Knowing how credit cards work can save you headaches and cash. In a nutshell, credit cards provide access to a revolving line of credit that allows you to make purchases that can be paid off later.
Credit cards charge interest like other loans, typically expressed as an annual percentage rate or APR. Because of this, if balances on your card aren’t paid off each month, you’ll be stuck paying interest charges that can add up over time.
Therefore, using one of the rewards credit cards can act like a power tool; in capable hands, a card may offer flexibility and lucrative benefits, but when poorly managed, it can severely damage your finances.
Jump to these sections below to learn more about how credit cards work.
- How do credit cards work?
- APR
- What is a credit score?
- Credit card payments
- Credit card fees
- Types of credit cards
How do credit cards work?
Credit cards allow cardholders to make purchases that can then be paid off at a later date. How much you’re able to spend on your credit card depends on your "credit limit."
Typically, credit card companies determine your credit limit by taking into account your credit history, credit score and financial situation. A high credit score signals to card issuers that you’re responsible with your finances, pay your bills on time and manage debt wisely.
Many credit card customers never make enough purchases to reach their credit limit (called "maxing out" your credit card). However, if you reach your credit limit on a credit card, you’ll have to pay off part of your balance before making any additional purchases on the card.
A good rule of thumb to protect or increase your credit score is to charge no more than about 30% of the total amount available to you on each card. If you demonstrate consistent on-time payments, your credit limit can increase over time.
APR
When you purchase with a debit card, you’re using your own money, but when shopping with a credit card, the money is drawn from the credit card company. So if you "carry a balance" on a credit card from month to month, meaning you don't pay your bill in full, you will be charged interest. How much you’re charged depends on your card’s APR.
Credit card APRs (annual percentage rates) vary from card to card, typically expressed as a percentage range. Often, if you have a higher credit score, you can land an APR at the low end of the card’s range. Currently, the average credit card APR is 22.77% for new offers and 21.16% for existing accounts.
What is a credit score?
To be approved for most credit cards, your credit score must fall within a certain range. Many credit card issuers look at your FICO credit score, which ranges from 300 to 850.
For some of the best cards, your credit score must be in the good to excellent range, or from 670 to 850. A good credit score shows lenders that you have a history of managing credit wisely and are more likely to repay debt. Therefore, it’s important to know and understand your credit score before submitting a card application.
You can check your credit score and review your credit history by accessing your credit report. A credit report documents your loans, credit cards, mortgages and other accounts, as well as payment history.
It's important to regularly check to ensure there are no errors in your report. The three major credit bureaus — Equifax, Experian and TransUnion — offer a free credit report to consumers each week at AnnualCreditReport.com. To learn more, read our article on credit score vs credit report.
Credit card payments
Every month, you will receive a credit card statement showing the total amount you owe and the minimum payment due. While you will not be required to pay off your total bill every time, you will have to make at least the minimum payment by a specific date.
Minimum payments usually range from 1% to 3% of your total balance. But beware; cardholders can quickly get into an overwhelming cycle of credit card debt by only paying the minimum amount due.
In fact, credit card issuers are required to disclose how long it would take you to pay off your balance if you only paid the minimum amount due, usually stretching into years. Therefore, you should ideally pay the total amount due each month.
And since late payments can drastically decrease your credit score, it’s also important to have a consistent history of on-time payments to maintain good credit.
Tip: Pay your credit card bill by the closing date instead of the due date. This simple practice can increase your credit score.
Credit card fees
Credit cards also carry additional fees that vary from card to card.
Balance transfer fee: You may pay a balance transfer fee when transferring debt from one credit card to another, usually to get a better interest rate. These fees typically range from 3% to 5%. If you using this option, be sure you understand how balance transfer credit cards work.
Foreign transaction fee: A foreign transaction fee is charged when you make purchases with your credit card outside of the U.S. These fees can range anywhere from 1% to 5%, but there are many credit cards with no foreign transaction fee.
Annual fee: An annual fee is what you’ll pay each year to keep your credit card account, and the amount varies between cards. Some cards waive the annual fee in the first year, and many cards charge no annual fee. Read up on our best travel cards with no annual fee.
Late payment fee: Many cards will charge a late payment fee if you don't make a payment by the deadline on your credit card bill.
Types of credit cards
There are also several types of credit cards, with varying benefits and rewards.
Balance transfer cards: If you’re carrying debt on your current credit card and are looking to pay it off with a lower interest rate, you can transfer that debt to a balance transfer card. Many have 0% introductory APR periods that will help you cut down on debt without being stuck with hefty interest payments.
Student credit cards: Student credit cards are a form of “starter card” for college students with limited credit history. Since they’re designed as a way for young adults to start building credit, they don’t usually have as strict requirements for approval or carry annual fees. Many student cards also offer rewards in categories that appeal to students, like cash back on dining and entertainment.
Secured cards: Secured cards are great options for those with little to no credit history or a bad credit score. With a secured card, your credit limit is determined by the size of the cash deposit you make upfront.
Travel cards: Many credit cards are specifically designed for travelers, offering no foreign transaction fees and helping users rack up airline miles on purchases.
Rewards credit cards: Many credit cards offer cash back or reward points on purchases. Some cards have a flat-rate cash back rewards rate, while others offer higher points on purchases made in specific spending categories. If you are interested in rewards cards, we have picked the best cash back credit cards, as well as the best rewards credit cards overall.
Authorized user cards for kids or teens: Adding an authorized user to your credit card allows someone (usually a child or other family member) secondary access to your card, which helps them build a credit history. Authorized users can make purchases on a credit card. However, the primary cardholder still has the responsibility of making payments. These cards are great options for kids and teens.
Store cards: Some retailers offer co-branded credit cards. Depending on the card, these can be used only at the associated store, while others can be used anywhere. Store credit cards allow cardholders to access in-store discounts as well as earn points or cash back when shopping at specific stores.
Bottom line on how credit cards work
Credit cards can be a valuable addition to your wallet, just as long as you know how to use them. They can be a great tool to shop with, as many let you earn cash back or travel rewards and come with additional benefits like purchase protection.
Just make sure you’re only spending what you’re reasonably able to afford, or you’ll be stuck with expensive interest charges and run the risk of missing payments.
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