How Do Credit Cards Work?

You probably know what a credit card is — at least, you’re familiar with the physical form, which is a rectangular piece of plastic or metal with numbers on it. This card can be swiped, inserted or tapped at payment terminals in exchange for goods or services, or you can enter the numbers to make a payment when shopping online. But how do credit cards work behind the scenes? In short, you’re borrowing money from a financial institution.

We’ll walk you through how credit cards work, such as when you may be charged interest and how to avoid it, and will compare credit cards to seemingly similar payment methods such as debit cards and prepaid cards.

When you pay for goods or services with a credit card, you’re borrowing money from a bank or credit union. You have a credit limit, which controls how much you can borrow at any given time, and you’ll have to pay back what you borrow. If you pay it back within the same billing cycle, you can typically avoid interest charges thanks to a grace period. But if you just make the minimum payment and carry a balance over to the next billing cycle, you’ll incur interest charges. Note that your available credit is your credit limit minus any charges or holds on the card.

Be aware your issuer can deny any transaction. You’ll be denied if you’re trying to submit a purchase that exceeds your available credit, for example, and you may be denied if your issuer determines a transaction is outside your typical spending habits and might be fraudulent — such as if your card is suddenly used in a foreign country.

So, what are the benefits of paying with a credit card? There are several:

• Protecting your money. If there’s an unauthorized charge on your account, or you’re charged an incorrect amount, a credit card provides a layer of protection by not pulling money immediately from your bank account.
• Safeguarding against fraud. It’s typical for credit cards issued in the United States to offer zero fraud liability, meaning you generally won’t be responsible for paying fraudulent charges on your account.
• Getting refunds. In cases where you didn’t get a good or service, or the service wasn’t of the quality promised, paying with a credit card boosts your odds of getting a refund. You’ll need to try to work with the merchant first to resolve the situation. But should that not prove effective, you may be able to dispute the charge, and your credit card issuer may be able to force a refund through what’s known as a chargeback. Be aware you’ll usually have to file your dispute within 60 days of the transaction.

How credit card interest works

Generally, if you carry a balance on your credit card from one month to another, you’ll incur interest charges. It’s important to understand that with credit cards, you’re dealing with compound interest. In other words, the interest you’re charged is added to your total balance, and you’re then charged interest on that higher amount. If you’re not disciplined about paying your card in full every billing cycle, credit card debt can snowball out of control.

TIP: You can identify your interest rate by looking for the APR — annual percentage rate — on your credit card statements. For some financial products, interest rate and APR differ, but in the credit card world they mean the same thing.

You should also know that there are different interest rates for different types of transactions. In most cases, you’ll be dealing with the regular purchase APR, which is the interest rate applied to most spending on goods and services.

However, you may also encounter the following types of credit card APRs:

• Introductory purchase APR — A reduced interest rate (or even no interest) for a period of time on new purchases. (Not all credit cards offer this.)
• Introductory balance transfer APR —  A reduced interest rate (or even no interest) for a period of time on debt transferred from another credit card. (Not all credit cards offer this.)
• Regular balance transfer APR — The interest rate that will apply after your intro APR on balance transfers comes to an end, or will apply immediately if your card doesn’t offer an intro APR.
• Cash advance APR — A special, usually higher, APR that applies to cash loans from your credit card account. (We generally advise against cash advances, as they can be costly.)
• Penalty APR — An extremely high APR (as high as 29.99%) applied by some issuers after you make a late payment.

You can typically find your account’s APR details on your monthly credit card statement.

Finally, know that most credit cards have variable APRs, meaning that issuers can increase or decrease them. Typically, issuers will base credit card APRs on an index, such as the Prime Rate.

How credit card fees work

There are a few fees you should be aware of that credit card issuers may charge:

• An annual fee — Some credit cards charge a fee each year just for carrying the card. Typically, these are either cards for people with poor credit or ones with premium rewards and benefits.
• A balance transfer fee — There are credit cards with no balance transfer fee, but typically, you can expect most cards to charge a balance transfer fee ranging from 3% to 5% of the amount transferred.
• A late fee — If you pay late, your issuer can charge you a late fee. As of the time of this writing, the maximum late fee for a first offense is $30, while a subsequent late payment within six billing cycles can be up to $41.
• A cash advance fee — Many credit cards charge a fee in the vicinity of 5% when you get a cash advance.

To encourage people to apply and spend on their cards, some credit cards offer rewards in the form of cash back, or points and miles that can be redeemed in a variety of ways, including for travel.

You may earn the same rewards on every purchase — “flat-rate” rewards — or bonus rewards in certain categories, such as gas or grocery shopping.

Redemption options will vary by issuer and the specific card you’re using. However, some common ways many issuers allow cardholders to redeem credit card rewards include the following:

• Direct deposits into a bank account
• Statement credits to lower your card balance
• Gift cards at a variety of retailers
• Travel bookings
• Point transfer to airline and hotel partners

If you’re disciplined about paying off your card in full every month, rewards are a great way to get extra value from your credit card. But if you roll over a balance month to month and incur interest charges, the interest you’ll pay will typically outweigh any value you get from rewards. We always recommend paying your card off in full every month — unless you’re in a 0% intro APR period, which can provide a temporary reprieve from interest.

Though debit cards and prepaid cards are visually similar to credit cards, they offer different ways to manage your money, and come with different pros and cons than credit card. We’ll examine each type of card below:

If you ever want to get an auto loan to buy a car, or take out a mortgage to buy a house, having a great credit score can help you get the best rates. Consider the following example from the FICO Loan Savings Calculator. In this example, the higher credit score could potentially save around $3,742 in interest over the life of the loan.

Worrying about accruing credit card debt is a legitimate concern. Paying with a credit card may lead to overspending because you’re not immediately seeing money leave your bank account. And in a world where many credit cards have APRs above 20%, if you carry a balance, interest charges can hurt your wallet, too.

The following steps can help you take advantage of a credit card’s positives while avoiding a mountain of debt:

• Spend like you’re using cash. Whether you prefer to use a budgeting app or website, a spreadsheet or some other method, it’s crucial to stick to a budget. Determine how much you can afford to spend in categories like groceries, restaurant dining and transportation, and don’t go over just because you’re using a credit card.
• Pay off your card weekly. Paying your card off in full every week helps keep you accountable, because you know the money is actually going to leave your bank account. Plus, it helps you avoid interest charges, since you won’t be carrying a balance from month to month if you stick to this routine.
• Prepare an emergency fund. When an emergency strikes, it can be easy to resort to a credit card to cover money you don’t have in the bank. But that can lead to carrying a balance, incurring interest charges and getting trapped in a vicious cycle of increasing debt. You should try to create a savings account with enough to cover a couple months of expenses. That way, if you have to deal with something like an unexpected car repair, you can pay it off immediately.

Here are a few of our recommendations for a first credit card: