How Credit Cards Work: The Ultimate Beginner’s Guide

Learn everything you need to know before you get your first credit card.
9 minute read | 9/12/19Sept. 12, 2019
Man using a credit card to pay at a cafe

Ready to start building some credit? Getting a credit card is a great first step toward beginning your lifelong credit journey. But navigating the ins and outs of what having a credit card means for you and how it can boost or bring down your credit history can be confusing.

This guide will help you understand how credit cards work and what you can expect once you get one.

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What is a credit card?

A credit card is basically a high-interest loan that you can access when you need money to pay for something. You get a physical plastic or metal card to take with you and use when making purchases at stores, restaurants, and more. You also get an account number you can use to make purchases online or over the phone.

Using a credit card allows you to repeatedly borrow money with a promise to pay it back. If you don’t repay the full amount by the due date, the bank that issues your card will charge you interest on the amount you borrow.

How do credit cards work?

When you get a credit card, you’re given a limit to how much you can spend. This amount is determined by the bank that issues the card and is based on your creditworthiness. The exact criteria a credit card issuer uses to determine your eligibility and how much you can borrow varies from bank to bank.

To use a credit card, you present your card or account information to a business as a form of payment. It then runs your information, and your card issuer tells the business if you have enough funds to pay for the purchase. If you do, your transaction will be approved, and you’ll likely be asked to sign your name on a receipt or computer to confirm that you agree to the amount being deducted from your credit limit.

During this transaction, the credit card company pays the business the amount you charge to your card, and you agree to pay the bank the amount of that purchase, plus interest charges if you don’t pay the money back in full by the due date.

How much you can spend on your credit card?

You’ll be able to use a credit card to make purchases until you reach your credit limit. However, just because you can spend up to your credit limit doesn’t mean you should.

Credit bureaus keep tabs on how much of your credit you use, a factor known as your credit utilization ratio. When you spend a lot of your available credit, your score can be negatively impacted. When you spend less, your score can get a boost.

It’s often wise to spend significantly less than your limit to have a positive effect on your credit score; ideally, your credit utilization should be 30% or less.

For example, if you have a $1,000 limit on your credit card, you want to make sure that your credit card balance stays below $300, which is 30% of your total credit available.

You also want to keep in mind how much you can afford to pay each month toward a credit card. You’ll have a minimum payment each month, and if you have a large balance and high interest rate, that monthly payment may be more than comfortably fits in your budget. To avoid this, you can choose to spend less on your credit card than you can reasonably manage to pay.

When is credit card interest charged?

Interest is the fee that a credit card issuer charges you for borrowing money. The amount you’re charged is called the annual percentage rate, or APR. The smaller a card’s APR is, the less you’ll be charged for the balance you have on your credit card.

A credit card may have either a fixed or variable APR. A fixed APR means you’ll be charged the same interest rate every billing cycle of the year. A variable APR is often based on something called the prime rate — a benchmark that changes frequently. That means a credit card with a variable APR can charge a different interest rate from day to day or month to month.

Compounding interest complicates things

How much you pay in interest depends not only on the APR, but also when your card’s interest is compounded. Compounding refers to how often the interest you accrued during a given time period is added to your current balance. When interest compounds, it’s added to your balance and starts accruing interest of its own.

Essentially, you pay interest on interest. The more often interest is compounded, the faster your balance grows and the more interest you actually pay.

For example, say you have a $100 balance on your card and a 12% APR that compounds monthly. You’ll be charged 1% interest on your balance each month; after interest is added in the first month, your balance grows to $101. If you don’t pay any of this amount, next month you’ll be asked to pay interest on $101, and so on.

Though charging interest monthly might make the math easier, many credit cards compound interest based on a daily periodic interest rate. This means your APR is divided by either 360 or 365 (the number of days in the year), and that percentage is applied to your balance at the end of every day. This causes your balance to increase daily from interest alone. All of these charges accrue throughout the billing cycle and are added to your balance.

When you don’t have to pay interest

Your monthly statement will show you how much interest you were charged for the month and the minimum payment you need to make.

However, it’s important to understand that credit card companies give you a grace period every month to pay your balance. Throughout this stretch of time, you won’t be charged interest. Grace periods are usually between 21 and 25 days after the first day of your billing cycle, during which you can pay all or some of your balance without being charged interest.

For example, the Chase Freedom Card sets your payment due date at 21 days after the end of each billing cycle. Pay your balance by that date and you won’t be charged interest on the new purchases you made that month. If you can only pay some of the balance, interest will be charged on the amount that’s left. Different rules apply to balance transfers and cash advances.

All of this information is available in the terms and conditions of your credit card.

How do I pay off my credit card?

The most inexpensive way to use a credit card is to pay off the balance every month, since this means you won’t be charged interest fees. However, this isn’t realistic for many people, and making payments and carrying balances for months or years is all too common.

When you get your monthly bill, you’ll have a minimum payment made up mostly of interest charges. What’s not applied to the interest is paid toward the actual balance — that is, the amount you spent on your credit card. Paying the minimum amount required will keep your account current with the credit card issuer, but this makes paying down a balance very difficult.

Making more than the minimum payment ensures a greater amount of money will go toward reducing your balance. You can also make multiple payments in a month to pay down charges you’ve made before interest has a chance to accrue or keep chipping away at your balance to minimize the next month’s interest.

How much do credit cards cost?

Some credit cards are free to get, and others charge an annual fee you have to pay each year to own the card. All credit cards have fees that you agree to pay in return for being able to use the card in certain ways. Here’s a look at some of the most common costs associated with having a credit card.

Annual fees

Some credit cards charge an annual fee for being able to use them. These cards usually have some kind of rewards program or offer an extensive amount of other benefits, such as travel credits or purchase protection. An annual fee is often around $100 per year, but it can be as low as $40 or as high as $500 (or more) for a premium card.

Interest

As discussed above, interest is a percentage of the amount of money you borrow using a credit card, which you agree to pay to the bank as a fee for using the card. It’s important to understand:

  • How a credit card charges you interest
  • The type and amount of the APR
  • If any penalties are applied that might change your APR
  • If different APRs apply to specific types of transactions, such as balance transfers or cash advances

This information can be found in the terms and conditions of your credit card agreement.

Late payment fees

If you’re late making a payment or pay less than the minimum owed, a credit card issuer may charge you a fee. Late fees vary from company to company, but banks can charge you up to $28 the first time you pay late. If you’re late with a payment within the next six billing cycles, you could be charged up to $39.

Over-limit fees

Sometimes a purchase you make on your card will push your balance above your credit limit. You may be assessed a fee if this happens and you’ve opted into allowing your credit issuer to approve charges that go above the limit. If you haven’t given permission for this to happen, a transaction that goes above your credit limit should be declined.

What types of credit cards are there?

One of the great things about credit cards is that there are lots of choices out there, and you can shop around for one that will benefit you most. Here’s a look at some of the most common types of credit cards available.

Student

Designed for college students who are new to having and using credit, these cards can help you establish a credit history and learn how to be a responsible spender. Student credit cards usually have low credit limits and no annual fees, making them one of the most basic types of credit cards you can get.

Secured

Secured credit cards are ideal for people who have poor credit or no credit at all. Banks view these cards as a low risk because they require you to make a down payment, which then becomes your credit limit. They work similarly to debit cards in that you’re really spending your own money, but your card use is reported to the credit bureaus. This could help you build credit if you use the card wisely — unlike debit cards, which don’t impact your credit score.

You can pay with a secured credit card wherever credit cards are accepted. Responsibly using the card in this way could help you repair or build your credit over time.

0% introductory APR

These cards offer new customers a period of time where no interest is charged. This can apply to new purchases or balance transfers from other cards — or both, depending on the offer.

How long you’re eligible for this rate can be anywhere between 12 and 24 months, which gives you a lot of opportunities to pay down your balance without having more money added in interest every month.

Cash back

Cashback credit cards actually pay you money! For every qualified purchase, you get a percentage of the amount spent credited to your account. That percentage can vary by purchase type (e.g., 2% on groceries, 3% on gas), certain locations (e.g., earn extra cash back by shopping at specific stores or websites), and timeframes (e.g., more cash back during an introductory period).

Travel rewards

General travel rewards cards allow you to earn points or miles based on how much you spend on qualified purchases. They’re a great option for people who frequently travel. Points can often be traded in for airfares, upgrades, hotels, car rentals, and other travel expenses.

Many offer expanded protection for car rentals, lost baggage, cancellations due to weather or sickness, roadside assistance, and other useful perks. You can also find cards that give you annual allowances that reimburse you for travel fees.

In all, having a credit card can be a good thing for your financial future. It’s important to understand how they work, what your responsibilities are as a cardholder, and what terms and conditions you’re agreeing to when you accept the card. Once you do, you’ll have a firm foundation for building a credit history that will give you more choices and opportunities in the future.

Ready to get started? Check out our top picks for your first credit card.

Eye-popping Cash Back

Chase Freedom Card

Chase Freedom Card

Chase Freedom Card

Benefits

  • $150 cash back welcome bonus
  • 5% rotating cash back in bonus categories
  • Cash back rewards never expire
  • No annual fee
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