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How Do Credit Cards Work?
Perhaps you’re a recent graduate seeking credit card self-education or a new company looking for business financing options. In either situation, you’ll want to learn more about the advantages and potential pitfalls of credit cards. While some folks may shy away from credit cards, wise management of these programs can help your cash flow in a pinch and pave the way to low-cost auto loans and low-rate mortgages. We’ll offer a more detailed analysis of how credit cards work below.
What is a credit card?
A credit card is a debt instrument. In simpler terms, you are borrowing money from a bank to use for the purchase of goods and services. This process is a little different than how debit cards work. When it comes to credit vs. debit, debit cards only let you pay for purchases using funds already in your bank account.
Obtaining a credit card is heavily dependent on your credit score — and your income to a lesser extent. One key difference between a credit card and an auto loan, for example, is most cards are unsecured. Unsecured means you are not required to pledge collateral to acquire a card. An auto loan lender would use the automobile’s title as collateral until the loan is paid off.
How do credit cards work?
If you’re wondering how credit cards work, the process starts with the application. You’ll provide basic personal information online or via mail to an issuing bank, such as Chase or Bank of America. The bank will pull your credit history, and if all looks good, you may have an approval decision within seconds if you’re applying on the card’s website.
You typically receive the card in the mail and can begin to use it once it’s activated. At this point, you can purchase items or services at any merchant who accepts the card you hold. While an issuing bank backs the credit line, the payment network facilitates the behind-the-scenes transfer of funds between the businesses and the cardholder. To illustrate further, you’ll often see a business say it honors Visa or American Express; these are the networks that charge merchants for moving money around.
Types of credit cards
There are a few different categories of cards aimed at the spending habits or credit goals of consumers:
- Travel rewards. This type of card may offer points or miles per dollar spent on all purchases or in specific categories, which can then be redeemed to offset future travel costs. Travel cards often have perks that include free hotel stays or complimentary access to airport lounges.
- Cash back cards. Rather than points, purchases with a cash back card receive an automatic rebate on what you spend, letting you purchase gift cards or apply a statement credit to offset existing or future balances.
- Credit rebuilding cards. These may not have any reward structure and are usually desired by individuals who are either establishing credit or have had some financial missteps in the past. APRs on these options can sometimes run high, and often, there are annual fees involved.
- Secured cards. These cards require you to plunk down a cash deposit with the issuer. From there, the credit line either matches or exceeds the deposit. Rewards are rare, but basic protections apply, such as zero liability for cardmembers on unauthorized purchases.
How to choose a credit card
Choosing the right credit card depends on your circumstances. You might be a business owner with employees who travel frequently. As such, a card offering the most attractive travel rewards might be a good fit. If you’re a college graduate hoping to build credit for the future, you may need to acquire a secured card until you can progress to an unsecured card.
Regardless of where you stand, credit cards are a great first step to bigger and better things. Owning a card helps set the table for mortgage or personal loan qualification. When used prudently, a credit card can help your bottom line by rewarding each purchase with points or cash back to reduce or offset costs. The problem with credit cards starts when indiscriminate spending creates big balances that can’t be paid off immediately. Those balances can accrue hefty interest costs, and if late or missed payments result, these missteps can damage your credit profile and make it harder to obtain future borrowing.
Glossary of credit card terms
- Credit card: A form of debt used by individuals or businesses for quick and convenient purchases of goods and services
- Annual percentage rate (APR): The interest rate charged for purchases on applicable balances.
- Balance transfer: The movement of a high-interest rate credit card balance to a low- or zero-interest rate card program.
- Daily periodic rate (DPR): The daily amount of interest accrued on an existing card balance or APR/360 or 365.
- Penalty APR: If you make a late payment, your APR will increase to a penalty APR in most cases.
- Grace period: A period of time, usually about 30 days, in which no interest accrues on new purchases.
- Due date: The date by which payment must be made without incurring fees or penalty APRs.
- Credit limit: The total amount of credit extended to you for purchases.
- Revolving credit: You can charge a $1,000 purchase on a card, pay off the balance, and repeat the process indefinitely.
- Late fee: A fee that applies when you miss a due date.
- Over-the-limit fee: A fee that applies when you exceed your prefixed credit limit.
- Balance transfer fee: In moving a balance from one card to another, you’ll often pay a percentage of the amount or a flat fee, whichever is greater.
- Cash-advance fee: The fee you’ll incur by withdrawing cash from an ATM or cashing a check cut by the issuer.
- Foreign transaction fee: A fee — usually about 3% — levied against the cost of goods or services purchased abroad.
- Returned-payment fee: A fee charged by the issuing bank should your payment not be honored by your personal bank.
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