How Do Credit Cards Work? A Beginner’s Guide to Plastic

With a credit card, you get access to a revolving line of credit and can earn valuable cash back, points, or travel rewards. But with high APRs, credit cards can be expensive if you carry a balance.

Man using a credit card to pay at a cafe
Updated June 14, 2024
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Credit cards seem to be the payment option of choice for most Americans. According to the credit bureau Experian, 95% of adults have an open credit card account, and there was $756 billion in outstanding credit card debt as of 2020.

If you’ve never used plastic to make purchases before, you may be wondering, “how do credit cards work?” As a revolving line of credit, you can use your credit card again and again. But although they’re convenient, you should know that credit cards can have high annual percentage rates and added fees.

Here’s what you need to know about how credit cards work so you can use them to your best advantage.

In this article

What is a credit card?

Whether you’re shopping online or at a brick-and-mortar store, you usually have the option of paying with a credit card. Credit cards are cards that give you access to a revolving line of credit — essentially a loan you can use and pay off repeatedly.

Issued by both banks and credit unions, credit cards charge interest on your statement balances There may also be additional fees to get and use a card.

Credit cards are usually unsecured, which means they don’t require property as collateral, and they can be a convenient way for cardholders to pay for purchases and services.

Because credit cards are often unsecured, credit card companies may have strict requirements for applicants. When a credit card company reviews your application for a credit card, it considers your credit history, income, and other debt to determine whether to approve you and how much credit line to offer you.

How do credit cards work?

When you’re approved for a credit card, the issuer will send you a physical card. But you can also use your credit card’s number to make purchases online. Although it can be exciting to get your first credit card in the mail, there are some basics you should know before you start swiping your card:

Using your card

The credit card issuer will set a credit limit for you. You can use the credit card to buy items totaling up to that limit. Once you reach the card limit, you can’t make any more purchases until you make a payment to lower your credit card balance.

Paying interest

If you’re wondering how credit card interest works, pay attention to the card’s APR — the total cost of interest and fees. The APR is a standardized measure that can help you compare credit cards and their terms.

With most credit cards, you have a grace period. The grace period is the time between the end of your billing cycle and the date your minimum credit card payment is due. If you pay the balance of how much you charged during the billing cycle in full by the end of the grace period, you typically won’t have to pay any interest.

Making payments

Your minimum payment is different from your statement balance. The minimum payment is the minimum amount you have to pay each month to keep your account in good standing. The amount of money this is will depend on how much you charged during the billing cycle.

Terms vary by credit card issuer, but your minimum payment is generally 2% to 4% of your account balance. For example, if you have a $500 statement balance, your minimum payment due on your next credit card bill would be between $10 and $20.

If you pay only the minimum, it can take months or even years to get out of debt, and you could pay much more in interest charges than you initially charged.

For example, say you had a $3,000 balance, an APR of 14.4%, and a 3% minimum payment. If you paid the minimum, it would take you 11 years to pay off the balance. Worse, you’d pay $4,745 in total. That means interest would add more than $1,700 to your original spending.

Making a little bit more than the minimum monthly payment could save you hundreds of dollars:

Starting balance (14.4% APR) If you make no additional charges and pay this amount each month: Duration before the balance is paid in full Total cost
$3,000 $90 — the 3% minimum payment 11 years $4,745
$3,000 $103 3 years $3,712
Total Savings: $1,033

Credit reporting

As you use your credit card, the issuer will report your activity to the major credit bureaus: Equifax, Experian, and TransUnion. Your payment history accounts for 35% of your FICO credit score. To improve your credit, make sure you always pay at least the minimum by every due date. Otherwise, missed or late payments could damage your credit.

The difference between credit cards vs. debit cards

With a credit card, you can repeatedly borrow money by agreeing to repay it — potentially with interest — in the future. The convenience of a credit card is offset by APRs.

By contrast, debit cards are tied to the money you have in your savings or checking account. You typically cannot use a debit card on purchases that exceed your bank account balance.

With prepaid debit cards, you buy a card that is loaded with the amount of cash you provide. You can use the card to purchase items up to the total of the cash you put on the card, and the card is not linked to a bank account.

Debit cards may have some fees, but they don’t charge any APR.

Types of credit cards

There are so many types of credit cards, it can be overwhelming. To help you navigate through the available options, here are some of the most common types:

  • Cashback credit cards: With a cashback credit card, you can earn cash on select purchases. For example, some cards offer 1% cash back on all grocery store purchases. If you spent $1,000 on groceries, you could earn $10 in cashback rewards. Cashback rewards are usually issued as statement credits, but some companies also offer bank deposits or physical checks.
  • Travel rewards credit cards: If you love to travel, it could make sense to get a travel rewards card. When you use your card, you can earn valuable points or miles that can be redeemed for flights, hotel stays, car rentals, and excursions. If you have one of the best travel credit cards, you may also qualify for exclusive discounts and travel perks.
  • Balance transfer credit cards: Balance transfer credit cards allow you to transfer your debt from one credit card to another. They usually offer low promotional APRs that last for several months. Once the promotional period ends, the regular purchase APR applies to any remaining balance. With a balance transfer card, you can pay down debt without paying interest charges as long as you pay it off by the end of the promo period.
  • Student credit cards: Student credit cards are specifically designed for college students. They have less stringent requirements than other credit cards, so you might qualify even if you have a limited credit history. By using a student credit card responsibly, you can establish good habits and build your credit.
  • Secured credit cards: Best for people with poor credit or no credit, a secured credit card requires a refundable security deposit. The deposit usually acts as your credit line. As you make payments on your secured credit account, you can establish a credit history.

6 top reasons to use a credit card

If you’re new to credit cards and are worried about interest charges and added fees, you may think always using a debit card is a better choice. But there are six excellent reasons to use a credit card instead:

1. You can build credit

Debit card activity isn’t reported to the credit bureaus, so you may have trouble establishing your credit if you only use your debit card for purchases.

Getting a credit card could help your credit in several ways:

  • They could improve your credit mix. Creditors and lenders like to see you can handle different forms of credit responsibly, such as having both installment loans and credit cards. Your credit mix accounts for 10% of your FICO credit score.
  • They could improve your credit utilization. If you use only a small portion of your available credit line, you can improve your credit score. Your credit utilization — the amount of available credit you use — makes up 30% of your score and lenders like to see it on the lower side.
  • Credit cards can start your payment history. If you don’t have a credit history yet, using a credit card and making your minimum payments on time will begin a positive payment history — the single biggest factor that determines your credit score.

2. You may need a credit card to book travel

When you travel, you may find that debit cards are an inconvenient payment option. Many rental car companies require customers to use credit cards. If they do allow debit cards, they may place a hold on your account, holding up hundreds of dollars.

Similarly, many hotels don’t accept debit cards, or they may require an additional deposit to cover incidental charges. Having a credit card avoids last-minute payment issues and costly account holds.

3. You can earn rewards on everyday spending

Many credit cards allow you to earn rewards on your routine spending, such as groceries, online purchases, or gas for your car. For example, the Citi Double Cash® Card allows you to earn 2% on every purchase with unlimited 1% cash back when you buy, plus an additional 1% as you pay for those purchases; plus, for a limited time, earn 5% total cash back on hotel, car rentals and attractions booked on the Citi Travel℠ portal through 12/31/24.

If you always pay your statement balance in full by the payment due date, you can earn rewards without paying interest charges.

4. Credit cards give you access to a credit line in case of an emergency

Most people don’t have a large emergency fund. If you have a sudden unexpected expense — such as repairing or replacing your car’s brakes or traveling to visit a sick family member — you could be left scrambling to cover the cost.

If you have a credit card, you don’t have to pay for those expenses upfront in cash. You could instead use your credit limit to cover the cost and repay it over time.

5. Credit cards often have added benefits

As you build your credit, you might qualify for cards that offer added shopping or travel benefits, such as extended warranty protection or travel insurance.

For example, the Chase Sapphire Preferred® Card includes benefits that can give you peace of mind when you travel. If you use your card to book your fare, you will get trip cancellation or interruption insurance, auto rental collision damage waiver, baggage delay insurance, trip delay reimbursement, and travel and emergency assistance services.

6. Credit cards are more secure

Unfortunately, theft and fraud are common. If you have a debit or credit card, you risk someone using your information to make purchases with your account.

However, your losses are limited if you use a credit card. With a credit card, the maximum you can be liable for by law is $50. And if you report that your card has been lost or stolen before it’s used, you’re not responsible for any unauthorized charges.

With a debit card, you could be on the hook for a lot more money. If you don’t report the loss or theft of your debit card within two business days, your liability is capped at $500. If you don’t report it until after 60 days after your account statement is sent to you, you’re responsible for all of the money withdrawn from your account.

The costs of having a credit card

When you use a credit card, you’re essentially just borrowing money. And borrowing money typically involves paying fees. Fees can vary widely from card to card, so make sure you review the credit card fee disclosures. You can find the card’s fees and interest rates in its Schumer Box — a table that appears in credit card agreements.

Look for the following fees when comparing credit cards:

  • Annual fee: Some cards charge annual fees. Typically found with high-end credit cards with robust benefits, annual fees can cost hundreds of dollars.
  • APR and interest rate: The APR is the total you’ll pay in interest and fees. In the Schumer box, you’ll see multiple APRs listed. The purchase APR applies to items and services you purchase. The balance transfer APR is applied to balances you move from one credit card to another. And the cash advance APR applies when you use your credit card to get cash from an ATM.
  • Late payment fees: If you miss a due date, the credit card issuer will usually charge you a late fee. The fee can be a flat fee or a percentage of the late payment amount.
  • Balance transfer fees: When you transfer your balance onto another card, the new card issuer will typically charge you a fee equal to a percentage of the balance.
  • Foreign transaction fees: If you use your card outside of the U.S., either while traveling or when you purchase from a foreign retailer, you might have to pay foreign transaction fees that are typically a percentage of the transaction amount.
  • Cash advance fees: When you take out a cash advance, you have to pay the cash advance APR. But you also will likely have to pay a cash advance fee, a one-time fee that is a percentage of the cash advance amount.

You can avoid many of these fees by using your credit card responsibly. Only charge what you can afford to pay off in full each month, and avoid cash advances if you can.

FAQs

Is there a monthly fee for credit cards?

Depending on the credit card, there may be monthly fees. The cards that charge monthly fees are usually designed for borrowers with poor credit or no credit. The fee is in place to offset some of the credit card issuer’s risk.

What are the disadvantages of credit cards?

Credit cards give you access to a revolving line of credit. That sounds great, but it has some significant drawbacks. If you have a large credit line, you could be tempted to spend more than you can afford and quickly rack up credit card debt. Credit cards also tend to have interest rates. As of May 2021 — the most recent available data — the average interest rate on all credit cards that assess interest was 16.30%. With such a high rate, it can be difficult to get out of debt.

How much money do I need to open a credit card?

Whether you need money to open a credit card depends on the credit card type. With most unsecured credit cards, you don’t have to have any money to open an account. The issuer grants you a credit limit solely based on your creditworthiness. Secured cards work differently because they require a cash security deposit. Depending on the card issuer, security deposits can range from $49 to $3,000.


Bottom line

If you’ve never had a credit card before, it can feel intimidating. There are a lot of terms to learn about and fees to keep in mind. However, credit cards can be excellent tools when they’re used responsibly. They could help you build your credit, earn rewards, and pay for emergency expenses.

To avoid falling into debt or incurring costly interest charges, always aim to pay off your statement balance and review your credit card agreement before using your card. If you’re not sure what all the information in the agreement means, the Consumer Financial Protection Bureau has published a sample credit card agreement with definitions and explanations you can use to better understand your card’s terms.

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Author Details

Kat Tretina

Kat Tretina is a personal finance expert focusing on practical financial matters, including student loans, debt repayment, side hustles, insurance, and healthcare. Drawing from her personal experience, she aims to simplify complex financial topics and provide individuals with the information they need to make informed decisions.