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How do credit cards work?: A simple guide
Credit cards are a quick and convenient way to pay for the things you want and need for a person on the go. There are a plethora of benefits to using credit cards, but there are also some risks if you don't now how credit cards work. Before you decide whether or not to start using a credit card, it's wise to gain the knowledge necessary to help you avoid costly mistakes.
The good news is that credit cards don't have to be complicated, and avoiding mistakes doesn't either. Here's what you'll need to know as a first-time credit card user.
What is a credit card?
A credit card is a type of revolving credit issued by a credit card company, a financial institution. When you make a purchase using the card, the financial institution loans you the money for the purchase with the agreement that you will pay the amount back in full by a certain date -- or they will charge you interest fees on the balance.
The card is a physical card, usually plastic or metal, with a unique credit card number and a three-digit card verification value (CVV) number for added security.
How do credit cards work?
When you apply for a credit card, the financial institution asks for various information related to your income and debts and then pulls your credit report to determine how much credit they are willing to extend to you. For example, the company may decide that your maximum available credit is $10,000. The company may also have a daily limit and a transaction limit.
The card issuer will also determine your annual percentage rate (APR), which is the rate they charge you on any outstanding balance after the payment due date, after the introductory period, if one is offered. These rates are usually high and range from 14.99% to over 21.99%. This is your cost of borrowing the money. Unless you pay the balance in full before the end of each billing cycle, you can avoid paying any interest fees.
Each time you make a purchase using the credit card, the purchase amount is deducted from your available credit until you pay it back. The card is tied to a billing cycle, and at the end of each cycle, the credit card company issues a statement itemizing the transactions you've made during that cycle, your total balance, minimum payment due, and due date.
Does a credit card work differently than a credit card?
There are two similarities between credit and debit cards. First, they are both tied to a financial institution. And second, they are both usually physical cards. Otherwise, debit and credit cards are entirely different.
Also: What is a debit card?
Debit cards are connected to an active bank account, usually a checking account. Using a debit card is much like writing a check, except the debit card will immediately be declined if there are not adequate funds for the purchase.
For example, if you have a traditional debit card tied to a checking account with a $500 balance, and you use your debit card to make a $600 purchase, the card will be declined. If you've chosen overdraft protection from your bank, the transaction may be approved depending on the bank's amount of protection.
Debit cards do not permit you to incur debts and do not impact your credit score.
Do I need a credit card?
Credit card usage is an excellent way to build credit and gain rewards if used responsibly. Building or improving your credit is important for many financial decisions in the future, like car loans, rental approvals, business endeavors, and even insurance rates.
But using a credit card doesn't come without risks. The good news is that you can offset those risks or avoid them entirely.
Also: The 5 best credit cards you can (and should) keep forever
The risks of using credit cards (and how can you avoid them)
One of the biggest risks of credit card usage is incurring too much debt. Using a credit card is easy, and since it doesn't require you to have the funds readily available, it is sometimes tempting to buy things you don't have the money to pay for. One simple way to avoid this is to establish the habit of paying the credit card balance every week or even every few days. Make a purchase? Pay it off as soon as it posts to the credit card account. Before you make the purchase, ask yourself, "Do I have the funds, right now, to pay this off?" Only make the purchase if the answer is "yes."
Another significant risk is late payments. If you charge more on the card than you can afford to pay or simply forget to make a payment, it can have a major negative impact on your credit score and also result in late fees and loss of your introductory APR. Payment history makes up 35% of your FICO score, which means that it has a big impact on your overall score. Eliminate this risk by making regular payments on the card, whether doing so each week, setting up reminders for payments, or enrolling in automatic payments.
Annual fees are another thing to consider with credit cards. Depending on the card you sign up for, there could be an annual fee which will be automatically paid each year on your card. These are usually associated with rewards cards. Review all details of a card before you apply for it to avoid surprise fees you're not prepared to pay.
How to shop for a credit card
Start by writing down your goals for using a credit card. If you're looking for a card to help improve a poor credit score, consider researching secured credit cards to get started. If you're interested in using a credit card to gain rewards, consider the type of rewards you're seeking. For example, are you looking for cash back, travel/miles, points, or a combination of different rewards? Or maybe you're starting a new venture and are looking for the best high-limit credit cards.
Also: 10 things to know before getting your first credit card
Once you've determined specifically what your goals are for using a card, start looking for cards that meet those goals. But in the meantime, also consider details like:
- APR
- Fees
- Rewards program
- Perks (rental car discounts, hotel discounts, introductory bonuses, etc.)
- Mobile app option
- Company reputation
Does a credit card help build good credit history?
This depends on your usage of the card, your current debt levels, how many other credit cards you have, and more. If your debts are not too high and you do not already have a large number of cards and available credit, a good credit card you pay off regularly to avoid paying interest can be a great way to improve your credit score.
Are credit cards safer than debit cards or other ways of spending?
Credit cards offer great fraud protection. Major credit card companies have built-in measures to identify and alert any fraudulent behaviors. But if something does slip through, your maximum liability is $50 as stated by federal law 12 C.F.R. § 1026.12. Unlike a debit card, the money spent comes from the card issuer, not from you.
How do credit cards work for people with bad credit?
If your credit is in the poor category due to lack of credit or poor credit history, your credit card options may be limited -- but there are still options available to you. Look for secured options, and, depending on your situation, there may also be unsecured options for beginner credit cards.