How Do Credit Cards Work?

Credit cards are one of the most flexible and convenient financial tools around.

You can use them to make purchases, access cash in emergencies, book a hotel stay, cultivate a positive credit history, and earn valuable rewards points.

However, they also come with drawbacks that can cause financial hardship if you use them carelessly.

For this reason, building good credit card habits is crucial.

What is a Credit Card?

A credit card is a product that allows you to borrow money from a bank, credit union, or other financial institution to make purchases.

Each card comes with a pre-set credit limit, which is the maximum amount you can charge to it before having to repay part of the principal.

As with any product that allows you to borrow money, credit cards charge interest and various fees. 

A credit card offers a revolving line of credit, which means that once you repay the principal, you can borrow again at your discretion, provided you don’t exceed the credit limit.

You don’t have to requalify for the card each time you wish to borrow. 

How Credit Cards Work

Below are a series of steps that outline how a credit card works in practice.

For this example, we’ll assume you’ve acquired a credit card with a $7,000 credit limit that charges a 20% interest rate on purchases.

Each billing cycle ends on the 20th day of the month.

• On May 19, the day before your billing cycle ends, you charge your card with $2,800 worth of purchases.
  Credit Card Balance Owing: $2,800
  Available Credit: $4,200 ($7,000 – $2,800)
• On May 20, the billing period closes. Your card issuer sends you a statement that specifies the following.
  Credit Card Balance Owing: $2,800
  Minimum Payment Required: $41
  Payment Due Date: June 11

  The time between the billing date of May 20 and payment due date of June 11 is the grace period.

  If you pay off your balance in full within this time frame, no interest charges will be posted to your account.

• You decide to make a payment of $800 on May 25, which reduces your amount owing to $2,000. Your card issuer will report this payment as being “on-time” to the credit bureaus as you contributed at least the minimum of $41 required. 
• Once the last billing cycle’s grace period expires on June 11, you’ll incur interest charges on the unpaid balance and any new purchases you charge to the card. In this case, the 20% interest rate (prorated daily at 0.0547%) will apply on the amount of $2,000 each day it remains unpaid, starting from the purchase date (May 19). You won’t receive the benefit of a grace period in this cycle as you’re carrying forward an outstanding balance.
• During the next billing cycle spanning May 20 to June 20, you refrain from making any further purchases or payments. On June 23, you make a payment of $2,039.45 ($2,000 principal plus $39.45* in interest accrued over the 36 days from May 19 – June 23) to settle your remaining balance. After the payment, your credit limit will reset back to $7,000.

One more thing worth noting about credit cards is the various fees you might be responsible for paying.

The most common is the annual fee, which is what you pay to use the card and enjoy any benefits it provides.

Other fees include:

• Cash advance fees
• Late payment fees
• Foreign transaction fees
• Balance transfer fees
• Over limit fees

*For simplicity, the interest calculation ignores the effects of daily compounding.
(0.20 / 365) x $2,000 = 1.095890410958904
$1.098590410958904 x 36 days = $39.45

Credit Card Interest Rates

Your card’s interest rate is referred to as the annual percentage rate (APR) in your cardholder agreement.  

In the context of loans, the APR differs from an interest rate.

The former is slightly higher because it includes various fees a borrower must pay.

However, a credit card’s APR is identical to the interest rate.

The main factor that affects the APR you receive is your credit score.

As alluded to previously, most credit cards offer a grace period, which covers the gap between the end of your card’s billing cycle and your payment due date.

This interval typically lasts for 21 – 25 days.

Provided you pay off your entire balance by the due date, you won’t incur any interest charges on purchases you made during the last cycle.

Suppose you fail to pay the amount owing in full by the due date.

In that case, interest charges will begin to accumulate on your account, both on the unpaid balance and new purchases you make.

The grace period resets once you bring your balance to zero by the next due date.

Many card issuers determine your interest charges by utilizing the daily balance method.

Under this method, interest accrues on your account every day.

The card issuer multiplies each day’s outstanding balance by the daily APR (annual APR / 365 days) to calculate the interest.

They then sum each day’s interest charged during the billing cycle and post the total to your monthly statement.

The interest compounds daily, so it can quickly add up on a large balance that remains unpaid for an extended period.

Credit Card Payments

Each credit card comes with a monthly billing cycle (28 to 31 days), much like any other bill you would pay.

At the end of each cycle, you’ll receive a statement that contains the following details:

• List of transactions made during the period
• Transaction dates and posting dates – the former refers to the time you conducted the transaction, while the latter refers to the time your card issuer applies it to your account.
• Statement date – the date the statement was generated
• Payment due date – the date your minimum payment is due
• Minimum payment required – usually equal to 2% – 3% of your outstanding balance
• Available credit
• Interest charges and fees 

To prevent your card issuer from reporting a late payment on your account, you should strive to contribute the minimum amount noted on your statement before the due date.

Paying late by more than 30 days will negatively affect your credit score.

If you’re concerned about missing payments, you can enable the “autopay” feature through your online banking, which most card providers offer.

Types of Credit Card Transactions

You can conduct various transactions using your credit card, all of which come with unique conditions and interest rates.

1. Purchases

Purchase transactions are what credit cards are most commonly used for.

They cover almost everything, from your everyday spending, such as a utility bill payment, to significant one-time purchases, such as a used car. 

The interest rate that applies to these charges is called the purchase APR. 

You can usually expect a purchase APR between 20% and 22% on most credit cards. 

2. Cash Advances

A cash advance is a type of transaction where you borrow cash from your credit card.

Unlike regular card purchases, this transaction doesn’t provide you with a grace period; interest begins accruing from the day you withdraw the cash. 

Cash advance APRs in many cases are higher than purchase APRs.

You’ll also incur a fee per transaction, either as a percentage of your withdrawal or a flat amount.

3. Balance Transfers

A balance transfer allows you to move an existing balance from one credit card to another.

The purpose behind this transaction is to consolidate high-interest debt on a card that offers a temporary low promotional APR.

This rate is usually between 0% and 2% and remains in effect anywhere from 6 to 12 months.

By consolidating your debt in this manner, you can save immensely on interest charges and better manage your debt.

However, once the promotional period expires, these cards revert to their default purchase rate, typically between 20% and 23%.

Good Credit Card Habits

Understanding how credit cards work will allow you to build good habits around the use of debt.

Here are some solid practices you can implement to reap the benefits of your credit card and avoid the pitfalls:

Pay off the balance each month

Clearing your outstanding balance at the end of each month is a wise move, as you’ll minimize the amount of interest that accumulates on your account.

It’s no secret that most credit cards charge a steep interest rate – and the interest compounds daily.

By routinely paying off your balance, you’ll keep more money in your pocket.

Make your payments on time

Timely payments are critical for proper credit card management.

Failing to pay on time allows for interest charges to accrue, and you could get hit with a late fee, as well.

In addition, late payments adversely impact your credit score.

Don’t get too close to your credit limit

You should be mindful of how much of your available credit you utilize.

The reason is that your credit utilization ratio is one of the factors that credit bureaus assess when they assign your credit score.

A good rule of thumb is to maintain a ratio no higher than 30%.

Only spend what you can afford to pay

Ensure that you charge to your card only what you’re confident you can pay back on time.

Otherwise, you could quickly find yourself buried in debt and struggling to keep up with payments.

Should you default on your payment obligations, your credit score will drop.

Frequently Asked Questions