How Do Credit Cards Work? (A Quick Review)
When I received my first credit card, I didn’t even know enough to wonder, “How do credit cards work?’
No one had ever spoken to me about credit cards, revolving credit and I had yet to hear of the words ‘Credit Score.’
Yes, I know you see where this is going, and your mental picture of a young man a few years later, deep in credit card debt, late payments and an almost non-existent credit score is absolutely correct!
However, you are much smarter than I was and are trying to figure out these rectangles of plastic before you mistakenly use their power for evil.
When you finish this short article, you will know everything you need to know about how credit cards work.
In addition to an excellent general overview of everything credit card, I will review some of the key topics that I think you need to have a good grasp upon, such as; how credit card interest works, what are included in your payments and the effects of the size of your payments, along with the different types of credit accounts.
What Is A Credit Card?
Well, the textbook definition of a credit card is that it is your best friend (so long as it still has money available), the devil on your shoulder, or your party until its declined card.
Ok, maybe we're being a little silly here.
In reality, a credit card can be an emergency fund, a cash advance opportunity, or even can be used to startup a business or keep it afloat.
Who would have thought a rectangular piece of plastic with a Visa, MasterCard, Discover or American Express logo on it, could mean so much to so many.
These mini passes to your revolving loans have a digital chip on one end and a black scanning strip on the back that allows merchants to access your financial information and charge the credit card company for your purchase.
The four major credit card companies include Discover, American Express, MasterCard, and Visa.
What Is A Credit Card Account Number (& How It Works)
A very common question to ask is, 'What is a credit card account number?'
Every credit card is linked to an individual credit card account number for each borrower.
The credit card account number is unique to every individual and no two separate account holders will have the same credit card account number.
After I received my credit card, I was given access to my personal online account.
Inside this account you can manage pretty much just about anything, including freezing your credit card when you misplace it.
As you can tell from my credit card statement below, there is a lot of options available to you.
The first thing I always notice when I open my Capital One credit card account is my current balance, available balance, and my credit limit.
All three are conveniently located at the top of the account page near the 'Make a Payment' button.
Notice that it says above that payment button that 'No Payment Is Due At This Time' which is because I just paid this credit card in the beginning of the week.
However, typically, you will also see when your next payment is due along with the minimum amount that you will need to pay.
The credit card account is a revolving credit account which means that you have an open revolving credit line with a set limit.
As you use your credit card, you borrow the money from the credit card company against your revolving credit line which increases your current balance and decreases your available credit.
The minimum amount that you have to pay each month is based on your current balance, the higher it is, the higher your minimum payment will be.
In addition to the financial information you will usually find a tool that will give you a credit score.
Capital One offers to 'Track My Credit Score' for free, which is a handy tool to keep track of how your credit history is doing.
You can also view old statements, review your most recent transactions, and see your payment history with your online account.
What Is A Credit Card Balance?
The credit card balance is the total amount of money you have charged to your card during a given billing cycle.
Each time you use your credit card, your balance will increase by the amount of your purchase.
Your balance will go down each time you make a payment on your credit card account.
If you are concerned about your credit, a good rule of thumb is to pay off the entire balance each month or billing cycle.
If you are unable to pay off the entire balance, generally, the belief is that you can use up to 20% of your credit limit without your credit score possibly being affected negatively.
For example, if you have a credit card with a credit limit of $1,000, each month you should not leave a balance of more than $200, to stay under the 20% credit use threshold.
What Is A Credit Card Credit Limit?
Finding out that first unsecured credit card credit limit was an exciting experience for me.
Today, we find out our credit limit almost instantly if we request a credit card online.
Simply put, the credit card credit limit is the maximum amount of money you can charge to your credit card.
When you apply for a credit card, the issuer will look at your credit score and your income to determine how much revolving credit they will issue you on their credit card.
This credit limit can be as little as $50 and as high as millions of dollars, with most people having a credit limit of a couple of thousands of dollars, if they have good credit.
The credit card companies can raise and lower your credit limit based on your credit history.
You can usually request a credit limit increase by accessing your account online and looking around the dashboard.
What Is The APR On A Credit Card?
The APR or Annual Percentage Rate is the interest rate you will pay on your credit card balance that remains after your billing cycle.
Most billing cycles are 25 days which means that if you make a regular monthly payment on your due date, you are paying interest on your credit card balance.
By making a payment a week prior to your due date you will not have to pay interest on that portion of the balance that you pay.
The credit card you qualify for will have a corresponding APR rate based on your present credit status of; no credit, bad credit, limited credit, poor credit, fair credit, or good credit.
People with good credit will receive the lowest APR rates and people with bad credit will receive the highest because they are the most significant risk to default on their payments.
APR rates can be fixed or fluctuate based on the current commercial prime lending rate.
Keep an eye on your APR rate and if you think that it is getting to high, call your credit card company and ask them to lower it, some will do so right over the phone.
The lower your APR rate is on your credit card the less amount of interest you will pay on your credit card balance.
How Do Credit Cards Interest Rates Work?
Many companies will call your credit card interest charges, 'finance charges'.
I think they do this to confuse you and not draw attention to the fact you are paying interest on your credit cards by calling them finance charges.
These finance charges are what credit card lenders charge you for the balance your carry on your card.
The APR rate is the amount of interest charged for your average daily balance over the month.
However, you typically have a 25 day grace period during which time any of your balance paid will not accrue any interest.
Any balance unpaid after 25 days will be charged interest at your APR rate.
These APR interest rates work by usually fluctuating with the financial market to maximize the credit card companies profits that make off of you.
Some credit cards have a fixed APR interest rate which will make it easier to budget for and plan paying on your balances.
What Are Credit Card Fees?
You need to understand that every credit card is different.
It is essential that you review all the financial disclosures closely before deciding on a credit card.
There are many different fees a credit card company may or may not charge you for the service.
Knowing what these fees are and how much your credit card will charge you for using the service will help you save money and use your credit card more effectively.
Here is a list of the most commonly incurred fees that you should be aware of:
Annual Credit Card Fee
The APR rate and the Annual Fee are the most two commonly advertised credit card costs.
The annual credit card fee is the amount a credit card company will charge you yearly for them letting you use their credit card.
Some credit card companies do not charge an annual fee while others may charge as much as $500.
Generally, most annual credit card fees range between $25 - $75 per year.
Balance Transfer Fees
There can be a fee charged when you transfer the balance of one credit card to another.
Often there are special offers by your credit card company to transfer balances free of charge if specific terms are met.
Keep an eye out for special offers that may waive this fee.
Cash Advance Fees
Some credit cards will allow you to take cash advances against your revolving credit loan.
This usually involves you going to an ATM and using your credit card to get a cash advance.
There can be a fee for this and sometimes there is also a higher APR rate for cash advances than traditional credit card usage rates.
Foreign Transaction Fees
When you use your credit card outside of the country, some lenders will charge a fee for these transactions.
Avoid Embarrassment... you usually must call the credit card company and let them know you will be using your credit card out of the country so that your card will work in a foreign country.
Failure to activate your card outside of your domestic country can result in the card being embarrassingly declined.
Late Payment Fees
The late payment fee is charged when you make your payment after your payment due date.
Not only will there be a fee charged but this can also be reported to the three big credit bureaus and negatively affect your credit score.
How Do Credit Card Payments Work?
When do you need to make a credit card payment?
How much do you need to pay?
And, how do credit card payments work?
These are important questions to understand as they all can make a big impact on your credit history and score.
Your credit cards payments will be based on a monthly billing cycle and contain all activities regarding your credit card account during that period.
Payment will be due on the same day each month, called a statement due date, that will include a minimum payment amount for the billing cycle.
You will need to make the minimum payment each month to keep your account in good standing and not have the credit card company make a negative report.
However, only paying the minimum payment will not make a big difference in the actual credit card balance as the minimum amount due barely covers the monthly interest costs.
Each month your goal should be to completely payoff your credit card balance.
If you cannot payoff your entire credit card, try and payoff as much as you can.
Your revolving credit card utilization ratio (the percentage of available credit card balance used) needs to be kept under 20% or you risk your credit score being negatively affected.
Guard the Door
Monitor your credit and protect it from inaccuracies
What Is A Credit Card Billing Cycle?
Every 25 to 31 days you will receive an invoice from your credit card lender with your present balance and when the next payment is due.
The balance will include any previous month balance rolled over to the present bill, any charges to your credit card during the current billing cycle, any payments made, and any fees or interest incurred.
Be sure an attempt to pay the entire balance each month as a good safe practice.
What Is The Statement Due Date On A Credit Card?
The Statement Due Date is the last day that your payment is due before it is late.
Failure to pay by the statement due date will result in a late fee and possibly a negative payment being reported to the three major credit bureaus.
If you find yourself in a position paying your credit card late, contact your credit card lender immediately to resolve this late payment and hopefully keep them from reporting it to the credit bureaus.
What Is The Minimum Payment On A Credit Card?
The minimum payment on a credit card is the amount the credit card lender must receive by the statement payment date.
The minimum payment amount is a small percentage of your remaining balance.
It usually covers the APR interest charged for the billing cycle and a small amount of the principal balance of your loan amount.
Paying the minimum on your credit card each month is not recommended unless the balance on your credit card is under 30% of your credit limit.
What Are The Three Types Of Credit Accounts?
There are three types of credit card accounts that you may encounter.
Revolving Credit Account
With revolving credit accounts, you will choose to pay the balance in full or choose to pay a portion of the outstanding balance.
Credit cards are the most common type of revolving credit accounts.
Charge Credit Account
These types of accounts require you to pay the entire balance every month and do not usually charge any interest.
You most typically see these types of accounts with local businesses extending a short time of credit with known consumers or to other local businesses.
Installment Credit Account
Installment accounts are more traditional loans where the borrower agrees to pay a fixed monthly amount over a set period.
Real estate mortgages, auto loans, and personal loans are a few examples of installment credit accounts.
Hopefully, you now have a much better understanding of how credit cards work.
By familiarizing yourself with the common terms associated with credit cards it will help you make smarter long term financial decisions.
Remember to try and keep your monthly balances below 20% of your total credit limit to avoid a possible deduction to your credit score.
Pay all credit card payments on-time and you will gain valuable payment history which will help you build your credit.
There are multiple other credit building tools to consider when trying to improve your credit score.
Editorial Note: The editorial content on this page is not provided or commissioned by any financial institution. Any opinions, analyses, reviews, statements or recommendations expressed in this article are those of the author’s alone, and may not have been reviewed, approved or otherwise endorsed by any of these entities prior to publication.
Mark B. Huntley, a personal finance writer who has contributed to such publications as Forbes, is a former finance and consumer advocates attorney who lost everything in the real estate crash in the late 2000s. Credit Knocks was inspired by the trials of his credit building experience and the desire to help others understand the easy steps necessary to improve one’s credit score.