How Does A Credit Card Work? Pros, Cons And Tips For Using Them Responsibly

No matter where you are in your financial journey, knowing how credit cards work is an important part of understanding and improving your finances. This form of payment can be a way to help you achieve your financial goals, whether it’s helping you build your credit score or fund a relatively large purchase. While there are many benefits to credit cards, there are also risks. Learning what the pros and cons of credit cards as well can help you decide whether now is the right time for you to open or keep using one.

What Is A Credit Card?

A credit card represents a loan from a financial institution (also known as the credit card issuer) that can be used to make purchases, conduct balance transfers or get cash advances. Your line of credit, or the maximum amount of money extended to you, depends on factors such as your credit history and income. All your transactions are processed by a major payment network determined by whichever one your card is attached to, like Visa, Mastercard, American Express, or Discover.

Credit card issuers require that you pay back a minimum amount up to the full balance by the due date to avoid late fees and other penalties. Interest is typically charged on any balance remaining after the due date. You may also be responsible for annual fees depending on the type of credit card. This process and your ability to pay off what you’ve borrowed, is what builds your credit score over time.

How Do Credit Cards Work?

Credit card issuers will issue you a line of credit based on your credit report, borrowing habits and income. Each credit card you take out will have its own spending or credit limit. You can borrow (either through purchases, balance transfers, or cash advances) up to the entire limit, although this is not recommended. As you pay down the balance, you can continue to borrow up to the spending limit.

For example, say you have a $5,000 credit limit and you’ve made purchases totaling that amount. You pay down $2,000 in the next 2 weeks. Now, you are able to borrow $2,000 again.

You may also have a credit card that offers other benefits, like travel miles or cash back. Depending on your financial goals and lifestyle, different credit card perks may be worth more to you than others.

Understanding Credit Card Costs

Most credit cards come with their own list of added fees, but some can be avoided depending on the type of card and how you make your payments. Here is a list of common fees and other charges you may encounter:

• Annual percentage rate (APR): Your annual percentage rate (APR) is the cost of using a credit card and carrying a balance between billing cycles. The best way to avoid these charges is to pay your monthly bill in full so that there is no balance rolling over into your next bill.
• Annual fees: An annual fee just for having the card, charged once a year. Some cards will waive this in your first year and others might not have these fees at all. Different types of credit cards may charge annual fees because of perks offered to cardholders.
• Balance transfer fees: This fee (either a flat fee or a percentage of your transfer amount) is for cardholders who transfer their credit card balance from one card to another. One of the main reasons to conduct a balance transfer is if one credit card has a significantly lower APR than the other.
• Late fees: If you don’t pay at least the minimum balance due on time, your credit card issuer will most likely charge you a late fee. Depending how late your payments are, you may also be subject to a higher APR.

Different Types Of Credit Cards

Credit card issuers offer different types of credit cards for various needs and financial circumstances. Some of these credit cards include:

• Secured credit cards: Secured cards are backed by a deposit of your own funds. Like a debit card, this deposit is effectively your credit limit. These are good for those looking to build credit or improve a lower credit score because secured cards tend to have a more lenient approval process.
• Unsecured credit cards: Unlike secured credit cards, unsecured cards don’t require a security deposit to open. They generally have higher interest rates and fees.
• Student credit cards: These cards are typically for students who have little to no credit history and are looking to build their credit. They also tend to have specific rewards tailored to student living, like cash back for gas, restaurants or groceries.
• Store credit cards: Many retail stores offer store credit cards and allow you to make purchases in the store at a discount or for other types of rewards. Be careful, as store cards often come with high interest rates that are likely not worth the initial discount.
• 0% interest credit cards: These credit cards offer an introductory period where you don’t have to pay interest on any balance you carry. Once this period is over, you will have to start paying interest fees just like you would with a normal, unsecured card.

Credit Score Impact

Using a credit card can have a major impact on your credit score. The higher your credit score, the more likely you’ll be approved for a loan or another credit card.

When using your credit card, your payment activity is monitored by your issuer and reported to the three major credit bureaus: Equifax^®, Experian™, and TransUnion^®. Your credit report helps bureaus determine your credit score based on your spending habits, how long you’ve had your credit card, and whether you’re keeping up with your monthly payments. Lenders look at both your credit history and score to determine how much of a risk it could be to lend you money in the future.

Some factors that could negatively affect your credit score include:

• Opening or applying for too many credit cards at once
• Closing a credit card
• Missing or being late on minimum payments
• Continually maxing out your credit cards

Credit Cards Vs. Debit Cards

A debit card’s funds come from your checking account, so the money you spend will be immediately pulled from your personal funds. There are no monthly bills to pay off or minimum payments involved. Using your debit card has no impact on your credit, unlike a credit card.

Credit cards are borrowed money you must pay back with any added interest. Your spending behavior on your credit card does impact your credit score. If you make consistent on-time payments, it can help build your credit. If not, it could negatively impact your score.

Pros And Cons Of Credit Cards

There are both advantages and disadvantages to having a credit card.

Should I Get A Credit Card?

A credit card can be beneficial when used responsibly. It can help to build your credit history, and in turn give you the opportunity to borrow money at lower interest rates. Better loan rates and terms can be extremely helpful for large purchases like taking out a mortgage or if you find yourself in need of a personal loan as it’ll help save you thousands in interest charges.

However, if you’re currently paying off high amounts of debt or don’t trust that you can use a credit card responsibility, it’s fine to hold off.

How To Get A Credit Card

The process of getting a credit card is simple and will be dependent on your financial situation:

1. Shop around and pick the credit card you want to apply for, based on your needs and the likelihood you’ll be approved.
2. Head to the credit card issuer’s website and pull up the online application form. Depending on the company you may be able to get preapproved, which won’t affect your credit score.
3. Fill in required information such as your name, address, phone number and Social Security number.
4. Provide any additional documentation if required by the card issuer to process your application.
5. If your application is approved, the issuer will mail you your new credit card along with other details such as your annual rate, APR and card features. Otherwise, you should receive communication as to why your application was denied.

Tips For Responsible Credit Card Usage

Once you have a credit card, being responsible when using it can help your financial situation. Here are some best practices to consider:

• Keep your credit utilization ratios low. Your credit utilization is the percentage of the overall credit limit you are using. Keeping it low shows lenders you don’t need to rely too heavily on credit regularly to pay your expenses. Most experts recommend keeping your utilization below 30%. For example, for a $5,000 credit limit, that would mean keeping your balance at any one time under $1,500.
• Consistently use and pay off your balance. Using your credit card regularly gives you the opportunity to establish a positive payment history as you’re paying off your balance on time. Payment history is one of the largest factors used to calculate your credit score.
• Set up auto-payments with and for your credit card. By setting up automatic payments, you won’t have to worry about forgetting to pay your bill on time.

Credit Card FAQs

Still unsure of your next step? Here are a few commonly asked questions about credit cards.

How do I use a credit card?

Once you receive your credit card, you must activate it first before you can use it. After that, you’re free to use it as a form of payment for most purchases. All you have to do next is make sure you’re monitoring your expenses and paying back your balance every month.

Is a credit card real money?

While the money you spend when using a credit card isn’t physical, it is still real money provided by your bank or credit card company. It is also your responsibility to pay back what you owe, so there is real money involved in the process.

Is there a best credit card to have?

The best credit card for your situation will be different than someone else’s. Perhaps you want to earn some cash back rewards, whereas others have lower credit scores and can only qualify for a basic secured credit card.

What is a billing cycle in credit cards?

A credit card billing cycle typically spans from 28 to 31 days and acts as a reference point for settling your statement balance. Smart credit card users often establish auto-payments to clear their billing statement balances either monthly or on a bi-weekly basis.

The Bottom Line

The most important thing to remember when applying for or using a credit card is that it can be a great tool for you to build your credit, as long as it is used responsibly. Make sure to pay off your balance on time and carefully consider which card is appropriate for your financial needs.

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