How Credit Cards Work: A Guide

A credit card is one of the popular financial tools as it offers several benefits. Knowing how credit cards work can help to avoid any potential pitfalls later on.

A credit card is a type of payment card that allows a user to borrow money from its issuer, such as banks or other financial institutions, to make purchases. Charges are made against the user's line of credit, also called their credit limit, or the maximum amount the user can borrow instead of his or her cash deposits. When a user purchases an item using a credit card, his or her account accrues a balance that must be paid off each month. If he or she fails to pay off the credit card on time, the bank charges additional interest and late fees.

How Do Credit Cards Work?
Every time someone buys something using a credit card, the line of credit decreases by the same amount. If a user has a credit limit of $1,000, for example, and buys an item worth $100, he or she has $900 available credit left. This means that he or she owes the bank $100. If the user buys another item worth $300 before repaying the outstanding balance of $100, the user will owe the bank a total of $400. Thus, the available credit remaining on the card is $600.

What makes credit cards different from regular loans is that the credit limit is restored when a user repays the balances. In the example presented above, when the user repays the $100 balance, his or her credit limit goes back to $1,000. However, if the user only pays off half of what is owed, the credit limit would only be $950. The credit limit decreases as the user makes a purchase but increases as he or she pays back the balance. Users can spend and repay as much as they want, provided that they abide by their banks' terms and conditions, such as making timely payments and avoiding overdrafts, which is charging more than a user has available in their bank account.

Credit Card Fees and Interest
Banks give people a certain period of time to repay all of their outstanding balances plus interest. This period of time is known as the grace period, which is typically around 25 to 30 days. If a user fails to pay on or before the end of grace period, the unpaid balance will start to accrue additional interest. The interest rate, known as annual percentage rate, varies from one institution to another.

Because credit cards are considered unsecured loans and require no collateral backing up the debt, the interest rate charged to the unpaid balance is much higher compared to other types of loans, such as mortgages. Not only will the balance and interest need to be paid off, but late payments could actually decrease a user's credit score. In addition to interest and late payment fees, other fees that the bank may charge include over-the-limit fees, annual fees, cash advances fees, balance transfer fees and foreign transaction fees.

Credit Scores and Rewards
When a user pays off his or her statement balance in full each month, he or she can expect his or her credit score to increase. This means that a user is more likely to qualify for a higher credit limit. The amount of a credit limit depends on a person's credit score and income. Credit cards can also come with rewards programs in which cardholders earn points for every dollar spent. The rewards can be redeemed for goods and services, cash back or frequent-flyer miles.