How Do Credit Cards Work?

How Do Credit Cards Work?

When used correctly, credit cards can empower you and help you build your financial future. Of course, they have their downsides, but by educating yourself on the answer to the question, “How do credit cards...

When used correctly, credit cards can empower you and help you build your financial future. Of course, they have their downsides, but by educating yourself on the answer to the question, “How do credit cards work?” you can put them to work for you in the right way.

Learning how to correctly utilize credit cards is one of the most important things you could do for your finances. 

What Are Credit Cards?

Credit cards let you borrow money from lenders, like banks, to purchase goods and services.

How do credit cards work, exactly?

  • You make a purchase against the credit limit given by your card issuer.
  • You receive a bill the next month.
  • You pay either part or the total amount of the bill.

A lender will give a due date for when you have to pay your bill. Paying off your bill in full, every month, ensures you don’t get into debt. On the other hand, sometimes a little time is needed to pay back charges. Credit lenders allow you to make anything from the minimum payment to paying off your balance in full.

Only making the minimum payment each month could cause you to go into further debt (with added interest) that you may not be able to pay off in the long run. If your debt gets too out of control for you to handle, you may have to file for bankruptcy to get back on track. 

How do credit card payments work when it comes to your credit score? Being responsible with your credit card payments by paying on time and staying out of debt will increase your credit score, a number that ranges from 300 to 850.

Your credit score shows your creditworthiness to lenders, as well as your ability to repay borrowed money. The higher the number, the more likely you are to receive attractive loan offers with favorable interest rates. 

A score lower than 580 is considered poor credit, while a score between 580-669 is fair. A score between 670-739 is good, 740-799 is very good and 800 or above is exceptional.

The three credit bureaus, Equifax, Experian, and TransUnion, will each give you a score and a breakdown through your credit report. You can check your credit report for free through any of these providers or through services such as Credit Karma.

Now that you’re aware of how credit card payments work, you can take control of your credit journey by staying on top of your payments and report to increase your credit score over time. 

How Do APR and Interest Work?

Now that you know the answer to, “How do credit cards work?” you’re likely asking, “How does APR work?” and “What does APR mean?”

The annual percentage rate (APR) is the interest rate you will pay to borrow money on your credit card. If your credit card is charging you interest, it’ll be based on the APR. For example, the average minimum credit card APR for borrowers with good credit is 14.92%. The maximum APR for those with bad credit is 22.85%. 

You’re aware of the answers to,” How does APR work?” and “What does APR mean?” but you should also know about penalty APR. Your credit card issuer might charge you a penalty APR, which is an increase in your APR percentage if you miss a payment or you have a payment rejected.

If you don’t pay off your card in full every month, you’ll have a revolving balance and need to pay interest on your balance based on the APR.

Sometimes, credit card issuers will offer borrowers 0% interest for a certain period of time as a special promotion. But once that period ends, it’s up to borrowers to pay back the interest based on the new APR. 

Avoiding Interest 

It’s crucial to make payments on time to avoid a penalty APR and interest in general. If you have a lower credit score, then you could be paying upward of 22% (or more) in interest each month.

This makes it much harder to pay down your debt. If you look at your credit card statement, it should tell you how long it’ll take you to pay off your debt if you only make the minimum payments every month.

You’ll see that it’ll take much longer—and you could end up wasting hundreds or even thousands of dollars because of high interest. 

Credit Cards for Bad Credit or No Credit

Typically, if you have decent credit, you can get an unsecured credit card, where you don’t have to put down any collateral in order to access your credit.

But if you have bad credit or no credit, then your only option might be a secured credit card, where you have to put down a security deposit to use the card. If you don’t pay your debt, then the lender will take your security deposit.

Usually, your security deposit is going to be your credit limit. Unfortunately, many of these card companies will charge you a higher APR than an unsecured credit card, which can cause more issues than it solves. 

Another option is to get a prepaid card. These are bank cards that you preload with money through cash, a paycheck, or a bank account. They won’t help you build credit, but they will teach you good spending habits since you can only spend as much as you put on the card.

Also, they are accepted anywhere you’d use a normal debit or credit card. 

Staying Ahead of Credit Card Debt

A credit card should not be treated like an extra savings account. Instead, you should aim to pay off your full balance on your credit card bill every month. Otherwise, aside from paying interest, you could overspend and hit your limits, which affects your credit utilization rate, one of the core components of your credit score. 

Your credit utilization rate is the amount of credit you use compared to the amount of credit you can use. If you max out all of your credit lines, your credit score may decrease, since your credit utilization ratio is the second-most important factor in determining your credit score.

Your ratio should be 30% or under to avoid a hit on your credit score. For example, if you have a $1,000 spending limit, you should aim to carry a balance less than than $300.

The lower your credit utilization ratio is, the better. 

Credit Cards vs Charge Cards and Debit Cards

You may be wondering about the difference between credit cards, charge cards, and debit cards.

Here’s some more information on each. 

Credit Cards 

Credit cards are what you use to borrow money from lenders. You’re expected to pay back your debt in a timely fashion. If you use a credit card responsibly, you could increase your credit score and gain access to better loan terms, both in the amount borrowed as well as APRs.

Charge Cards

Charge cards are like credit cards because you’re borrowing money up to your credit limit. However, some charge cards do not have a credit limit and will approve your bigger purchases on a case-by-case basis.

Typically, you will need to pay back your charge card balance within a month.

Debit Cards 

When you make a purchase with a debit card, the money is taken directly out of your checking or savings account.

Debit card usage does not impact your credit score. 

How Do I Choose the Right Credit Card?

There are various types of credit cards you may have heard of, from unsecured to secured credit cards and student cards to cashback credit cards, rewards cards, and more.

Here’s some more information below.

  • Unsecured credit cards: These are standard and for people with fair to exceptional credit scores. They do not require collateral, like a security deposit.
  • Secured credit cards: These are for people with poor to fair credit scores or no credit, and require collateral, like a security deposit.
  • Store credit cards: These are specific to a store and may offer incentives and discounts at the store when you use them to make purchases.
  • Student credit cards: If you’re still in school, you can start slowly building your credit with a card that’s marketed specifically to students. It's important, however, to be especially careful with these types of cards. Only spend what you can pay back each month, and monitor your balance carefully to avoid going into debt.
  • Cash back credit cards: How do cash back credit cards work? When you sign up for a cash back credit card, you will see that it gives you a certain percentage back, such as 1-2% based on the types of purchases you make. Then, you can use that 1-2% back on other purchases, or you can put it toward your credit card bill.
  • Balance transfer credit cards: These credit cards allow you to transfer your credit card balance from one card with interest to another card that will give you an introductory period offering no or low interest. This also works if you find a credit card issuer with better overall rates than your current one, such as one from a credit union.
  • Mileage rewards credit cards: How do credit card miles work? You’ll need to sign up for a rewards travel credit card first. These credit cards give you perks like airline miles with specific airlines for every purchase you make. As you accumulate miles, you can apply them to ticket purchases or even to cover an entire trip. Pay close attention to the terms on these cards, however, as many have blackout dates, or dates you can't purchase a ticket for. Some also only allow for a certain type of travel, such as domestic only, or only to certain parts of the world.
  • Rewards credit cards: The types of cards usually have a point system to reward you for every purchase you make. This could be a percentage of the entire purchase, or a dollar to point ratio. For example, 20% of your purchase converts to points, or for every $2 spent, you get one point. These rewards can then been redeemed for gift cards, goods or experiences such as concert tickets.

Keep in mind:

  • Most credit cards charge late fees for late payments.
  • Other fees usually include foreign transaction fees, balance transfer fees, cash advance fees and other types of payment fees.
  • Credit card companies like Mastercard, Visa, and American Express offer fraud protection in case your card gets lost or stolen.
  • Deciding what the best credit cards for you are going to be based on your lifestyle, FICO credit score and spending habits.

Credit Card Alternatives

If you need to borrow money but don’t want to become a credit cardholder, then you may want to consider taking out a personal loan from a lender. You can compare rates from lenders and see how much they’re willing to let you borrow.

A short-term loan could help you cover costs in the immediate future. You’ll need to pay it back quickly, or else you could be subject to high interest. 

Additionally, you could use Possible Finance, a payday loan alternative.

We offer lower fees than a traditional payday lender and let you borrow up to $500 in a matter of minutes if you use our app. You can build a positive credit history by repaying on time and can apply even if you have bad or no credit. 

Getting Started With Credit Cards

Once you feel like you’ve learned how credit cards work, you can choose to sign up for one to build your credit.

If you pay off your full balance on time every month, you remain in good standing with the credit bureaus and can achieve a brighter future when it comes to your personal finances. 

And if you’re thinking of a credit card alternative like Possible Finance, then make sure you download our app today to apply.

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