Credit cards offer a line of credit that allows you to use a card to make purchases online and in person.
When you use credit cards, you are borrowing money from the bank that will need to be repaid and will likely accrue interest until you pay it back. There are some benefits to credit cards, such as earning rewards and building credit.
Erika Taught Me
- Credit cards are a line of credit from the bank
- You are issued a credit limit and can make purchases against it, you’ll then make payments to pay back the money you borrowed.
- You can earn travel rewards or cash back on your spending from some credit cards
Important credit card terms
Before we get into the nitty-gritty of how credit cards work, it’s important to know some basic terms. After all, knowing the terminology of a subject is half the battle.
Credit limit: This is the maximum amount you can borrow on your credit card at one time. It is recommended that you keep your balance below 30% of your credit limit.
Balance: This is the total amount that you owe on your credit card.
Available credit: This is how much of your credit limit you have left. It’s your credit limit minus your balance.
Minimum payment: You’ll see this number on your statement each month. This is the smallest payment you can make to keep your account in good standing and avoid a late fee.
APR: This is the annual interest rate you’ll pay on your balance.
Grace period: This is the amount of time after you make a purchase before interest starts accruing. This only applies to purchases and only if you paid off your balance in full at the last statement.
Billing cycle: This is your statement period. For example, if your statement prints on the 20th of each month your billing cycle will be from the 21st of one month to the 20th of the next month.
Accrued interest: This is interest that your account has earned but that has not yet been applied to the account. Interest is applied on the day your statement prints, but may be earning interest all throughout the month.
How credit cards actually work
A credit card issues you a line of credit called your credit limit. When you make purchases using your card you are borrowing money from the issuing bank, this decreases your available credit and increases your balance.
When you make a payment you are paying back some, or all, of what you borrowed. This decreases your balance and increases your available credit.
For example, Let’s say you have a credit limit of $1,000. If you make a purchase for $150, your balance will be $150 and your available credit will now be $850. ($1,000 – $150 = $850). If you make a payment of $100 your new balance will be $50 and your available credit will be $950.
Seems simple enough, however, we are forgetting an important part of credit cards — interest.
On the last day of the billing statement, the bank will add any interest your account accrued during the month to your balance. In the example above, you’d probably owe about $2 in interest.
So when you received your statement you’d actually have a balance of $152. If you make your payment of $100 your balance would then be $52. Next month, assuming no more purchases, you’d have a little bit more interest, let’s say $1, and your balance would be $53. If you made a $53 payment you would then have your balance paid in full.
Related: How to choose a credit card
Types of credit card balances
There are three different types of balances you can have on your credit card — purchases, balance transfers, and cash advances.
Think of each of these balances as their own individual buckets and each one will likely have its own interest rate and can accrue interest differently.
Credit Card Balance transfers
Balance transfers are balances that have been moved over from a different account. Sometimes these have promotional periods, say 0% APR for six months. During those six months, this balance will not accrue any interest.
Once the promotional APR is finished it will begin accruing interest at the regular APR. If you don’t have a promotional period of 0% then balance transfers will begin accruing interest right away.
Credit Card Cash Advances
Cash advances are when you take actual cash off of the card. For example, some credit cards allow you to use an ATM to get cash. You can also go into the issuing bank, if they have physical locations, and get cash off of your card.
The interest rate on cash advances is likely very high, possibly over 30%, and will begin accruing interest right away.
Credit Card Purchases
Purchases are, well, the purchases you make on the card — items from the store, paying at a restaurant, buying plane tickets, etc. These are your everyday transactions.
These accrue interest differently than balance transfers or cash advances. Purchases have a grace period on interest. If last month you paid your balance in full you will not be charged interest on purchases this month.
However, if last month you carried any balance over to this month then you will be charged interest on your purchases, even if you paid off the purchases balance last month.
For example, let’s say in January you did a $1,000 balance transfer at 0% APR for six months. When you got your January statement you made a payment of $200, carrying over $800 into February.
In February you make a $300 purchase. Since your balance transfer is at 0% and purchases have a grace period you may be thinking that as long as you pay at least $300 you’ll avoid interest, but that is not correct.
Because you carried a balance from January to February your purchases will begin accruing interest immediately. When you get your February statement, you will have an interest charge for the $300 purchase.
How payments are applied on credit cards
Since different balances can have different interest rates, what happens when you make a payment?
It is required by law that your payment be applied to the balance with the highest interest rate.
Let’s take the example above of a statement that has an $800 balance transfer at 0% and a $300 purchase at 17%. On this statement, you’ll also have about $4 in interest.
If you make a $400 payment it would first pay that $4 in interest off, then pay off the $300 purchase balance, leaving $96 to go towards the balance transfer.
After the payment you’d owe $704 on your balance transfer and the purchase balance would be completely paid off. Your entire balance would be back at 0%.
Credit Cards Rewards
One of the benefits of having a credit card is earning rewards, such as travel rewards or cash back.
For travel rewards, every program works a bit differently but you’ll usually earn either points or miles. Those points and miles can be redeemed for travel. Typically, this is the way to get the highest value from credit card rewards.
You’ll see travel reward earnings written as 3X on groceries, 2X on gas, and 1X on everything else. This means that you’ll earn 3 points for every dollar spent on groceries two points for every dollar spent on gas and one point per dollar on spending outside those two categories.
How you redeem your travel rewards will depend entirely on that specific travel rewards program.
Cashback is a little more straightforward. You’ll see cash back advertised as a percentage of the money spent. For example, 4% on gas, 3% at restaurants, and 1% on everything else. So if you spent $100 on gas, you’d earn $4 in cash back. $50 at a restaurant would earn you $1.50, and so on.
Cashback can typically be redeemed as a statement credit or be sent to you in a check.
Welcome bonus
Welcome bonuses are additional rewards you can earn when you first sign up for the card. These are promotions put on by the banks to get new customers.
A typical welcome bonus on a cash-back card might be something like $250 if you spend $1,000 in the first 3 months after you open the account. Or on a travel rewards card, you might see something like 20,000 bonus points if you spend $4,000 in the first six months.
The spending that is required to get the bonus is often referred to as the “minimum spend”.
To get the welcome bonus you have to be a new cardholder and meet the minimum spend requirements. If you do that, you’ll automatically receive the bonus after a period of time, say 30 – 90 days.
Here's our list of cards with the best welcome bonuses.
Pros and cons of credit cards
Pros
- Convenient and safe way to spend money
- Earns rewards
- Builds credit
Cons
- Can create a cycle of debt
- Can hurt credit if not used responsibly
FAQs
How do credit cards build credit?
Credit cards are lines of credit that banks will report to the three credit bureaus. They will report your credit limit, balance, and payment history. If you pay on time and keep your balances well below your credit limit you’ll likely see an increase in your credit score.
What is the difference between a credit card and a debit card?
A debit card is tied to your checking account. When you use a debit card to make a purchase that money is immediately withdrawn from your checking account.
However, a credit card is a line of credit. When you use a credit card to pay for a transaction you are borrowing the money and will receive a statement later with a payment due. Carrying a balance on a credit card will result in interest charges.
