How do credit cards work? Surprisingly, there are many people who don’t understand how credit cards work and how to use them responsibly.
I have heard so many false things and myths about credit cards even though they have been around for decades.
So today, I want to clear everything up for anyone who has ever asked the question, “how do credit cards work?”
When you know how they work and use them responsibly, there are some great benefits of having credit cards — a higher credit score, cash back, airline miles, rewards, etc.
Those benefits are why I love using credit cards, but I understand that they aren’t for everyone.
A family member of mine once struggled with credit cards, and they found that using a cash only budget was the best way to stay out of credit card debt. Fortunately for them, they were able to recognize their credit card mistakes and found a way to make sure they weren't adding any debt. Part of that was being proactive and noticing that they had an issue early on.
However, others are not as lucky.
I’ve heard many stories about people who continue struggling with credit cards and keep adding to their debt. And I’m always shocked when I find out it’s simply because they don’t understand how credit cards work.
Learning how they work is the first step to having a good relationship with credit cards.
One of the biggest benefits of using credit cards responsibly is that it can increase your credit score. With a higher credit score you can get lower interest rates on your mortgage or loans, better car insurance rates, easier approval for renting a home or apartment, and more. Some employers even check credit scores.
Understanding how credit cards work and then using them the right way may save you money.
This is why I believe that learning how credit cards work can help everyone.
Content related to how do credit cards work:
- Top 5 Credit Card Mistakes And How To Avoid Them
- 6 Credit Card Myths You Need To Know The Truth About
How do credit cards work?
A credit card is different from a debit card. A credit card is more like a short-term loan, whereas a debit card pulls money from your checking account.
However, it's different in that you get to “reuse” the loan as many times as you want, as long as you make your payments and don’t go over the credit limit.
Here is a quick summary if you’re wondering how do credit cards work:
- First, you find a credit card. You may receive an offer in the mail, hear about one on a blog (my favorite is the Chase Sapphire Preferred), on a recent flight (many airlines promote their credit cards on flights), and so on.
- After you are approved, you'll then receive the credit card in the mail. There will be terms that go along with it, so make sure you understand what you are agreeing to before you start spending on your new credit card! You will learn about credit card terms in the next section.
- You can then start using your credit card. Your credit card is swiped at a store, entered online, etc. As long as you are not going over your credit limit, your transaction should be approved.
- You will receive a billing statement either in the mail or online (make sure you have the settings and information correct so that you receive this!). Your statement will list all of your transactions and the amount you owe.
- You are responsible for the total amount you spent on your credit card, and you should make payments in full every single month. If you don't pay your full balance by your due date, then you will have to pay interest on top of your balance.
How does a credit card work? Start with understanding the terms.
Before you sign up for a credit card, you should understand all of the common terms. Sadly, many people do not fully understand credit card terms, and that's a leading cause for why some fall into credit card debt.
I know that the process of researching and understanding these basic credit card principles may seem like a lot of work, but if you don’t understand how your credit cards work, you may wind up in debt or further into debt than you already are.
Your credit cards can work for you if you are careful, but if you aren’t, they can wreck your finances and your future.
You should do your research and understand:
- Interest rates and how they work. If you do it right, your credit card won’t cost you any extra money. If you pay your balance in full each month, then you don't have to pay interest. However, if you don't pay your balance in full, or only pay your minimum payment, then you'll most likely owe interest that continues to grow until your balance is fully paid off.
- What “balance” means. Your balance is how much money you have spent using your credit card before making any repayments. So, if you spent $100 on your credit card and haven't paid anything back yet, then your balance is $100. But, if you paid $100 towards your credit card, then your balance would be $0.
- Minimum payments. This is such an important topic so I dedicated a whole section to it later in this post. So many people get confused on this subject! But the basic idea is that the minimum payment on your credit card is the smallest amount a lender will let you pay every month, and if you only pay this amount, they will start adding interest changes to your total amount due.
- Credit limit. Your credit limit is how much money you can spend on your credit card altogether. It may be $300, or it may be $30,000+. Credit card companies decide what your limit should be based on your credit history, length of time you have had credit cards, your income, and so on.
- How your credit card use impacts your credit score. I recommend clicking on that link to learn about credit utilization rate, payment history, amounts owed, credit mix, new credit, and more.
If you are going to be using a credit card, you need to know all of this information before making your first purchase!
And while these things apply to all credit cards, not every credit card is the same. People are approved for different things, have different limits, terms, etc.
This means that even if you have the same credit card as someone else, their approval and terms are probably different from yours.
So, you should know and understand the terms of each of your credit cards. You might be surprised at how different some of them are.
If you don’t know your credit score or are interested in learning more about it, please check out How To Build Your Credit Score. It includes a link to Credit Sesame so that you can check your credit score safely for free.
Realize that a credit card is not free money.
How do credit cards work? Well, they aren’t free money.
I can’t say this enough — credit cards are not free money! Unfortunately, too many people treat them like they are.
If you are using a credit card, you should always make sure that you have cash or money in your personal bank account before thinking you can afford something.
That jacket, video game, and so on aren’t worth taking on debt if you can’t actually afford it. A simple $100 pair of pants may balloon into hundreds of dollars of credit card debt because of interest fees.
If you find that you are struggling with whether or not you can afford something, there are several things you can do.
- Wait 24 hours, at least, to make the purchase.
- Think about the other things you could use that money for.
- Think about how much time you will have to work to pay for it.
- Think about whether you’ve made a similar purchase that you’ve regretted.
If you just take a minute to think about those four things, you may realize that you can’t actually afford the purchase in the first place.
If you are wanting to get better about tracking your spending, check out Personal Capital. This free online tool tracks your purchases, your debt, investments, and more.
Remember to pay your credit card bill.
If you take out a credit card, please make sure that you remember to pay your monthly bill.
Even if you have the money to pay your credit card balance in full each month, that’s only good if you remember to pay your bill each month. I honestly can’t tell you how many people have told me that they don’t remember to pay their bill each month.
And, many of these people could have paid the balance in full!
Paying your credit card bill late can lead to many problems. It can lead to late fees, added interest, and it can negatively affect your credit score.
If this is a mistake you tend to make, you should set up reminders on your phone, put due dates on your calendar, and/or more.
If you are a little late one month because you forgot to pay, you may be able to ask your credit card company to waive the late fee and possibly even the interest charges. It doesn't hurt to call and ask!
Pay your full monthly credit card payment.
If you’re wondering how do credit cards work, then this is one of the most important things to learn. You should always aim to pay off your credit card balance in full each month.
If you find that you don’t have the funds to pay your full credit card balance each month, then you should better assess your purchases before you make them.
I’ve also heard that some people only pay the minimum payment because they don’t understand how credit card payments work. And, many people actually believe that making the minimum payment is all they need to do in order to avoid interest charges.
YES, I actually just said that.
I have heard this from countless people.
Many people seriously think this is true, and this is why everyone needs to fully understand what “minimum payment” means and what happens if that’s all you pay.
Here’s a basic breakdown of what minimum payments are:
- Minimum payments are basically the smallest amount your lender will let you pay each month.
- Only making minimum payments lead to paying more in the long run because of interest charges.
- While minimum payments may keep you in good standing, they can affect your overall credit score.
You should always try to pay more than the minimum payment. If you do not, you will have to pay interest charges, which may inflate your credit card debt significantly each month.
What credit card fees should I be aware of?
If you are not careful, then you may end up paying credit card fees. Some of the common credit card fees include:
- Interest charges- This one is discussed throughout this blog post, and is usually the most common.
- Late charges- If you pay your credit card payment late, then you may be charged a late fee.
- Annual dues- Some credit cards have fees that you pay once a year (these are usually the rewards credit cards). There are plenty of free credit cards, though, so you can do that as well.
- Foreign transaction fees- If you use your credit card in another country, then you may be charged a fee. More and more credit cards these days have no foreign transaction fees, though.
- Cash withdrawal charges- If you withdraw cash using your credit card, then you'll pay a fee. This is not something I recommend doing.
As you can see, there are many credit card fees. However, you can easily avoid all of these now that you know what you're dealing with!
How do travel credit cards work?
Travel credit cards are becoming very popular these days because people who use them responsibly can earn points, miles, and cashback on travel expenses. They can be a great way to save and earn money on travel.
Here’s a quick summary of how travel credit cards work:
- You find and sign up for a credit card with some kind of reward that you’re interested in, such as points, cash back, or travel rewards.
- These cards ask you to meet a certain spending requirement to receive your rewards, like spending $3,000 in the first 90 days.
- When you reach that spending requirement, then you receive your points.
- Those points can then be used towards some sort of reward, which may be cash back, hotel, airfare, or something else.
- To use your points or miles, you may have to spend them through your credit card company’s website, transfer them to an airline, etc.
Credit cards can be great, especially if you use them to your advantage. One way is by using rewards and travel credit cards.
You can see one example here: How To Take A 10 Day Trip To Hawaii For $22.40 – Flights & Accommodations Included.
In that example, you learn how to take a 10-day trip to Hawaii for just $22.40. And, that is not a typo. It's real and real people have done it.
My husband, Wes, has taken a first class trip from London to Los Angeles, for only about $75. It would have been less but we booked it just days in advance.
We've also earned other nearly free vacations and thousands of dollars in cash back on our credit cards.
Let's look at an example of a rewards credit card signup bonus: The Chase Sapphire Preferred Card is my top recommended credit card and it currently gives a 50,000 Chase Ultimate Rewards point bonus when you spend $4,000 in the first three months after account approval. The $95 annual fee is waived the first year as well. I believe this was my first rewards card and it has been my favorite for years. Super easy to use and understand too!
$4,000 may sound like a lot to put on a credit card, especially after I told you that you need to pay your balance in full every month. But to reach the spending requirement, many people use their travel credit card to pay for every day expenses, such as gas and groceries.
Then, they pay the balance off in full every month.
Credit card reward points are great, but if you spend more than you can actually afford so that you can earn “free” vacations, gifts, and more, nothing is actually free.
Some will spend more money than they have so they can reach the spending requirement needed to earn rewards points. Remember, though, those rewards are only rewards if you are using your credit cards responsibly.
To successfully use rewards credit cards, you must have good to excellent credit scores, have your finances already in order, and have great organizational skills. If that doesn’t apply to you, you can always work on improving your credit score and your financial situation.
Related content to how do credit cards work: How to avoid getting into trouble with rewards cards.
What questions do you have about how do credit cards work? What credit card mistakes have you made?