How Do Credit Cards Work? Get to Know the Basics
If you haven’t had one before, you might be wondering, “How do credit cards work?” Read our beginner’s guide to understand what you should know.
Author: Arro Team
November 8, 2022|Blog
We all hear about credit cards, but how much do you know about how they work? The process might seem mysterious but it’s actually pretty straightforward and once you understand it, you’ll have a better sense of how to use a credit card properly. Read on to learn how credit cards work and how Arro can help you navigate this system.
What Is a Credit Card?
First things first: Let’s make sure we’re on the same page about what we’re discussing. You’re probably familiar with those little plastic rectangles, but what do they actually represent?
Credit cards are a line of credit that you can use to make purchases or even take out a cash advance, but there’s a limit to how much you can spend. You can think of a credit card as a loan that you have to pay back each month, otherwise you’ll have to pay interest — which we’ll get into more later.
Types of credit cards include Visa, Mastercard, American Express, and Discover. Visa and Mastercard are payment networks, which process card transactions. These networks rely on credit card issuers, which are financial institutions — primarily banks. For instance, a Bank of America Visa has both logos on the card. American Express and Discover are both credit card issuers and payment networks.
Credit Cards and Credit Scores
Your credit score can impact being approved for a credit card, your credit spending limit, and your interest rate. So what is a credit score? Well, the Consumer Financial Protection Bureau describes it as a prediction of credit behavior. It’s based on factors ranging from your current unpaid debt, bill-paying history, whether you’ve ever filed for bankruptcy or been in foreclosure, and your loan account types and balances.
The higher your score, the better position you’ll be in to get approved for a credit card or other loan with favorable terms. Credit scores range from 300 to 850, but what’s considered a “good” credit score? Equifax says a “good” credit score is between 670 and 739. A “great” credit score would be even higher than this.
But Equifax isn’t the only authority on credit scores. There are three major credit bureaus — Equifax, Experian, and TransUnion — and you can get a free annual credit report from each of them to help keep tabs on your score.
Beginners and Credit Cards
Good credit versus bad credit makes a big difference in your financial future. The good news is you can take proactive steps to improve your credit score. As a beginner, with your first credit card you can aim to build credit by carefully using your credit card accounts.
One option is a secured credit card, which offers a good way for first-time cardholders to establish a credit history and boost their credit score. For these cards you have to provide a security deposit that serves as collateral. However, the credit card issuer only uses this security deposit if you default on the bill.
How Do Credit Cards Work?
To get a credit card, you’ll need to fill out a credit card application. Along with your credit score, the credit card company will evaluate things like your monthly income and expenses when determining whether to approve your application. They’ll also decide what your spending limit is, as well as the interest rate on any balance you carry.
When you make a purchase, the amount counts against your spending limit. For example, if your limit is $500 and you make a $100 purchase, you have $400 left of your card limit until you pay off the $100 charge, assuming you don’t make any other purchases.
How Credit Card Payments Work
Knowing howcredit card payments work is critical. With every monthly billing cycle, the cardholder receives a statement. Your credit card bill lists all the purchases you made and includes your total credit card balance, payment due date, available credit, and minimum payment amount, which is the least amount you can pay that month and keep the account in good standing if you’re not able to pay your balance in full.
Keep in mind that you can typically pay online, by phone, in-person, or through the mail, but you can’t use another credit card to make a payment.
There are several components to achieving a good credit score, and payment history is one of the most important — so you don’t want to forget to pay your bill! If you don’t pay on time, you might also have to pay a late payment fee.
Understanding Interest on a Credit Card
The annual percentage rate (APR) is the interest rate (also called a finance charge) added to your balance on the card if you don’t pay your credit card bill in full each month. Basically, the APR is your cost for borrowing money.
If you pay off your balance completely by the monthly due date, you can avoid those dreaded interest charges. If you maintain an outstanding balance, expect to see a monthly charge based on your interest rate. With a good credit score, you pay a lower interest rate than if you have bad credit.
Bottom line: You can avoid finance charges by paying your bill in full and on time.
Credit Cards vs. Charge Cards vs. Debit Cards
With a credit card, you can spend up to a certain amount of money each month. Rather than make a monthly payment for the outstanding balance, you can opt to make a partial or minimum payment and pay interest.
Charge cards, such as American Express, work differently. There’s no option for paying a minimum amount or just part of the bill. Instead, the outstanding balance is payable in full each month. However, there’s typically no card limit on spending.
When you pay with a debit card, the funds are taken out of your checking account immediately. Don’t forget to make sure you have enough money in your account to cover the transaction!
Pros and Cons of Credit Cards
Credit cards have many advantages but there’s also a downside. Let’s take a look at some of the pros and cons of credit cards so you can make an educated decision.
Credit Card Pros:
Convenience: Credit cards are the most convenient way to pay for purchases. Add your credit card to mobile pay on your phone and transactions are seamless. You just tap and go, without having to count out cash or wait for change.
Building credit: Responsible use of a credit card is one of the best ways to build credit. When you have good credit, you become eligible for better interest rates on mortgages and car loans.
Rewards credit cards: What’s your favorite credit card reward? Is it cash back on purchases you make or rewards points towards gifts or travel? These perks run the gamut, and you can make decisions about card offers based partly on the rewards.
Credit Card Cons:
The downside of credit cards is unwise use can make overspending easy. That means getting into credit card debt and potentially ruining your credit rating. By keeping careful track of your balance, you can avoid maxing out your credit card. That’s something you never want to do because it seriously impacts your credit score.
You can also rack up a lot of fees if you aren’t careful about your spending. These might include:
Finance charges if you carry an outstanding balance
Overdraft fees if your credit card issuer allows you to exceed your credit limit
Late fees for late payments
Cash advance fees
Balance transfer fees for transferring debt to another credit card account
Foreign transaction fees when making purchases in another currency
Finding the Best Credit Card
Credit cards aren’t one-size-fits-all. The credit card that works at a particular stage in your financial life isn’t necessarily the same one you’ll need later on, especially if you’re just starting to build your credit. Learn how to compare credit cards so you can find the best ones for your current needs. Here are some things to take into consideration:
Annual percentage rate: If you never have a credit card balance, the APR doesn’t matter. But when you carry an outstanding balance from month to month, expect to owe interest, so pay careful attention to what rate you’re offered when you apply. Some cards also offer a low- or zero-interest introductory period — just be sure you’re clear on how long it lasts.
Annual fees vs. no fees: Some credit cards charge an annual fee just to have the card, while others are no-fee cards. According to Value Penguin, the average credit card fee as of 2022 is $147. Does that mean you should always look for a card that doesn’t charge fees? While the answer is generally yes, there are consumers who opt for cards with an annual fee because they offer valuable rewards programs, such as frequent flyer miles. Credit cards aimed at students and those who are just beginning to establish a credit history usually don’t charge fees.
Where you can use it: Not all businesses accept all types of credit cards. For example, a mom-and-pop restaurant might not take American Express cards. Meanwhile, Visa and Mastercard are widely accepted both in the U.S. and internationally. Also, if you apply for a credit card with a specific store, you might only be able to use it there.
Let Arro Help
At Arro, we offer a new way to build your credit and financial knowledge. Learn how to track and build your credit score while increasing your personal finance skills. At Arro, all you need is a bank account and your Social Security number to apply for an Arro Card.