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How Do Credit Cards Work? Complete Guide

How Do Credit Cards Work? Complete Guide
Jamie Cattanach
Jamie CattanachUpdated March 26, 2025
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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.
Credit cards are powerful financial tools that offer convenience, security, and the ability to build credit. Unlike debit cards, which withdraw funds directly from your bank account, credit cards allow you to borrow money up to a set limit and repay it later. If used responsibly, they can help you manage expenses, earn rewards, and build your credit score.Understanding how credit cards work is essential for making informed financial decisions. Here, we’ll cover key aspects of credit cards, such as credit limits, interest rates, payment terms, and fees. Whether you're a first-time cardholder or looking to maximize benefits, this complete guide will help you navigate credit card usage effectively.

What Is a Credit Card?

A credit card, issued by a bank or financial institution, enables you to pay for items on credit up to a predefined maximum limit, also known as a credit limit. Cardholders must repay the borrowed amount, usually on a monthly basis, and may incur interest if the balance is not paid in full. Credit cards can also offer rewards, cashback, and other benefits, making them a convenient way to manage expenses. However, responsible use is essential to avoid debt and maintain a good credit score.

Credit Card Interest

Credit card interest rates are notoriously lofty, especially if you don’t have a high credit score. 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 can be difficult to pay down, and it can happen in a short amount of time.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 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. Recommended: Guide to Compound Interest

Credit Card Grace Period

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 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.

Credit Card Minimum Payment

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. Missing payments will cause damage to your credit.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. It’s 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.Recommended: Guide to Credit Cards vs. Debit Cards: All You Need to Know

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 for a credit card. If you do qualify and are approved, your credit score will 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, it will have a negative impact on your credit score, whereas 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. You can compare credit builder cards to see which one might be the best fit for you.Recommended: How to Build Credit

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. Read on to learn some pros and cons.

Pros of Credit Cards

  • Convenience: Easily make purchases online and in-store without carrying cash.
  • Builds credit: Responsible use helps build your credit score.
  • Rewards and cashback: Earn points, miles, or cashback on purchases.
  • Fraud protection: Many cards offer zero liability for unauthorized transactions.
  • Emergency funds: Provides financial flexibility in unexpected situations.

Cons of Credit Cards

  • High interest rates: Carrying a balance can lead to costly interest charges.
  • Debt risk: Overspending can lead to financial difficulties.
  • Fees: Some cards have annual fees, late fees, and foreign transaction fees.
  • Credit score impact: Late or missed payments can lower your credit score.
  • Temptation to overspend: Easy access to credit can lead to impulse purchases.

Tips to Make the Most of Your Credit Card

Since all credit cards are not created equally, here are some tips to keep in mind when choosing a credit card:

Pay Attention to Fees

Along with interest charges and late fees, some credit cards also come with an annual credit card 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 an annual fee 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 cashback 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. Many of these rewards cards do not have annual fees, either. 

Make Sure You Can 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.Recommended: 8 Ways to Consolidate Credit Card Debt

Common Credit Card Terms to Know

These are some of the basic credit card terms you should know.
  • 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 be a valuable and rewarding financial tool. Furthermore, in some cases, you need a credit card — it can be difficult to do things like reserve a hotel room or book a rental car without it.If you’re in the market for a credit card, Lantern by SoFi can help. With our online tool, you can quickly compare card rates and terms. That way you can get a range of options that are targeted to your wants and needs.

Frequently Asked Questions

How does a credit card differ from a debit card?
What happens if I don’t pay my credit card bill on time?
How does interest work on a credit card?
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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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