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How Do Credit Cards Work?

By Ellevest Team

If you’ve never had a credit card before, trying to learn more about them can be … a lot. There are so many options to choose from, and the world of credit cards has some hefty vocab that doesn’t always get defined.

How Do Credit Cards Work?

But once you learn the basics, credit cards are pretty straightforward. And once you have an understanding of how they work and how to use them responsibly, they can be a useful tool in your financial toolbox.

First things first: Do you need a credit card?

Nope. It might seem like you need a credit card, based on the billion dollars a year (literally) that credit card companies spend trying to convince you to get one. Or based on that Instagrammable vacation your friend booked on credit card rewards alone. Or even based on the fact that it just feels like everybody has one. But it’s not true.

It’s entirely possible — and reasonable — to forego the whole credit card thing and just use the debit card connected to your bank account instead. You wouldn’t be alone. Far from it, in fact: Recent research found that debit cards are people’s “overwhelmingly preferred method of payment,” with 54% of respondents saying they prefer to pay for things with debit cards. Meanwhile, only 26% of people preferred credit cards.

Also worth noting: A lot of the advice about how to build or boost your credit score involves credit cards (more on that in a minute). But using a card is not the only way to do it — in fact, here’s a whole roundup of advice for building credit without a credit card.

So whether or not you get a credit card of your own is entirely your preference. There are pros and cons either way. If you do decide to get a credit card, here’s what you need to know.

How credit cards work

In the moment, using a credit card feels a lot like using a debit card — the cashier rings up your snacks, you swipe or insert your little piece of plastic, the machine thinks for a sec, and then your payment is “approved.” You grab your bag of chips and guac and head off.

But they work differently behind the scenes. With a debit card, you’re paying for your purchases directly. When a transaction is approved, the money is taken out of your bank account (aka debited) right away. But with a credit card, you’re actually spending someone else’s money — not your own — and you’re expected to pay it back later.

Using credit cards is a form of borrowing money

Instead of being linked to your bank account like your debit card is, a credit card is linked to an account you hold with your credit card provider (Mastercard, American Express, Visa, etc). Your account lets you borrow money from them, up to a certain amount, so that you can buy things.

This type of borrowing works differently from installment loans, like mortgages or student loans. With those, the bank lends you a set amount of money up front, and you pay it back over time in installments. A credit card account, on the other hand, is a form of revolving credit — which means you can dip into it a little bit at a time, again and again, on a use-it-as-you-need-it basis.

Every time you use your credit card to buy something, the amount of your purchase is added to your account’s outstanding balance. Every time you make a payment to your credit card provider, it lowers your outstanding balance. So if you were to spend $250 on your card today and then $50 the next day, your account’s outstanding balance would be $300. Then if you were to pay $100 back, your new outstanding balance would be $200.

The max outstanding balance that your credit card provider will let you hit is called your credit limit. They decide on that number based on your income and credit history. If you spend your card’s whole credit limit (aka “max out” your card), you won’t be able to use it again until you pay back some of that outstanding balance.

Here’s an example: Let’s say you have a credit card with a limit of $2,500. If you had an outstanding balance of $250, you’d only be able to spend $2,250 more. Once you paid that balance, all $2,500 of your credit limit would be available to you again.

How the process of borrowing and paying back works

Credit card accounts typically operate on a monthly schedule, called a billing cycle. On the last day of your billing cycle (aka its closing date), your credit card provider will finalize your monthly billing statement.

Your statement will show a list of the transactions you made during that billing cycle, including all of your individual purchases and payments. (We recommend checking this list each month to make sure it’s accurate, and reaching out to your provider if it’s not.) These transactions will all add up to your statement balance, which is the total amount you owe the credit card provider at that time.

If you’re able to pay back the whole statement balance at once, you should (more on why in a sec) — but you don’t have to. You’re only required to pay back a small part of the balance each month, which will be listed on your statement as the minimum payment due. This amount is usually either a few percentage points of your statement balance or a set minimum, like $25 — whichever is higher.

You have to pay the minimum payment by the listed due date, or else your credit card provider will probably charge you a late fee and list the missed payment on your credit report (not good). Your due date will usually be about a month after your statement’s closing date. (This buffer of time is called the grace period.)

Why you should always try to pay back your whole balance every month

If you pay back your whole statement balance every month, then that’s that, and you’re good to go. But if you don’t pay the whole thing off — like if you only pay the minimum payment — you’ll carry a balance to the next month. And carrying a balance isn’t free. If you do it, you’ll have to pay interest.

You’ll be given an interest rate based on the market interest rates and your credit history, and it will be listed on your account’s cardholder agreement. It’s expressed as an annual percentage rate (APR), which is the percentage of unpaid charges you’ll pay per year. You’ll see any interest charges (sometimes called “finance charges”) listed on your billing statement.

The average credit card interest rate in the US is almost 18% — and that’s really high. To put that into perspective: Let’s say someone owes $9,300 in credit card debt with an interest rate of 17.8%. They make minimum payments only, assuming these payments are 3% of their balance or $25, whichever is greater. It would take this person more than 17 years to pay off their card. And they’d pay $8,600 extra in interest. Yup.

This is why credit cards can be so risky: It’s possible to spend more on your credit card than you can afford to pay back each month — but if you do, it will cost you. That’s what makes it so easy to dig yourself into credit card debt, and really hard to dig yourself out.

What to know about credit card fees

Mainly: that they exist, and they’ll be listed in your cardholder agreement. Here are some common ones:

Annual fees

This is a yearly fee that you pay in exchange for the right to own and use your credit card. Some cards have no annual fee at all, which is nice. But the cards that charge annual fees usually provide extra value — things like more cash back, more rewards points (things like airline miles), access to services (like a special airport lounge), or reimbursement for some types of charges (like checked bag fees).

If your card has an annual fee, it will typically show up on that month’s statement as an extra charge. Keep track of when your annual fee will be charged so that you’re ready when it hits.

Late fees

If you don’t pay your minimum payment by the due date, you’ll probably be hit with a late fee. There are laws about how much this can be — up to $25 the first time you’re late, and $35 after that. You also can’t be charged a late fee greater than the amount you owe.

Foreign transaction fees

You can use most credit cards in other countries, but it’s not always free. Some cards will charge a foreign transaction fee (sometimes called an FX fee) if you buy something in a different country or currency. A common foreign transaction fee is 3% of the purchase amount.

Cash advance fees

Some credit cards allow you to tap into your credit account to get cash. You’d “withdraw” cash (which technically belongs to your card provider) using your credit card, and then you’d pay it back later. Typically, you’d have to call your provider to set up a cash advance PIN, and then you’d be able to use your card at an ATM. Your cash advance limit will probably be lower than your normal credit limit.

Cash advances tend to come with fees, usually around 5%. They also typically have a higher interest rate than everyday purchases, and the interest starts accruing immediately (aka there’s no grace period). So they’re expensive, but they’re an option you could turn to in an emergency.

Other types of credit cards

Retailer credit cards

These work mostly the same way as “normal” credit cards, but instead of having a financial institution as your credit card provider, the credit card provider is a retailer, and the only place you can use the card is at that specific retailer. Target’s RedCard is one example.

Retailer cards’ big pro is that they usually come with extra discounts or perks when you use them. That’s a tool to promote loyalty, of course, but it also costs the retailer less when you use their card at their store — if you use a “normal” credit card, the retailer would have to pay your provider a small fee. Retailer cards’ big con is that they tend to have higher-than-average interest rates (Target’s is almost 25%) — so they can really cost you if you don’t pay the statement balance.

Some retailers have partnerships with major credit card providers, like Amazon’s Visa credit card. Those still work like “normal” cards, and you can use them anywhere. They just get you extra perks with that retailer.

Charge cards

Charge cards are less common than “normal” credit cards, but they work similarly. The main differences are that you aren’t given a credit limit, and you aren’t allowed to carry a balance. Instead, the card provider would approve each of your purchases as you charge them, one by one, based on your credit history, income, etc. At the end of the month, you must pay the whole statement balance. That means there’s no interest to pay (but there are late fees).

Charge cards have annual fees and have historically come with more perks, although competition in the credit card market is changing this.

Secured credit cards

Secured credit cards also work more or less the same way as “normal” credit cards, except your credit limit is secured (aka backed) by a cash deposit that you put down. If you can’t pay off your balance, the credit card provider just keeps your deposit. So they’re easier to get approved for, because there’s less risk that the provider will lose money on you. That makes secured cards especially useful if you’re trying to build or boost your credit score. Keep in mind, though, that they sometimes have more fees and higher interest rates than “normal” credit cards.

How using a credit card can help or hurt

As we mentioned above, the ideal way to use a credit card is to pay your statement balance in full, on time, every month. This means not spending more than you can afford to pay off. It means avoiding those interest charges, and avoiding debt. Using credit cards like this can do a lot of good for your financial situation.

But credit card debt … happens. Maybe you didn’t have enough cash to pay for a financial emergency — credit cards are really useful in situations like that. Or maybe money was tight, and you needed to rely on credit to make ends meet. Sometimes it’s about doing what you can with what you have, and there’s nothing wrong with that.

What’s not so OK is racking up expensive credit card debt to buy things you don’t need, or things you could have saved up for instead. The temptation is very, very real, but trust us — credit card misuse is just not worth it.

The perks of careful use

Credit score

When you use credit cards responsibly, they can help you build up a credit score if you don’t have one yet, or boost your score if you do. That’s because the biggest aspect of your credit score is your payment history. Making on-time credit card payments month after month is exactly the kind of thing you want to show up on that history.

You can also help boost your credit score by keeping a low credit utilization rate — aka the percentage of your credit limit you’ve used up. If you keep your utilization rate less than 10% — by either not spending much on your card, or by making payments more frequently than once a month — that can also help a lot. (Under 30% is second best.)

Finally, having a credit card can add some variety to your credit report. The more types of credit you have (cards, student loans, auto loans, personal loans, etc), the better for your score.

Rewards

Credit cards almost always come with some type of rewards system. Maybe you get paid cash back, equal to a certain percentage of the purchases you make each month. Or maybe you earn points that can be redeemed for cash, or airline miles, or hotel rooms, or something else like that.

Rewards can be really great — you can put cash back toward savings or student loans, or save money next time you travel with airline miles. But it’s definitely not worth it to spend money you can’t pay back just to get points. Any rewards you’d earn wouldn’t be worth more than the interest you’d pay.

The risks of misuse

Debt

Credit card debt costs a lot. Remember that (hypothetical) person we mentioned who paid only the minimums on $9,300 in credit card debt for 17 years and ended up paying $8,600 more in interest charges? That doesn’t sound fun. Debt also takes away some of your flexibility and makes it harder to get through emergencies — your credit card provider will still come calling if your source of income goes away.

In one recent study, 60% of people who had credit card debt said it caused them at least some stress, with 30% saying it caused a lot of stress. Makes sense.

Credit score

Just like using a credit card responsibly can help your credit, misusing it can hurt your credit. If you miss credit card payments, that hurts your credit report’s payment history. Your credit card provider might also add a derogatory mark to your report, which instantly lower your score and stay on for a really long time. Carrying a balance would probably mean using up a good amount of your overall credit utilization rate, too.

How to know if you’re “ready” to get a credit card

If you think you want to get a credit card but you’re nervous about the slippery slope toward debt, there are some good habits you can work on building up first. Once you’ve mastered them, you’ll know you’re ready.

First, make a spending plan for the month ahead. (We like the 50/30/20 rule, which is a high-level, flexible budgeting approach.) Second, keep track of your bank account’s balance. Know how much you have coming in each month, and pay attention to what you’re spending that money on. And third, don’t overdraw your account. This is the ultimate version of not spending more than you can afford to pay.

Once you’ve successfully followed those habits for several months in a row, you might give credit cards a try. Later, if you get a credit card and find yourself overspending, you can reverse course: Hide your card in a drawer or something until you get your habits back in check, and then try again.

If you’re still with us after alllll that info, you’re a rock star. But you’re also super knowledgeable about how credit cards work and how you might use them (if you want) to improve your financial life. Go forth and spend! (Responsibly!)


Disclosures

© 2020 Ellevest, Inc. All Rights Reserved.

You may or may not have noticed that we linked to creditcards.com for information about credit card interest rates. FYI, LinkOffers, Inc (“Solicitor”) serves as a solicitor for Ellevest, Inc. (“Ellevest”). Solicitor will receive compensation for referring you to Ellevest. Compensation to the Solicitor will be $10 per membership activated. You will not be charged any fee or incur any additional costs for being referred to Ellevest by the Solicitor. The Solicitor may promote and/or may advertise Ellevest’s investment adviser services. Ellevest and the Solicitor are not under common ownership or otherwise related entities.

Retailer credit card examples are provided for informational purposes only, and do not constitute or imply an endorsement of any third party’s products or services.

The information provided should not be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice.

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Investing entails risk including the possible loss of principal and there is no assurance that the investment will provide positive performance over any period of time.

Banking products and services are provided by Coastal Community Bank (“Coastal”), member FDIC, pursuant to license by Mastercard International. Your Ellevest Spend and Save Account deposits will be insured to the regulatory limits by the FDIC.

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