How do credit cards work? | An In-depth Beginner’s Guide

Quick Answer: There are many types of credit cards for different needs but they all work the same. A credit card can be used to make purchases and earn rewards from it, and won’t have to pay any interest if you pay the balance in full amount in a month before its due date, if the deadline gets missed then you need to pay the balance with certain interest amount.

When you need to buy any item or pay a bill, at that time making payments from credit cards can offer both convenience and a chance to save more money in terms of rewards for what you’ve spent at the time of purchase. If you’re making the right use of credit cards by paying credit cards dues before their due date then this habit helps you to build a good credit history.

While both credit and Debit cards may look similar but both of them work differently, if you are a new credit card user or want to buy a new one then here’re a few important credit card facts you should know:

CREDIT CARD FACTS –

• Every individual gets a certain credit limit that can be used to make purchases via credit cards, the spent amount can be repaid later before the given due date. 
• Taking out cash from ATMs with credit cards can trigger higher interest rates. 
• It’s very important to read the fine print written in small words on credit card promotional offers. 
• Some credit cards give you rewards on the purchases you made from credit cards in the form of points, cash back or miles.

How do credit cards work?

Now let’s understand clearly how do credit cards work. A credit card is a physical plastic or a metal card that can be used to make purchases, pay bills online or in case of emergency withdraw cash as well. The simplest way to understand a credit card is, it’s like a short-term loan which comes with a certain due date before which we need to pay the full spent amount.

When you open a credit card with the company of your choice, you’re given a set credit limit as per your credit history and income. This is basically an amount of money that the credit card company allows you to use for making purchases or paying bills. As you start spending money for paying off your bills or while making purchases the available credit on the card starts reducing, now whatever the amount that you spent within a month you’ve to pay the spent amount in full before its due date.

How Do Credit Card Payments Work?

A typical credit card billing cycle consists of 30 days, once the month is ended the credit card company issues a statement of your credit card. A credit card’s closing date is the last of your credit card billing cycle, this is the date when the statement for your credit card will be issued

Your bill isn’t due till this date, but you’ll typically have anywhere from 21 to 25 days from the closing date to pay your outstanding dues,  

For e.g., if we consider march month then the 31st of march will be the closing date for your card and your credit spent payment due date will be anywhere around the 21st to 26th of April. 

21 days is the minimum amount of time finalized by the law between the closing date and due date under the Credit Card Accountability, Responsibility and Disclosure Act of 2009 (or the CARD Act)

Although credit card companies give you a minimum amount due from the total outstanding payment you’ve to make, it’s basically a minimum amount that you’ve to pay to keep your account up and running and in case you’re not able to make full payment before it’s due date then interest will be only charged on the remaining amount.

These overlapping timelines can be a bit confusing, so here are the 6 important terminologies you need to remember: 

1. Statement balance: You get this balance at the end of your billing cycle. If you paid all your credit spent amount each month before its due date then you won’t have to pay interest on your spent credit. 
2. Minimum payment: You can make a minimum payment of your total outstanding amount to keep you in a good standing state and avoid any additional late payment fees. 
3. Current Balance: You can check this balance by logging into your account. It’ll have the most recent payments, transactions and purchases you’ve made.
4. Grace Period: This is the period from the closing date of your last billing cycle, which is generally between 21 to 25 days. If you paid the full amount during this period then no interest will be charged on your due amount,
5. Credit card closing date: Your credit card’s closing date often called a credit car’s statement closing date is the date when the statement for your card is generated, now from this date you have a minimum of 21 days to make the payment before the due date, this due date depends on the company 
6. Credit card payment due date: Your credit card’s due date is the date when your payment is due, before this date no additional interest will be charged if you’re carrying a balance on your credit card account

How Does Credit Card Interest Work?

Credit cards have different interest rates or APRs (Anuual Percentage Rate), which determine how much interest you’ll have to pay when you use credit cards in multiple ways.

Purchase APR: This interest rate is applied if you make purchases with your credit card.

Balance transfer APR: When you do a balance transfer from your credit card this interest rate is applied to it

Cash advance APR: This interest rate is for cash advances and some cash-like product purchases e.g. Lottery tickets or wire transfer 

Penalty APR: If you don’t pay payments on time then this higher interest rate is applied on your due amount 

Promotional APR: A temporarily lower (sometimes 0%) APR could be applied on both your purchases and balance transfers  

As most of the cards have a grace period generally between 21 to 25 days from the closing date, if you paid your due amount in full during this grace period then you won’t have to pay any interest but if you missed this grace period then your due amount stats occurring the interest daily

Types of Credit Cards

All credit cards share some of the characteristics, such as having a certain credit limit, minimum monthly payment amount range, and it’s Annual percentage rate (APR). But due to certain traits and different benefits that credit cards are offering these credit cards are put into different groups which are : 

Secured Credit Cards: These cards are generally for new credit card users or for those who are building their credit. To open a new secured card, you have to send the card issuer company a refundable security deposit or lock money in the linked bank’s account. 

Now, these security funds secure the card’s credit limit if the cardholder stops making payments on the card then the card issuer company can keep the money. 

Unsecured Credit Cards: Under Unsecured credit cards, you don’t have to lock up any security deposit to the issuer bank. While issuing these types of cards the card issuer approves or denies your application based on your credit history, credit score and total monthly income.

This is why it’s always advised to have a good credit score so that you can qualify for more cards and can have higher credit limits and lower APRs on your credit card account. 

Student Credit Cards: Student credit cards come under the unsecured cards category which is specifically created for a student, It can be easier to qualify for these types of cards as card issuer companies don’t expect students to have higher incomes and long good credit history, but these cards do have lower credit limits 

Store Credit Cards: Some retail stores offer special store credit cards to their customers. With these cards, customers can avail of special benefits while shopping at the stores such as reward points or a longer return period on their purchases. These cards often come with some closed-loop conditions as in you can only use them at the associated brands.

Rewards Credit Card: Reward crest cards offer various rewards, including credit points, cashback and miles. Although there are many reward cards they’re further categorised based on the type of rewards they offer 

For example, while booking an airline ticket you can use your travel cards by which you won’t be charged extra on your ticket instead you’ll get some reward points which you can use later.

Business Credit Cards: Business credit cards are generally for small business owners. As these cards may provide benefits which can align with business owner’s needs, such as while doing media advertising and free cards for the employees that are linked with their bank accounts 

So these are some of the common categories of naming the different types of credit cards, you can pick cards from the above categories as per your needs.

Credit Cards vs. Debit Cards

A credit card and a debit card may seem to be the same thing but both cards have different purposes. When you’re making purchases with your credit card, in that case, you’re not spending your own money, Instead, you’re actually spending the credit money given by the issuer company, which you have to pay back before its due date and if got late then potentially with the interest too. 

As debit cards are linked to your bank account (they aren’t exactly the same as a prepaid card). When you make any purchase with your debit card, the money gets automatically deducted from your bank account as soon as the transaction is successfully processed. There’s nothing to pay back later since the money has already been taken from your account.

Many credit card issuer companies offer a $0 fraud liability guarantee automatically, meaning that you aren’t responsible for any fraudulent charges made with your credit card.

Debit and credit cards also differ according to the impact they have on the credit score. Using a debit card has absolutely no impact on your credit score because your bank account activity is not reported to the credit bureaus.

While credit cards, on the other side, has a direct impact on your credit score. Basically, your credit score is calculated based on below parameters :

• Payment history
• Credit usage
• Credit age
• Credit mix
• Inquiries for new credit

If you keep a healthy habit of making credit card payments on time then it helps to build your credit score while paying late could hurt it. Similarly, if you’re utilizing lesser credit from your monthly credit limit then it puts a positive impact, while using a higher amount from your credit limit can hurt your score.

Another major difference between debit cards and credit cards is fraud protection. Credit cards are offered more fraud protection by Federal law than debit cards.

Pros and Cons of Credit Cards:

The biggest advantage of having a credit card is its ease if use and safety. If your ard gets stolen then if you informed the issuer bank immediately then that card gets blocked and you’re likely to be reimbursed for any fraudulent charges. 

And another advantage is along with almost every purchase you make you get some regards or cashback which you can use later to avail of different monetary benefits. If used responsibly then credit cards can also help you boost your credit score. 

Now on the other side, credit cards also come up with heavy interest rates, which can be very expensive if you don’t maintain a healthy habit of paying your full due balance before the due date. It’s easier to spend more money with credit cards but in comparison to that you get a very short period to pay off the due amount  

If your credit card debt spirals and you can’t make minimum payments on your cards then it’ll hamper your credit score very badly, along with this late fees can also add higher interest rates, and because of such higher interest rates, you end up paying a lot more amount to the issuer banks.

Credit Card Pros & Cons

Pros: 

• Safer than Cash
• Reward points and cashback
• Helps you boost your credit score 
• Ease of use 

Cons: 

• Higher interest rates and late payment fees 
• Debt Spiral 
• Missing due dates hampers credit scores

How Do Credit Cards Affect Your Credit Score?

Credit cards can affect your credit scores in different ways, it totally depends upon how responsibly you use your card, late’s look at the five major scoring categories which contribute to deciding your final credit score:

Credit Usage :

How much of your monthly credit you use determines your credit utilization ratio. It’s calculated based on credit limits and balances that card issuer companies generally report at the end of each month’s billing cycle.

Having a lower credit utilization ratio is best for your credit scores and you can lower this ratio by opening new cards and using a limited credit amount from each card 

Payment History : 

Making a least a minimum payment before the due date each month can help you build a long history of on-time payments which ultimately benefits your overall credit score, missing the payment dates consistently will definitely hamper your credit score  

Credit Mix : 

Credit scoring models often consider whether you have an experience with instalment and revolving credit card accounts. Having different types of revolving accounts can help you improve your credit mix and ultimately increase your scores

Account’s age : 

If you have a long experience of dealing with credit cards can also help you build your scores so the older the account the higher can be the credit score (depending on the payment history)

Hard Inquiries : 

Card issuers will generally check your previous credit reports after you apply for a new credit card. If you have a bad credit report then this may hurt your score and can possibly create issues in getting a card 

How to Compare Credit Cards –

Now if you’re planning to buy your first credit card or maybe your next new credit card then it’s vital to compare various credit card options available in the market that fits your needs. Here are some of the key parameters to look out for while doing the credit card comparisons : 

• Introductory Bonus offer terms 
• Annual Fees 
• Annual Percentage Rate (APR)
• Interest Rates 
• Credit Limit 
• Reward Programs and Loyalty Points  
• Other/Additional fees (Late payment fees, Foreign transaction fees, Balance transfer fees etc.)

While choosing a card it’s helpful to look at the other benefits and features that the card is providing. For example, if you travel frequently then you’ll be looking for a travel credit card to get the reward points but at the same time if you get additional benefits in the same card such as airline fee credit or airport lounge access then definitely that card will help you make more reward points and save your money too! 

Every card has an annual fee, that’s why it’s important to compare the value of reward points and other benefits that we can get from the card with its annual fee

How to Use Your Credit Card Responsibly –

After receiving your new credit card, you need to be extra careful with it and use it responsibly to help manage your finances, earn more reward points and improve your credit score and that too without any extra cost! 

Below are some of the vital points you need to remember while using your credit card:

•  Pay your every month’s due balance in full before its due date, this way you can save unwanted interest charges on your spent credit amount 
• It’s important to treat your credit like a debit card, which means only using the credit card for the purchases that you can afford as per your income capacity. This is exactly similar to debit cards as we only spend that much amount which is available to spend.
• Try to use a small proportion of your monthly credit limit even if you’re pretty much sure that you can pay the amount in full before the due date, because if you use a large portion of your credit limit then it’ll increase your credit utilization ratio which in turn can decrease your credit score and can make card issuers worry that you’re overextended and can  face difficulty in paying the new debt 
• If you’re not able to pay the full amount before the due date then to avoid late payment fees at least pay the minimum amount that the issuer will inform you, also if the payment gets delayed by 30 days or more then could also harm your credit score
• And the most important point to remember is to read the terms and conditions page to learn more about the credit card’s fees so that you can have an idea that how and where you can use your credit card  

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