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How Do Credit Cards Work? Understanding the Basics of Credit Cards

  • A credit card is essentially a small loan from a bank whereby you borrow money to pay for purchases, repay it, and then continue this process repeatedly.
  • Credit cards are different from debit cards as they are tied to a line of credit from a lender instead of physical funds in your bank account.
  • Credit cards are tied to your personal information and track your spending and payments to create a personal credit history and credit score that lets banks and other lenders gauge how trustworthy you are as a borrower.
  • If you pay your debts on time and in full, you will benefit from a good credit history that will give you access to better loans, mortgages, and other financial products in the future.

Discover the basics of how credit cards work and get an understanding of common terms and language surrounding credit cards. We’ll show you the different types of cards available, how to use a credit card wisely, and what fees to look our for when spending in this comprehensive guide on how credit cards work. First, here is a quick overview.

Credit cards let consumers make purchases or pay bills.

When you use a credit card, however, you’re borrowing against a line of credit that was assigned to you when you were approved. You can use your credit card up to the credit limit if you prefer, but there’s no obligation to use a credit card at all.

While credit cards and debit cards look very similar, there are some huge differences in terms of how they work, their protection against fraud, and their perks and features.

If you’re curious whether you should get a credit card, arming yourself with information is the first thing you should do. Read on to learn how credit cards work in practice, which credit card fees you may have to pay, and how to use a credit card to your advantage.

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Credit card basics

A credit card is a type of cashless payment method that uses borrowed money to pay for goods and services. A key factor of credit cards is that they pay for your purchases now and let you pay them off at a later date. When you use a credit card, a bank lends you the money and pays the store for you. Then, you are expected to pay the bank back for what you owe.

Credit cards have a limit to how much you can spend before you need to begin paying back what you owe. If you spend more than you are able to afford and don’t pay back what you spent by the end of the month, the bank will charge you more on top of what you already owe. This is known as interest.

Credit cards can be risky if you spend more than you can afford to pay back. Many people find themselves in credit card debt as the interest rates for credit cards are quite high. Therefore, the key to using a credit card is to not spend more than you can afford and to pay back what you owe on time and in full each month.

In a lot of ways, a credit card can serve as a flexible, short-term loan. Just keep in mind that, like personal loans, auto loans, and other types of debt, you’re responsible for repaying every cent you borrow plus transaction fees and interest charges.

How do credit cards work?

When you apply for a credit card, credit card companies consider your credit score, your credit history, your income, your debt-to-income ratio, and other factors before they approve you. If they deem you creditworthy, you’ll be issued a credit card with a set credit limit you can borrow against.

You can use a credit card to pay for purchases and bills in-person or online until you spend up to your credit limit. In some cases, credit cards can also be used to withdraw cash from an ATM, although cash advance fees will apply.

Your credit limit depends on factors like your current income and credit history and can range from $300 to $20,000 or more. This figure represents the limit you can spend on purchases and bills using your credit card. As you make purchases on your card, the amount of available credit you have will decrease until you pay it back.

Over time, your card issuer may offer you an increase to your credit limit if you remain in good standing.

How credit card transactions work

When you use a credit card to pay for a purchase, your credit card details are sent to the merchant’s bank for authorization. The bank seeks out authorization from the credit card network, which allows them to process the transaction and approve your card for the charges.

If the transaction is approved by all the interested parties, your credit card issuer will pay the merchant electronically on your behalf.

How credit card bills work

Your credit card also has billing cycles, which are usually around 30 days long. You’ll get a credit card bill at the end of each billing cycle that lists all the purchases you made. From there, you’ll have a period of time known as a grace period to make a payment on your credit card.

You can choose to make a minimum payment on your credit card, which is usually anywhere from 2% to 4% of your balance. If you choose to make the minimum payment or any payment that’s less than the full amount you owe, you’ll begin accruing interest charges based on your credit card’s APR and your revolving balance.

On the flip side, you can also pay your credit card balance in full by the due date. In this case, you won’t owe any interest charges since you’re not carrying a revolving balance from one month to the next.

Flow chart showing the process of using a credit card Flow chart showing the process of using a credit card

How do credit card payments work?

If you use your credit card to make purchases, the bank will pay the merchant for you and send you the bill at the end of the month. Each month you will receive your credit card bill that includes an outstanding balance showing how much you owe, the minimum required payment amount and the payment due date.

Most companies offer the options to pay online, over the phone, or to set up automatic payments.

You aren’t required to pay the full outstanding balance each month. However, paying in full each month is the best practice to follow with a credit card to ensure you maintain a good credit score.

If you don’t pay off your balance each month, you will begin to rack up extra debt from interest charges on the outstanding balance which is how people get into trouble with credit cards.

If you can’t pay your balance in full, then you should aim to make at least the minimum payment required, as this will help reduce any negative impact on your credit score. It’s also important to make sure you pay by the due date to avoid any late fees.

Learning how to use a credit card can be difficult to master, but with good payment practices you’ll soon begin to see good fruit.

Here are three examples of how credit card payments work in different payment scenarios:

1

Paying in full (on time)

The best option is to pay your balance in full by the due date. This is what your credit card company expects from a good borrower, and it will help you avoid interest, and late fees, and will help keep your credit score strong.

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2

Making the minimum payment

This is the best option if you cannot make the full monthly payment. If you meet the monthly minimum, the credit card provider will report that you met the payment requirements that month and will not ding your credit score for missing a payment. Keep in mind that if you only pay the minimum, you will be charged interest on what you owe. That means you will have to pay more the longer you leave the balance unpaid. This can leave you with long-term debt, so be careful.

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3

Paying late

Any time you can make a payment is a better alternative to not paying your credit card bill. That said, late payments mean you will incur interest and late fees which will leave you in greater debt. It’s better to pay in full or pay the minimum balance required. If you make a late payment by mistake, you can contact your bank and explain the situation to avoid having your credit score impacted.

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Credit cards vs. debit cards

Credit cards and debit cards can look very similar. However, these two financial products are very different.

The main differences between credit cards and debit cards come down to:

  1. Borrowing money vs. spending your own money
  2. Reporting spending & building credit history
  3. Fraud protection and liability
  4. Rewards for spending

When you make purchases with a credit card, you’re borrowing money with the promise to pay it back at a later date, including interest and fees. On the other hand, when you pay for something with a debit card, you’re paying for the purchase with cash savings directly from your bank account.

On another note, credit cards report your credit balances and payments to the credit bureaus — Experian, Equifax, and TransUnion. As a result, they help you build credit which means using a credit card can help you improve your credit score.

By contrast, debit cards don’t report your purchases to the credit bureaus since you’re spending your own money. This means purchases on a debit card won’t help you build credit.

It’s also worth noting how different credit cards and debit cards work in terms of liability.

If a fraudster gets their hands on your credit card or your card number, you can only be liable for up to $50 in financial losses per details in The Fair Credit Billing Act (FCBA). On top of that, most credit cards promise their customers 0% liability protection.

With a debit card, on the other hand, you won’t have similar protections. In fact, if you don’t report a fraudulent debit card charge within 60 days after receiving your credit card statement in the mail, the Federal Trade Commission (FTC) says you could lose “all the money taken from your ATM/debit card account, and possibly more; for example, money in accounts linked to your debit account.”

Finally, credit cards offer the potential to earn rewards in the form of cash back, statement credits, gift cards, or travel points. Co-branded credit cards from hotels and airlines also make it possible to earn airline miles or hotel loyalty points. Similarly, it’s possible to do things like rent a car with a debit card but debit cards don’t come with any car rental protection, whereas many credit cards do.

With a debit card, you’re unlikely to earn any type of reward at all.

Credit cards vs. debit cards at a glance

? Credit Cards Debit Cards
Where the money for purchases comes from A line of credit you borrow against Your own bank account
Builds credit Yes No
Ability to rack up credit card debt Yes No
Potential to earn rewards on spending Yes Unlikely

Common credit card fees explained

Credit card fees are different from interest. Interest happens when you don’t pay off your monthly balance, but credit card fees will be charged based on the type of transactions you make. In that sense, it’s possible to incur both fees and interest with a credit card.

Learning how to use a credit card without getting charged extra fees is key to helping save you money in the long run.

Here are some common credit card fees to watch out for:

Common types of credit cards

There are many types of credit cards on the market today, each of which comes with its own selection of pros and cons.

Common card types include the following:

Benefits of using a credit card

Using a credit card can be beneficial in more than one way, but it all depends on?how?you use credit on a daily basis.

Some of the main benefits of using a credit card include:

  1. Building credit history
  2. Earning rewards for spending
  3. Convenient cashless payments
  4. Increased buying power (borrowed funds)
  5. Fraud protection on purchases
  6. Emergency funds

The number one benefit of having a credit card is building a positive credit history which will allow you to get approved for loans and other important financial products in the future. By using your card for purchases and paying it off early or on time each month, you can prove your creditworthiness and boost your credit score over time.

Credit cards typically come with rewards such as points or cash back. If you use a credit card to earn rewards or take advantage of cardholder perks or consumer protections, keep in mind that the high interest rates credit cards charge can wipe out any benefits in a hurry. Therefore, we only suggest using credit cards for purchases you can afford to pay off and striving to only carry a balance if you have to.

Credit cards can also become valuable in an emergency. If you lose your job, face surprise car repairs, or run into any other financial emergency, having a line of credit in place can help you get back on your feet faster than you might be able to otherwise.

How to build credit with a credit card

If you decide you do want your own credit card, you should use it to build credit you’ll definitely need later in life.

Important steps you should take to build a good credit score include the following:

Credit card basic terms glossary

While we already explained how credit cards work in general terms, knowing all the basic credit-related terms can help you understand more about this financial product.

Below you can find an explanation of the most common credit card terms you should know about:

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About the Author

Holly D. Johnson
Holly D. Johnson Finance Expert

Holly D. Johnson is an award-winning personal finance writer who covers topics like insurance, investing, credit and family finance. As a leading voice in the travel and loyalty space, Johnson has traveled with her family to more than 50 countries over the last decade.

The author has also written extensively on the power of household budgeting, and she even co-authored a book on the topic. Zero Down Your Debt: Reclaim Your Income and Build a Life You’ll Love was originally published in 2017, and it teaches families how to use zero-sum budgeting to reach their financial goals. She is also the co-owner and founder of the family finance and travel website, ClubThrifty.com.

Johnson’s 10+ years of writing have focused on helping families make important financial decisions at each stage of their lives. The author also applies the financial principles she teaches to her own life, and she is currently on track to retire in her late 40’s with her partner. She currently lives in Central Indiana with her husband and children, and she is a regular contributor for Bankrate, CNN, Forbes, U.S. News and World Report Travel and many other notable publications.

* Opinions expressed here are those of the LA Times Compare Cards Team and have not been reviewed or approved by any advertiser or entities included within this content. See our editorial policy for more details.

All products or services are presented in this content without warranty. The information, including card details such as rates and fees, is accurate at the time of publish. Please visit each bank's website directly for the most current information.

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