How Do Credit Cards Work: The Definitive Guide

how do credit cards work

In this world of fast-paced technology, you must learn about the essential ones to stay ahead of the curve.

You need to make sure that you know everything about how to do credit cards work.

Want to know the best part?

You will get to know every bit of essential information about the working of credit cards. The good thing is that every part of it will be in detail and easy to understand.

So, let’s get started,

What Is a Credit Card?

What Is a Credit Card

A card that you can use to make any sort of purchasing, withdrawing cash, or paying bills. This physical card is also referred to as a short term loan.

When you first get a credit card, the company sets a credit limit for you. Within this limit, you can pay bills and do purchases as allowed by the company.

As you keep using the card the available credit reduces to a limit. You then need to pay back the credit card company as much as you spent from that card.

Here’s the kicker!

Credit cards are either unsecured or secured. So if you opt for secured, you need to deposit cash first. This cash usually doubles up as your credit limit.

How do Credit Cards work?

How do Credit Cards work

We all know what credit cards are for; bills, purchases, etc. The bank agent receives your details even if you use the card once. To process the transactions, the credit card network gives authorization to the bank.

After verification, these transactions are either approved or declined by the card issuer. If the transaction gets approved, your available credit reduces. Also, the payment goes to the seller.

Once the month ends, you will get a statement from your card issuer. It shows all the transactions of that month alongside your new and previous balance. Also, the due date and min payment due to the billing cycle.

Here is a basic example to explain how credit cards work. For instance, you bought an item with a bill of $100. So you will simply insert the credit card and the rest goes on like:

  • First, the details go to the agent’s bank called acquiring bank. So the respective bank needs to get authorization from the credit card network.
  • Now, this authorization request can be also routed through the card issuer. The issuer can confirm the number, security code (CVV), and credit limit.
  • Keep in mind that Visa and Mastercard come with a 3 digits security code. Whereas American Express offers a 4 digit security code.
  • The card issuer will either approve the transaction or decline it. Then sends the respective response to the acquiring bank.
  • Once the bank gets authorization for accepting the transactions. The issuer will put the amount on hold and your available credit value decreases.
  • The agent will send all the transactions along with a batch to the bank.
  • Afterward, you come across the clearing process. Now, the bank will send this batch for processing to the card network.
  • Next, this transaction goes to the issuer from the credit card network. The issuer will respond to this and send the amount to the credit card network.
  • The credit card network will pay the less applicable fees to the bank. Once the fees are clear, as recompense the bank agent will receive up to $98 for your $100 bill.
  • To avoid any interest you will need to pay the $100 amount sent by the credit card issuer within the due date.

Take Advantage of the Grace Period:

By grace period it means a period between the dates of purchasing on the card to the due date on the statement.

Now, this period can easily vary depending upon the card issuer. Yet the common grace periods are from 21 days to max 25 days.

If you pay the total bill within your due date, you are good to go. Or if you didn’t have any balance from the previous month then also you are free from interest charges.

Here’s the deal!

At this point, most of the users make a big blunder by underestimating the dues. They think that ignoring the balance once won’t make a difference. But what they don’t know is that debt is a black hole that sucks up everything.

The APR or annual percentage rate depicts the cost of balance carried on an annual basis. This rate includes the interest rate as well as other costs.

Tied to the Prime Rate often credit cards have variable APR. This refers to the fact that the APR can change over time.

Even though strict guidelines are set by the CARD Act of 2009. The act allows credit card companies to either raise the raise or not.

How Does Credit Card Interest Work?

How Does Credit Card Interest Work

No matter which credit card you have, it comes with an interest rate. This is an annual percentage rate or APR that measures your annual borrowing cost. It also includes any extra costs like the annual fees, etc.

The interest rate can vary as most credit cards use a variable APR. It gets affected by fluctuations in the prime rates. The Federal Reserve is responsible to set this prime rate.

For instance, the base rate will be 10.74% if the prime rate is 4.75%. Then the variable APR will be 15.49%. You will end up paying compound interest if you carry any balance.

It is a great thing to have compound interest in regards to saving accounts. But for the credit card balance, this can be a major setback.

Credit Cards vs. Debit Cards: What’s the Difference?

Credit Cards vs. Debit Cards What's the Difference

If you are also confused by the terms credit and debit card like the majority. Most people do not know how do credit cards work let alone know the difference between a debit and a credit card. Don’t worry we are here to help you out and clear the differences.

First, we will take a look at credit cards. So when you use a credit card to buy a thing or pay for anything.

The money used is not yours but of the credit card company. This money you will have to return at the end of the billing cycle along with interest (if any).

Whereas debit cards are the complete opposite of credit cards. Unlike the money deducted from the credit card company, it goes off from your bank account. 

So in short, when you use a debit card the money spent is your own. And the plus point is you won’t have to pay back to any company as the money was yours.

Another prime factor that differentiates credit and debit cards is the credit score. With a debit card, you won’t have to worry about credit score impact. As there is no report sent to any credit bureaus.

But on the opposite hand, credit cards do have a direct impact on the credit score. Most of the credit companies calculate this score based on factors like:

  • Payment history
  • Credit usage
  • Credit age
  • Credit mix
  • Inquiries for new credit

Then another aspect to consider is that timely credit card payments help you score. But the late payments have an alternate impact on this score.

Moreover, if your balance is low compared to the credit limit, it is a favorable point. Yet again maxing out the limits can have negative impacts on the score.

One of the most important points to ponder is fraud protection. With debit cards, you may not be able to enjoy such benefits. But the Federal Law offers more protection to credit cards.

Debit Card Liability:

  • If a stolen or lost card gets reported before someone else uses it. You won’t be responsible for those unauthorized transactions.
  • The liability is only limited to $20 if the lost/stolen card gets reported within 2 days.
  • The liability is limited to $500 if the card gets reported after 2 business days. But the days are less than 60 calendar days with the statement sent to you.
  • You will be responsible for transactions if the card gets reported after 60 days.
  • In case your card is not lost but still used for unauthorized transactions. If reported within 60 days you won’t be liable and the statement sent to you.

Credit Card Liability:

  • Your liability for unauthorized transactions is $50 under the Fair Credit Billing Act.
  • You won’t be responsible even if the card number is stolen and not the card.

How to Compare Credit Cards?

Comparing credit cards is important especially if you are about to buy a new one. Even if it is not your first ever, still comparing a few options won’t do any harm.

When looking at different options, here are the key aspects any credit card must have:

  • Introductory bonus offer terms
  • Promotional APR terms and conditions
  • Annual fees
  • Reward programs
  • Regular variable APR for purchases
  • APR for balance transfers and cash advances

Apart from these major aspects, you need to take into account other features and benefits (if any).

To decide if it’s worth a credit card with an annual fee, would help to compare the value benefits and rewards to the fee.

Then if you opt for a travel credit card, it usually offers you to earn points or miles toward hotel stays, flights. etc. So look for benefits like airline fee credits or airport lounge access.

Types of Credit Cards:

Types of Credit Cards

Below are the most common types of credit cards.

Plain Vanilla Credit Cards:

Such cards won’t offer you any rewards but have low APR. That is why they are referred to as vanilla credit cards.

If you want to have a card that would fit in for a financial emergency, this one’s for you.

The reason is a card with a low-interest rate will save you money if you had to carry the balance for a few months.

Rewards Credit Cards:

As the name depicts, these cards bring along rewards that you earn on purchases.

Even under this category, you can find several types. Like travel reward cards, cash back cards, airline, and hotel-branded cards, etc.

If you can devise a particular spending pattern, you can get profit via reward points.

For instance, do you often travel? Where you spend the most money at?

Such credit cards come with a high APR so check the rates and fees beforehand.

Also, it would be smart not to carry any balance on these cards. But if you use reward cards with strategic planning you can earn a profit.

Balance Transfer Credit Cards:

It sometimes happens that we have a balance on our cards with high APR. So what can you do to save money?

Well, by transferring the debt with a 0% introductory APR to a balance transfer card can be your key.

Now, what most of you won’t know is that a transfer fee of 3% to 5% of the transferred amount.

Also, keep in mind how long this intro period lasts. For once the period ends the rate spikes up to the purchase APR.

Student Credit Cards:

We all have been through student life with limited credit. But this card here is specially designed for such students. Often these vary but many student credit cards have decent awards and APRs.

For students who are 21, a co-signer is a must to get this card. But if you prove that you earn enough to pay back any debts, you are good to go.

Secured Credit Cards:

As we already mentioned above about secured and unsecured credit cards. So people who are about to get their first-ever credit card, avoid unsecured.

Hence a secured credit card is for people with bad credit card history or new buyers. A secured credit card requires you to make a security deposit.

This is your credit limit and you need to pay the bill on time. Only then you can build up this credit and can score to get an unsecured credit card.

Business Credit Cards:

If you started a small business or own one already, you can get a credit card for that. Such cards offer a variety of rewards so try to opt for one that fits well with your needs.

Common Credit Card Fees:

Every credit card must disclose its fees and rates. According to the Truth in Lending Act (Regulation Z), it is a must. When one applies for a credit card, such laws are for their protection.

Still, you can go for a little research and upon receiving the card. It is best to read out the disclosures, etc.

Purchase APR:

According to U.S. News data the average APR credit cards have is 16.75% to 23.62%. Yet this rate can be lower or higher than the average.

It depends on how worthy you are for the credit. Keep in mind that higher APRs come with reward cards.

Balance Transfer APR:

You will get an APR when transferring a balance from 1 credit card to a balance transfer card. This APR is for the amount you transfer from 1 to another card.

People who have some good credit can easily qualify for a balance transfer card. And that too with 0% introductory APR.

Balance Transfer Fee:

This fee is charged by most balance transfer credit cards. It ranges from 3% to 5% of the transferred amount.

Cash Advance APR:

You will be likely charged at a higher APR for the amount withdrawn if you use a credit card to get cash. But cash advance APR comes around 26% or even above.

The interest on a cash advance starts accruing with most of the cards. So your best option to pick is to avoid getting cash by this method.

Cash Advance Fee:

This fee charged is around 3% to 5% with most credit cards of the withdrawn amount.

Annual Fee:

Some credit card companies are charging an annual fee for using the card. This fee can vary depending upon the features/rewards offered with the card.

Penalty APR:

If your bill payment is 60 days late some cards charge a higher APR.  This penalty can spike up to 29.99% APR but timely payment can save you from the burden.

Foreign Transaction Fee:

For any purchases made in foreign countries, you are charged around a 3% fee. But the plus point here is that many credit cards don’t charge this fee anymore. So people who often travel should carry a credit card that won’t come with any fee.

Late Fees:

If you get late with the payments, you need to pay this fee. Now, based on the duration or how late you are, the amount may vary.

For the first negligence, you can get charged $28 by the issuer. Some of the issuers may be kind enough to not charge you but timely payment can help with credit history.

Conclusion!

If you use your credit card smartly, these can be your tool to build credit. All you need to do is timely payment of bills, maintain a low balance.

Then only get a credit card if you need it and choose one according to the requirements. With these simple tips, you can maintain a good credit history.

One thing that you must avoid at any cost is interest and debts. These are like a rabbit hole and would only make things worse for you. But if you pay the bills every month within the due date, you are all settled.

For any further assistance or guidance regarding the ways for knowing how to do credit cards work, feel free to contact us. We hope this brief article will clear out all the doubts relevant to credit cards.

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