How Do Credit Cards Work?

Using a credit card isn’t that different from using a debit card for making purchases. For instance, you can use a credit card to pay at checkout in a store by dipping or swiping your card at the terminal. 

You can also use your card to buy things online. To do that, you’ll need to enter your card details at checkout, including the card number, expiration date, and the three- or four-digit verification number. 

The difference between a credit card vs. a debit card is where the money comes from to cover your purchases. 

With a debit card, you’re spending money from your bank account. When you use a credit card, you buy goods and services with the credit card company’s money. As part of your cardmember agreement, you’re obligated to pay that money back later. 

The credit card company can charge interest on purchases, and you might also pay an annual fee to have the card. The credit card company determines your credit limit, or how much you can spend. As you make purchases, your available credit shrinks. Your credit limit will increase when you make a payment toward your balance.

What do I buy with my credit card?

Credit cards are a convenient way to pay for a variety of purchases. For example, some of the things you might charge to a credit card include:

• Groceries
• Gas
• Online shopping
• Hotels and rental cars
• Flights
• Medical expenses
• Vet care for pets
• Emergency expenses

Your card network determines where you can use a credit card. A card network makes it possible to complete credit card transactions by transferring information from one place to another. In the U.S., there are four major credit card networks: American Express, Discover, Mastercard, and Visa.

So if you have a credit card with the Visa logo, you can use it anywhere Visa is accepted. A credit card can come in handy if you’re somewhere that doesn’t accept cash or you want to buy something and pay for it later.

How does cash back work?

Credit cards aren’t all the same. Some sweeten the deal by rewarding you with points, travel miles, or cash back for the things you charge. 

Cash back credit cards can pay you back a certain percentage of every purchase in cash or in points you can redeem for cash. So, for example, you might earn 5% cash back at grocery stores, 2% back at gas stations, and 1% back on all other purchases. 

Getting cash back from a credit card can be like getting a discount on those purchases if you’re redeeming your rewards as a statement credit. That means you tell the credit card company to use your rewards to pay down some of your balance instead of cutting you a check or putting it in your bank account.

Check the annual fee if you’re considering a cash back rewards card. Earning $100 in cash back may not be that great if you’re handing $95 of that back to the credit card company for the annual fee. And it’s also helpful to consider the interest rate you might pay if you carry a monthly balance.

There are benefits to using credit cards, and there are a few potential downsides to using them. It’s important to look at both sides to understand how credit cards work and how you’re meant to use them. 

Here are some of main pros of credit cards:

• Convenience. When you want to buy something online or in a store, you can use a credit card to make the purchase. You don’t have to hit the ATM for cash first or fumble with writing a check.

• Credit card benefits. Some credit cards can offer cash back, points, or miles. But you can also unlock other benefits with the right card. For example, a premium travel credit card can include features like airport lounge access, free checked bags, and annual fee credits. 
• Security. Credit cards can come with built-in security protections that you don’t always get with debit cards. And if your card is lost or stolen, your liability for those losses is limited, so you’re not on the hook for an identity thief’s purchases.

In terms of the downsides, the most obvious one is cost. If you carry a monthly balance and your credit card company charges interest, everything you buy becomes more expensive. And if you’re not keeping track of your spending, you could easily find yourself in debt.

Building credit

As mentioned, credit cards are often touted as a tool for building credit. Good credit can make a difference in how easy it is to get approved for loans when you need to borrow. Your credit scores can also affect the interest rates you pay. 

A credit score is a three-digit number based on your credit reports’ information. FICO credit scores, which are the most common, range from 300 to 850. You can consider an 850 score to be “perfect” credit.

Five factors comprise FICO credit scores:

• Payment history – 35% of your score
• Credit utilization – 30% of your score
• Credit age – 15% of your score
• Credit mix – 10% of your score
• Credit inquiries – 10% of your score

So how does a credit card work to help you build credit? 

Making credit card payments on time each month can help you to establish a positive credit history. Lenders like to see that you have a track record of paying bills on time. 

Keeping balances low can also work in your favor. Your credit utilization, which accounts for 30% of your FICO score, means the amount of your available credit that you’re using. Having low balances relative to your limits is a good sign that you know how to use credit responsibly. 

Is a credit card the only way to build credit? No, not at all. But it may be easier to get approved for a credit card versus a loan, so you might want to consider a credit card as your go-to credit-building tool.

Knowing how to use a credit card to buy things in stores or online is one thing. Knowing how to use it responsibly is another. 

Again, the way that you use a credit card can influence your credit scores. Your credit card company reports your payment history and usage to the credit bureaus. The credit bureaus add that information to your credit report to generate your scores. 

For that reason, it pays to use your card wisely. Remember to:

• Pay your bill on time (or early) each month
• Keep balances low
• Keep older credit accounts open, even if you aren’t actively using the card
• Limit how often you apply for new credit cards or loans
• Use different types of credit, i.e., credit cards, personal loans, etc. 

Does paying your balance in full help your credit score? Yes, it can, if it improves your credit utilization ratio. The other benefit to paying in full each month is that it can help you to avoid credit card interest.

Demystifying credit card interest rates will help you understand how credit cards work. Credit card companies can apply an annual percentage rate (or APR) to credit card balances. So what is APR on a credit card?

The APR is the annualized rate of interest you’ll pay if you carry a balance on a credit card. In other words, it’s the price you pay to borrow the credit card company’s money. The higher the APR, the more you’ll pay. 

Credit card interest rates are usually variable, meaning your rate could go up or down over time. 

You might have multiple APRs, depending on the card. For instance, you might have one APR for purchases, one for balance transfers, and one for cash advances.

Some cards may apply a 0% introductory APR for purchases and balance transfers for a certain time. Once the introductory period ends, the regular variable APR for those transactions kicks in. 

The best way to avoid credit card interest is to pay your balance in full by the due date. Be aware that if you pay late, your credit card company could impose a penalty APR, which might be higher than your regular APR.

There are many credit cards out there, and what works for one person might not work for you. Choosing a credit card depends on how you typically spend and what you might need your card to do for you. 

When comparing credit cards, consider:

• APR. Credit card APRs can easily be in the double digits, so it’s important to know what you might pay if you carry a balance. And if you’re checking out a card with a low introductory APR, be sure you know when that rate ends.
• Fees. Whether it makes sense to pay an annual fee for a credit card depends on how often you plan to use it and what kind of benefits you expect to get in return. For example, you might justify a $95 annual fee if you expect to earn three or four times that amount in cash back each year. On the other hand, if you only use the card once or twice per month, you might not get as much value in return. 
• Rewards. Does the card earn rewards, and if so, what kind? Are rewards unlimited? How will you be able to redeem the rewards you’ve earned?

It’s also helpful to consider what kind of cards you can get approved for. 

A premium travel rewards card might be out of reach if you’re new to using credit. On the other hand, you might find it easy to get approved for a secured card or a Credit Builder card.

Credit cards can get a bad reputation, but it’s to your benefit to know how to use them. When you understand credit card interest, fees, and rewards, using credit becomes a little less daunting.

If you’re just starting to use credit, a credit card can be a helpful introduction to the basics of borrowing money and paying it back. You can learn how to use credit cards responsibly and hopefully raise your credit score over time. 

Ready to begin your credit journey? Join millions already using Credit Builder to start building credit for a better future.