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A credit card is a financial tool issued by a bank that you can use to access a line of credit, which is essentially a loan. You can use the card to make purchases and, if you pay your balance in full every month, you won't have to pay any interest on the balance. If, on the other hand, you run up charges you can’t afford to pay off, you could end up with expensive debt.Read on for a closer look at how credit cards work, how they compare to debit cards, their pros and cons, plus tips for how to find the right card for your needs and qualifications.
What Is a Credit Card?
A credit card allows you to borrow money from a bank to buy goods and services from merchants that accept credit cards. Credit cards come with a maximum amount of money you can use for everyday expenses or large purchases, known as a credit card limit. Your credit limit is set by the card issuer and is largely determined by your credit history and score. Once you pay off what you’ve borrowed, you have access to that credit limit again, which is why credit cards are referred to as “revolving credit.”Like traditional loans, a credit limit is subject to interest. This is added to your credit card bill if you don’t pay off your balance in full.
How Do Credit Cards Work?
Here’s a look at how credit cards work: When you swipe or tap your credit card, you are essentially authorizing the credit card company to make a purchase for you, with the intention of paying the credit card company back later.Once a month, you get a statement from the credit card company listing your purchases and your payment due date. You can choose to pay it all at once, or opt to pay just a portion and carry the rest of the balance to the next month. If you carry a balance, you'll have to pay interest — a percentage of the money you owe — on top of what you borrowed.
What Elements Make Up a Credit Card?
Credit cards contain a number of different components. Here’s what you will likely see on your card.
Issuer logo: The front of the card will feature the issuing bank’s logo (such as Bank of America or Wells Fargo), as well as the credit card payment network (like Visa and MasterCard), which processes payments.
EMV chip: Many cards now have an EMV chip (which stands for Europay, MasterCard, and Visa). This chip stores card data in an encrypted fashion, making it harder for anyone to steal your card number. EMV chips can only be authenticated by special card readers.
Magnetic strip: Credit cards also often have magnetic strips. Like an EMV chip, the strip contains information about your account that can only be read through specific machines used for monetary transactions.
Your name and account number: Your name (as you wrote it on your credit card application) appears on the front or back of the card, as well as your account number.
Credit card expiration date: Your card expiration date shows merchants the month and year when your credit card expires.
Customer service number: This is the number you can call with any questions or concerns about your card or to get your current account balance.
Signature box: Your card may also have an area where you are expected to sign your name.
Types of Credit Cards
There are several types of credit cards, each offering unique benefits and services. Here’s a look at some of the options you may find on the market.
Balance Transfer Credit Cards
A balance transfer card typically offers an attractive introductory interest rate on balances you transfer over from another card to incentivize customers to switch. You may also be able to transfer balances from other types of debt, like a car loan. Balance cards typically charge a fee, however, for each balance transferred.
Rewards Credit Cards
A rewards credit card allows you to earn points for every dollar you spend with the card. Typically, you can redeem your points for statement credit, merchandise purchased through your card issuer, gift cards, and/or travel perks. At the end of each billing cycle, you can see your current rewards balance on your credit card statement.
Premium Credit Card
Premium credit cards offer special perks like concierge services, travel insurance, access to airport lounges, hotel upgrades, and invitations to special events. Typically, these cards come with a higher annual fee than other cards.
Retail Credit Card
A retail credit card is issued by a store and can be used to cover purchases made at that store (or multiple stores owned by the same company). These cards often come with a discount on the first purchase you make with the card, and sometimes other ongoing discount opportunities.
Secured Credit Card
Typically used by people with limited or poor credit, a secured credit card requires putting down a cash deposit to secure the card before you can use it. Often the card’s credit line is equal to the deposit. Should you fail to pay your bills, the card issuer can recoup its losses by keeping your deposit.
Pros and Cons of Credit Cards
Credit cards come with numerous benefits, including convenience, rewards, and an opportunity to build credit. But they also have some significant downsides, like allowing you to spend more than you can afford, high interest rates, and fees. Here’s a look at how the pros and cons stack up.
Pros
Cons
More convenient than having to keep cash on hand
Many cards charge fees like annual fees and late payment fees
Can earn valuable rewards, like points and cash back
Interest rates are typically higher than other types of debt
Used responsibly, can help you build credit
Poor credit habits could damage your credit history and lower your credit score
Offers an interest-free loan if you pay your balance in full each month
Certain cards might not be accepted by every merchant
May be able to get a 0% introductory interest rate
If you don’t pay off your balance before a 0% APR offer ends, you could get hit with high interest charges
Important Credit Card Terms
If you’re new to using a credit card, you may want to become familiar with these common credit card terms.
Interest Rate
Interest is the fee that the bank charges for loaning money. You’ll only pay interest on your credit card if you carry a balance from one month to the next. Credit card interest rates vary depending on the credit card issuer, and the credit score and credit history of the applicant.
Annual Percentage Rate (APR)
The APR of a credit card refers to the interest rate. With most loans, APR refers to the annual cost of borrowing money, including fees that are not factored into the interest rate calculation. With credit cards, however, the APR is the same as the interest rate, since annual fees and other fees are not included in this rate. Other transactions — like cash advances and returned payments — are also subject to APRs, which might be higher than your regular rate.
Credit Limit
A credit limit is the maximum amount of money a lender will allow you to spend on a credit card. Generally, credit card issuers want limits to be high enough that you’ll use the card, but low enough that you won’t spend more than you can afford to pay back.
Credit Card Balance
A credit card balance is the amount of credit you've used on your card, which includes charges made, balances transferred, and cash advances (like ATM withdrawals). Your balance also includes any interest or fees charged.
Cash Advance
A cash advance is when you use your credit card (rather than your debit card) to withdraw cash. With a cash advance, your credit card company is essentially lending you money and charging your account. Cash advances are typically subject to transaction fees and higher APRs, and are typically not recommended unless absolutely necessary.
Understanding Credit Card Fees and Costs
Credit card companies generally make money in three ways:
Processing fees: Credit card processing fees are paid by the merchant whenever you use your card for a purchase.
Cardholder fees: Credit cards can charge a number of fees, including annual fees, late payment fees, transaction fees, and cash advance fees. Most fees are avoidable, however, even annual fees. Unless you’re in the market for a premium or secured credit card, you can generally avoid having to pay an annual fee.
Interest: This is a major source of profit for credit card companies. However, interest is also avoidable. Issuers charge interest only when you carry a balance. If you pay your balance in full each month, you’ll pay no interest.
Credit Cards vs Debit Cards
They look and feel almost identical, but there are some key differences between credit cards and debit cards.
Credit Cards
Debit Cards
Pay later
Pay immediately
Offers points and rewards
No points or rewards
Will pay interest on any balance you don’t pay in full
No interest charges
Can help you build credit
Does not impact credit
Possible to overspend
Can only spend what’s in your checking account
Not liable for fraudulent charges
May be liable for fraudulent charges
When you use a credit card, you are essentially borrowing money to pay for the charge. When you pay with a debit card, on the other hand, it’s equivalent to paying cash. That’s because the money is immediately “debited” out of your bank account. If you don’t have the money in the account to cover the purchase, you can’t use your debit card.Both types of cards have their pros and cons. You can’t run up expensive debt with a debit card. However, if you're the victim of fraud or theft, it's usually easier to get your money back from your credit card company. Another difference is that you can't build credit with a debit card, as these charges are not reported to the credit bureaus, whereas you can build credit with a credit card. Also, you can earn rewards (like points and cash back) with a credit card, but you can’t with a debit card.
Tips for Choosing a Credit Card
If you’re in the market for a credit card, here are some things to consider when comparing your options.
APR
APRs vary from one credit card issuer to another, and the rate you’re offered will mostly depend on your credit score. To find the best deal, it can be a good idea to shop around and compare credit card offers. You can prequalify (which involves a soft credit check) without causing any damage to your credit score.
Annual Fee
Premium travel credit cards which offer generous perks, like free hotel upgrades and travel credits, often come with hefty annual fees. If you’re not going to benefit from these rewards, you may just want to go with a no-annual-fee credit card.
How You’ll Use the Card
If you have a large upcoming purchase that will take some time to pay off, you may want to look for a card that has a 0% introductory rate. If you can pay off the charge before the intro rate expires, it’s like getting an interest-free loan. If, on the other hand, you plan to pay off your balance in full each month, you may want to go with a card that offers more rewards. Rewards-earning credit cards often have higher interest rates than other cards. That interest rate could quickly erase the value of any rewards, but it won’t be a factor if you don’t carry a balance.
Tips for Applying for a Credit Card
If you’re new to credit or have made some mistakes in the past and have poor credit, you may have difficulty getting approved for a regular credit card. However, you do have other options. Here are two to consider.
Become an Authorized User
One way to build (or rebuild) credit is to become an authorized card user on an established credit account, such as a parent or spouse. The cardholder’s account is added to your credit report and, ideally, their good credit management helps you improve your creditworthiness. If their financial choices are poor, on the other hand, that will also reflect on you.
Consider a Secured Credit Card
Secured credit cards are easier to get approved for since they require a deposit for the credit limit. If you are having trouble getting an unsecured card, you may want to consider getting a secured card. Once you establish a history of on-time payments, you’ll be in a stronger position to qualify for other types of cards.Recommended: Important Credit Card Requirements to Know Before You Apply
The Takeaway
Used wisely, a credit card can be a powerful financial tool and a key part of building credit so you can achieve future goals, like buying a car or a home. You can also use credit cards to get rewards (such as cash back) for purchases, and access other card benefits. On the downside, credit cards may bring fees, high interest rates, and the opportunity to spend beyond your income.To get the benefits without the costs, you’ll want to use your credit card judiciously, which means only charging what you can afford and paying your bills on time (and, ideally, in full) each month.If you’re in the market for a new credit card, Lantern by SoFi can help. With our online marketplace, you can shop different types of cards (including rewards, no-fee, and credit-building cards) and compare multiple offers all in one place.
Frequently Asked Questions
Which credit card type is the best?
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Do you need a job to get a credit card?
Photo credit: iStock/Maksym Belchenko
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About the Author
Jason Steele
Jason Steele has been writing about credit cards and award travel since 2008. One of the nation's leading experts in this field, he has contributed to dozens of personal finance and travel outlets and has been widely quoted in the mainstream media.
