Written by: Linsey Knerl
Edited by: Lillian Guevara-Castro
Reviewed by: Jon McDonald
Credit cards are an important, if not essential, part of being a consumer today. Plastic is accepted almost universally as a form of payment worldwide, and credit cards can offer some much-needed flexibility and protections against hacking, fraud, and faulty purchases. But just how do credit cards work? And what can you do to use them to your best advantage?
Let’s take a look at the basics behind one of the most popular ways to pay today, including 11 facts about APR, interest, and rewards. We’ll also explore exactly how exactly credit cards work and look at some of our top choices for credit cards available today that offer a range of perks and are suited for a variety of different credit scores.
1. How Do Credit Cards Work?
Simply explained, credit cards are access to a personal line of credit with a set limit, but do not have a pre-determined (or installment) amount to pay back each month. You can borrow as much or as little of your available credit as you’d like (but it’s a best practice to keep your credit utilization ratio below 30%).
By using the card, you agree to the repayment terms, interest rates, and other contracts of the card. Credit cards are perhaps the most commonly used type of personal loan, and proper use of a card can help you build or even rebuild poor credit.
Those with bad credit histories should look into the benefits of having a credit card. Using a credit card responsibly can be one important way to improve your rating and continue getting better credit terms for a more satisfying credit experience.
2. How Does Interest Work?
Interest, or the amount you pay to the lender for the privilege of borrowing money with your credit card, is a normal part of lending. All loans charge interest, and credit cards are no exception. The specific terms of interest will vary widely from card to card. Some cards will offer low or no-interest rates for a limited time (also called a “promotional period”).
Others will have a standard rate anywhere between about 9% and 29%. Credit cards most often use a “variable rate” formula, which is the current “prime” rate set by the federal banking system, plus their own percentage rate.
Interest most commonly doesn’t start accruing on your purchases until after a card’s “grace” period (usually between 20 and 30 days). This means that you will not have to pay interest on your purchases if you pay off the balance of your card in full before this time limit expires. Your card’s Annual Percentage Rate (APR) only applies if you carry a balance on your card from month to month.
3. How Does APR Work?
So, what if you do have a balance at the end of the month that you can’t pay? Your card’s APR kicks in. Card terms differ, but here is the most basic example of how it works — if you owe $1,000 on your credit card, and the APR is 10%, you’ll owe $100 in interest at the end of a year on that money.
It’s important to remember, however, that you are required to make monthly payments on your card, and they are designed to bring that balance down. So, the likelihood that you’ll pay a full annual percentage rate on that same $1,000 is unlikely.
Unless you continue to charge up your card with new purchases, your interest paid over time should decrease each month.
It’s also important to note that you can have more than one APR on the same card. The promotional rates we mentioned before can differ from the card’s standard APR.
4. How Do Payments Work?
Today, most payments are done online, which gives consumers ultimate control over how much and how often they pay. While most cards do not have a limit on how often you make payments, some might. To get the most from your card and keep the terms of your agreement favorable, be sure you are scheduling payments that are:
- Prior to the due date and in time to process before the due date
- More than the minimum amount required
If you’ve made several purchases that are subject to different APR’s, be sure your payment is going to the highest-APR purchases first!
If you cannot pay the balance of your card in full, at least try to pay the “statement balance.” This is the amount that was charged prior to the close of your billing period and is most likely the amount outside of the grace period and accruing interest.
Check your statement carefully, as it will explain this amount, as well as how minimum payments will affect the total time needed to pay off your balance. Paying your monthly credit card bill on time is one of the most important factors in building and maintaining a healthy credit score.
5. How Do Secured Cards Work?
Secured credit cards are cards that require a prepayment of the money that cardholders can spend with the card. This money is held in a separate account and can sometimes earn a nominal amount of interest. To get a credit card with a $500 limit, for example, the cardholder must prepay $500 to the credit card company.
Secured cards are usually an option for those with poor or bad credit and a history of not making their credit card payments. There are many benefits to owning a secured card:
- Ability to pay at locations that don’t accept cash or check
- Protection against fraud, unauthorized transactions, or faulty merchandise/services
- Discreet method of payment that looks like any other credit user
- Potential for cash back bonuses and points promotions
In addition to being incredibly convenient, your use of a secured card is reported to the credit reporting agencies. A good history of secured card use can raise your credit score and make you eligible for future lines of unsecured credit.
6. How Do Prepaid Cards Work?
Prepaid cards are a bit different than secured cards in that you are using your own money and your purchases are not treated as credit card purchases. You may pay transaction fees or even monthly maintenance fees, but you can reload your card at any time.
You may be able to load much more onto your prepaid card than you can on a secured credit card, but your charges are much like debit card transactions in that they are usually not protected by your financial institution.
A good prepaid card can keep you from overspending, however, and many use prepaid cards as part of an overall budget system to keep their financial goals in reach.
7. How Do Balance Transfer Cards Work?
Many credit cards will offer generous balance transfer promotions, either upon first applying for the card or later on. Most users look for very low APRs for balance transfers, with many aiming to get a rate of 0% for a specific time.
Once you accept and initiate a balance transfer offer, your new credit card’s lending bank will send a payment to the card you wish to have transferred, which can take up to 4 weeks to process. (You’ll want to keep making payments to your old card during this time.)
Once finished, you will pay the new rate for your credit to your new credit issuer. Most balance transfers are also subject to a “transfer fee” of up to 5% for the total transferred, although these can sometimes be as low as 1% — or even zero! These best balance transfer cards have low rates and exclusive bonuses after purchase.
8. How Do Cash Back Cards Work?
One of the most sought-after perks of a credit card is the cash back offer. It’s a simple as it sounds, giving cardholders a certain percentage of eligible purchases back to them as cash, check, or a credit statement.
Balance transfers are usually not eligible for earning cash back, and some cards restrict the amount you need to cash out. Yet more cards will let you earn up to 5% back, but only in select categories. The most common rate of return on the best cash back credit cards is 1-5%.
9. How Do Travel and Miles Cards Work?
If you travel often, you may find a travel and miles reward card to be your best option. While some are airline-specific and only reward you with miles that can be redeemed for that brand’s travel services, others are more flexible and can transfer the rewards to most any loyalty travel program’s account.
An additional perk to travel and miles cards is they can give users double or even triple miles for their travel-specific purchases. Between this bonus and frequent promotional offers, it can be easy to build up miles to redeem for free stuff!
Other perks may include free checked bags, seating upgrades, and companion tickets. See this list of the best airline miles credit cards for current offers available to you.
10. How Do Student Cards Work?
Designed for college students with the need to establish good credit early on, a student credit card is usually easier to be approved for than most cards because of the limited credit accompanying most student applicants.
Student credit cards oftentimes come equipped with bonuses for good grades and other perks and protections attractive to students, like cash back rewards, ride sharing credits, and cell phone insurance. These kinds of cards are great for young adults learning to build their credit and can be a valuable financial tool when used properly.
11. How Do Business Cards Work?
More and more new businesses are created each year, and that has led to a larger market of business credit cards. The perks of a business card are usually focused on the needs of today’s entrepreneur, and may include the ability to have multiple cards for employees, advanced tracking and reporting, discounts on popular business services, and higher credit limits.
In order to apply for a business card, you do need to own a business, but most companies will accept applications from companies of any size — even sole proprietors.
