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How Do Credit Cards Work? Complete Guide

How Do Credit Cards Work? Complete Guide
Jamie Cattanach

Jamie Cattanach

Updated November 13, 2021
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
Chances are, you already have one in your wallet — or are considering getting one soon, if you’re reading this article. Credit cards are, physically, little pieces of plastic or metal. But in truth, they’re a kind of upfront loan product: they allow you to purchase items with money you don’t necessarily have yet, on the condition that you’ll pay it back later. But how, exactly, do credit cards work — and what’s the most responsible way to use them? Understanding credit cards is an important part of avoiding spiraling into credit card debt, which is notoriously easy to do. (Case in point: the average per-capita credit card balance in the United States is more than $5,500, per 2021 figures from Experian.)Learning how credit cards work can help you avoid becoming part of that statistic while still enjoying the many benefits credit cards can offer. Let’s take a closer look.

What Is a Credit Card?

A credit card is a slip of plastic or metal issued by a bank or financial institution. The card enables you to pay for items on credit — which is to say, to borrow money — up to a predefined maximum limit, also known as a credit limit, on the condition that you’ll pay the money back. (Psst: If you’re wondering what the difference is between credit cards vs. lines of credit, the answer is that a credit card is a line of credit, though not all lines of credit have a physical card attached.)

Understanding Credit Cards

Credit cards are billed on a monthly basis, and while you don’t have to pay back all of the money back each month, you can be charged interest on any revolving balance you keep on the card. Credit card interest rates are notoriously lofty, especially if you don’t have a very high credit score to begin with. What’s more, it’s compound interest — which means you end up paying interest on interest you’ve already accrued. It all can add up to sky-high totals that are very hard to pay down, and it can happen in a very short amount of time.That said, it is possible to use credit cards in a way that won’t ruin your finances. In fact, used wisely, credit cards can actually help put money back in your pocket. It’s all about making sure you never spend more than you actually have.

Credit Card Interest

Credit card interest is expressed in APR, or annual percentage rate, which is a figure that reflects the amount of the principal balance (money you actually borrowed) that you might pay over the course of a year. Credit card interest is usually compounded, or calculated, on a daily basis, which is part of why it’s so easy to fall deeply into credit card debt.But there is a way to avoid ever paying credit card interest at all, and it’s actually pretty simple: you have to pay your card off in full, on time, each and every month. When you get your credit card statement in the mail, you’ll see two separate dates listed on the bill: your statement closing date, which is the end of your billing cycle,  and the payment due date. The space between these two dates is also known as the grace period. If you pay off the balance in full during the grace period, you will usually not be charged interest. But beware — credit card companies aren’t required to offer a grace period. Always make sure you read the fine print of your credit card agreement.Alongside that payment due date, you’ll also see a minimum payment amount. This is the amount you must pay each month to avoid being charged late fees and having the credit card issuer count it as a missed payment. Failing to make minimum payments on your credit card each month leads to the card being marked delinquent by the issuer. That information is then passed on to the credit bureaus, who calculate your credit score. Long story short: it’s bad news, so you probably want to try hard to avoid it. Keep in mind, too, that if you’re only making minimum payments, you will be charged interest fees, unless your card offers a 0% interest rate (which is usually only for a temporary, promotional period).

Credit Cards vs. Debit Cards

While credit and debit cards might look the same, they serve very different purposes. A debit card is attached to your bank account and draws money directly from the account — so it’s not a loan but money you already have. Thus, you can’t be charged interest on debit card purchases, and you can’t accrue debt, though you may be charged a fee if you overdraft your account (meaning, spend more than you have, sending your account balance into the negative).Here are some important differences between credit cards and debit cards at a glance.

Credit History and Credit Score

As their name implies, credit cards are deeply tied to your credit history and credit score. Your access to credit cards can be impacted by your credit history — and your use of credit cards can impact your credit score going forward.When you apply for a credit card, your credit history will be pulled, and you’ll need to meet certain minimum requirements to qualify at all. If you do qualify, and are approved, your credit score can also be used to calculate what your interest rate will be and how high of a credit limit you’re approved for.Then, once you have a credit card, your behavior with the card can affect your credit score going forward. If you miss payments or make them late, that information will be passed along to credit bureaus, where it can have a negative impact on your credit score; on the other hand, if you make your monthly payments in full and on time, that can have a positive effect. In fact, many people take out credit cards specifically for the purpose of building credit, though you may need to start with a secured card if you’re starting from scratch, which requires a deposit to open.Keep in mind that keeping a revolving balance can also drag down your credit score. That’s because one of the factors that credit bureaus use to calculate your score is credit utilization ratio, which measures how much credit you have available versus how much you actually use. The lower your use, the better — which is another great reason to keep your balance low or non-existent.

Pros and Cons of Credit Cards

While credit cards can be risky for some, they do have benefits worth considering if you’re able to use them responsibly. Here are some pros and cons.

Tips to Make the Most of Your Credit Card

One of the best ways to ensure your plastic ends up being a boon rather than a burden is to take care when choosing a credit card. Since all credit cards are not created equally, here are some tips to keep in mind when looking for a card:

Pay Attention to Fees

Along with interest charges and late fees, some credit cards also come with an annual membership fee, which could easily be $100 or more. While higher annual membership fees sometimes mean more valuable available rewards, it’s relatively easy to find cards that don’t charge any annual fee at all and still have some worthwhile incentives for cardholders.

Look for the Right Rewards for You

Speaking of incentives, that’s another thing to look for while you’re shopping around. A cash-back rewards credit card can put a small percentage of every dollar you spend back into your pocket, while travel rewards cards might pay you back in miles. Lots of the top credit cards currently on the market offer these sorts of rewards without assessing annual fees. 

Make Sure You Can Fully Pay Off Your Balance Every Month 

No matter how good a credit card’s rewards are, remember that it’s only worthwhile if you actually pay off the card in full each month. If you keep a revolving balance, the interest you accrue will more than likely outstrip any rewards you might earn.In fact, it’s so important, it’s worth repeating ourselves again: our best tip for using a credit card responsibly is to pay the card down in full each and every month, and to avoid ever carrying a revolving balance. That means never spending more than you actually have. By doing so, you can get all the rewards the card offers without ever paying the credit card company a dime — along with the convenience and security of being able to use plastic (or metal) instead of cash.  

Common Credit Card Terms to Be Aware Of

Phew! That’s a lot of information. To review, let’s go over some of the basic terms regarding credit cards that might be unfamiliar to you.
  • APR stands for annual percentage rate, and is the way credit card interest is expressed.
  • Your balance is the amount of money you owe on your credit card at any given time.
  • The grace period is the stretch of time between the end of the billing cycle and the payment due date. If you pay off your balance in full during the grace period, you won’t be charged interest — but make sure your card offers one.
  • Interest is the money you pay the card issuer for the privilege of borrowing funds, and it’s charged as a percentage of the amount you borrow. However, because credit card interest is compound, interest can also be charged on the interest you accrue, which is part of why it’s so easy to slip into credit card debt.
  • The minimum payment is how much you must pay each month to avoid your credit card being marked delinquent by the issuer, which can lead to negative ramifications on your credit history and credit score.

The Takeaway

Credit cards can lead to a debt spiral for some consumers, but when they’re used responsibly, they can also be a valuable and rewarding financial tool. Furthermore, in some cases, you simply need a credit card — it can be difficult to do things like reserve a hotel room or book a rental car without that ever-present plastic.Shopping around for the best credit card can help stack the odds in your favor when it comes to getting the most out of your card while paying the least out of pocket. One important part of that is to compare credit card rates. While credit cards tend to have higher interest rates than some other forms of debt, and your specific rate will depend in part on your credit history, some cards’ rates are simply higher than others. Lantern makes it easy to check out the best credit cards on the market in just minutes.
Photo credit: iStock/max-kegfire
The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.SOLC1021234

About the Author

Jamie Cattanach

Jamie Cattanach

Jamie Cattanach is a full-time freelance writer whose work has been featured at CNBC, Yahoo Finance, The Motley Fool, the Huffington Post and other outlets. At SoFi, she writes about investing, retirement, student loans and how to get your money right -- no matter what that means for you.
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