing the right one can be a time-consuming task.
The Credible credit card comparison tool simplifies the task, pulling in data on tons of cards to personalize recommendations based on the type of card you’re looking for, your credit score, and the card attributes most important to you. Compare credit cards and find the right one for you.
Keep reading: How To Get A Credit Card For The First Time
