How Do Credit Cards Work?
When used responsibly, a credit card can help you finance new purchases, shop securely or earn rewards in exchange for spending. But with high APRs and a range of fees, they can also be risky. Here’s a closer look at modern credit cards and what you need to know about them.
Some loans – such as purchases you make on a charge card – are expected to be repaid quickly. For example, a charge card requires you to pay off your purchases in full when you receive your monthly bill.
Other loans, such as credit cards, give you more time to pay off your purchases and only require you to pay a minimum amount each month. In exchange for allowing you to carry over your debt from month-to-month, your credit card will charge you interest.
The amount of interest you’re charged will depend on the card you choose and your credit history. For example, travel cards tend to charge higher amounts of interest. So do cards that are designed for consumers with low credit scores.
Unlike charge cards and installment loans, credit cards give you a revolving line of credit (often called your credit limit) that allows you to borrow up to a certain amount.
For example, if you have a $5,000 credit limit, you’ll be allowed to charge any amount you want, up to that $5,000 limit. However, you won’t be able to charge any more than $5,000 until you’ve paid down your balance or have been given a credit limit increase.
Common credit card charges
Most credit cards charge a wide range of fees. However, the fees are typically tied to optional services, such as balance transfers, cash advances and revolving balances. As a result, you may not have to pay any fees at all if you use a no annual fee credit card, pay off your purchases in full each month and only use your card to make new purchases.
Here are some common charges you might encounter on your credit card:
- Standard APR: Your annual percentage rate (APR) determines the amount of interest you’ll be expected to pay if you carry a balance from one month to the next. Most credit cards are variable-rate credit cards, meaning their APRs are tied to a benchmark interest rate called the prime rate. However, some cards are fixed-rate credit cards and so their APRs are unaffected by the prime rate.
- Balance Transfer APR: If you transfer an old balance to your new credit card, your balance transfer APR will determine how much interest you’re charged on your transferred balance.
- Cash Advance APR: If you borrow cash from your credit card – for example, by writing a credit card check or taking out cash from an ATM – you’ll be charged a special cash advance APR that’s often significantly higher than your regular APR.
- Penalty APR: Your credit card issuer may also charge a higher APR, called a penalty APR, if you fall behind on payments.
- Annual fee: Some credit cards charge a fee just for owning the card. For example, if you open a rewards card with extra generous benefits or get a secured card for consumers with bad credit, you may be charged an annual fee.
- Balance transfer fee: If you transfer debt onto your new credit card, your card issuer may charge you a percentage of the total amount you transferred. Balance transfer cards usually charge a fee of $5-10 or 3-5% of the transferred balance.
- Cash advance fee: Your card issuer will also charge you a percentage of the amount you borrowed if you take out a cash advance.
- Foreign transaction fee: Some credit card issuers also charge a percentage of any transaction that you make abroad or in a foreign currency. Foreign transaction fees tend to be 3% of the purchase. If you’re going to be traveling overseas, a card with no foreign transaction fees can help you save.
- Late payment fee: Your credit card issuer may also charge you a fee each time you pay your bill after your payment due date. Under federal law, a late payment fee can’t exceed $40.
See related: Picking the right credit card
Credit card benefits and promotions
Many card issuers also add special promotions and benefits to their credit cards in order to attract new customers and encourage existing cardholders to continue using their cards. As a result, your card may offer:
- An introductory APR: Some credit cards offer new cardholders a low or 0% APR on new purchases for a set period. For example, a card may offer to temporarily waive interest for a year or more.
- An introductory balance transfer APR: Some credit cards also offer a promotional interest rate on balances you transferred from other loans or cards. For example, you may be given a year or more to pay off the transferred balance before you’re charged any interest.
- Fee waivers: To attract customers, some credit cards waive common fees, such as balance transfer fees or foreign transaction fees.
- Rewards: Many cards also offer a rewards program. For example, you may be offered cash back, points or travel miles in exchange for using your credit card.
- Sign-up bonuses: Some credit cards also offer a one-time rewards or cash back bonus when you first sign up for a credit card. They often require you to spend a certain amount in a set time period in order to receive the bonus.
- Ongoing bonuses: A credit card may also offer other kinds of bonuses throughout the year. Depending on the card, you may receive a bonus when you redeem your rewards or when you spend a certain amount.
- Credit card benefits: In addition, many credit cards offer purchase protection and travel insurance benefits, such as extended warranty, car rental insurance and travel accident insurance. Most cards also offer zero liability fraud protection, so you don’t have to worry about losing money if your card information is stolen.
- Additional card perks: Some rewards cards with annual fees also offer other credit card benefits, such as travel credits, airport lounge access and more.
Credit cards are also subject to a number of consumer protection laws, including:
- The Credit CARD Act of 2009: This law offers a number of protections for consumers, including protection from sudden rate increases and excessive fees.
- The Fair Credit Billing Act: Among other protections, this law gives consumers the right to dispute fraudulent or inaccurate charges.
- The Fair Credit Reporting Act: This law gives consumers the right to access their credit reports once per year from each of the three credit bureaus – Equifax, Experian and TransUnion – for free through AnnualCreditReport.com and dispute errors on their reports.
See related: 8 things you must know about credit card debt
How to get a credit card
You’ll need an established credit history, with a track record of on-time payments, in order to qualify for most credit cards. However, some credit cards are easier to get – even if you’ve never used credit before.
Secured credit cards are designed to help cardholders build a positive credit history. In exchange for a refundable deposit to help secure the loan, you’ll be given a card that you can use to make a limited number of purchases. Over time, you’ll build a positive credit history by making on-time payments.
Once you’ve built up a track record of using credit responsibly, you’ll eventually be able to qualify for other cards – including cards that offer rewards and other benefits.
Kelly Dilworth is a former staff reporter at CreditCards.com. She began her career in journalism at The Atlantic in 2007, then detoured into nonfiction book publishing for several years. She returned to journalism in 2010 and since then has written about everything from 20-somethings with Herculean credit scores to the Federal Reserve’s monetary policy decisions.