How credit cards work
Credit cards are a popular way to make purchases, pay bills and even help manage debt in some cases. They're quite convenient and many offer the chance to earn rewards.
Below, we'll break down the things you need to know about credit cards:
- What is a credit card?
- How does a credit card work?
- The difference between debit and credit cards.
- Types of credit cards.
- Why get a credit card?
- How to get a credit card.
- Tips for using a credit card.
What is a credit card?
A credit card is a form of revolving credit — meaning you borrow with it when you want, up to your credit limit, and pay when your bill is due. This means that you don't spend your money when you make a purchase using your credit card. Instead, you're borrowing that money against your available credit and accumulating a balance. When you agree to open an account, you agree to pay back this money to your credit card issuer.
This concept of borrowing money makes you the "borrower" and your card issuer or issuing bank the "lender." As a result, the issuer reports your payment activity to the credit bureaus, and your payment history is one factor in determining your credit score, a figure that describes your creditworthiness.
Before we explain how this works in more detail, here are some important credit card terms to know:
- Annual fee: The fee which some cards charge once per year for use of the card.
- Balance: The amount of borrowed money on your card that you have not paid.
- Credit limit: The maximum amount you can borrow on your credit card.
- Credit card network: Credit card networks authorize and process credit card transactions. They facilitate the information transfer between merchants and issuers.
- Interest/APR: Interest is the price you pay to borrow money. The interest rate charged by a credit card company is typically stated as a yearly rate called the annual percentage rate (APR). Interest is charged during every billing cycle you have any unpaid balances. Your credit card may also have different APRs for balance transfer, cash advance and purchase balances.
- Issuer: The bank or financial institution that gives you your credit card. You make payments to your credit card issuer.
- Minimum payment: The minimum payment consists of a small percentage of your balance, plus accrued interest and fees. The minimum monthly payment is due on or before the due date.
How does a credit card work?
More often than not, credit cards are used for purchases and paying bills, and a few things happen in the span of several seconds:
- You swipe, insert or tap your card at the card reader when checking out. If you're paying a bill or shopping online, you'll enter your card's information instead.
- The merchant contacts your credit card issuer through the credit card network to request an authorization for the transaction.
- If approved, the transaction will go through and money will transfer from the issuer to the merchant.
Every billing period (approximately 28 to 31 days), you receive a statement containing all of your transactions for that period, your total balance and your minimum payment. You may get a grace period, which is usually 21 days but varies by issuer, to pay at least the minimum amount due.
If you don't pay the full balance, your issuer charges interest based on your APR and remaining balance. The lender adds this interest to your balance unless you're using a card with a 0% introductory APR. Making only the minimum payments may cause your interest charges to grow, whereas paying your full balance means you pay back only what you owe and may not accumulate interest charges.
The difference between debit and credit cards
The primary difference between credit and debit cards is that credit cards let you borrow money, whereas debit cards draw on money you already have.
This distinction means a lot for your finances. For one, credit cards let you borrow money and expand your purchasing power beyond the money you have. With debit cards, you use the money you already have and you avoid incurring debt.
Because you're borrowing money with a credit card, how you use it may affect your credit score. Debit cards don't affect your credit because you can only use money you have available in your bank account.
Types of credit cards
There are several types of credit cards to choose from, each designed for different users:
- Unsecured credit cards: Unsecured credit cards don't require any cash deposits. The lender determines your credit limit based on your credit reports, gross annual income and other variables, depending on the company. Most traditional credit cards are unsecured.
- Secured credit cards: Secured credit cards require a cash deposit as collateral, and your limit is equal to or greater than the value of cash deposits.
- Personal credit cards: Personal credit cards are designed for everyday spending, such as gas, groceries, entertainment, car repairs and dining at restaurants.
- Business credit cards: Business credit cards are intended for business-related purchases. For example, if you purchase office supplies for your home office or travel frequently for work, you can use your business credit card. Business credit cards help separate your business and personal expenses.
Rewards credit cards — travel and cash back
In general, rewards credit cards offer different rewards for your spending. The types of rewards you earn are measured in different ways, so think about rewards cards in terms of their most popular rewards.
- Cash back credit cards: These earn you points redeemable for cash back, a statement credit, gift cards or shopping at various retailers.
- Travel credit cards: You earn points or miles on purchases you make with your credit cards, and the rewards tend to be most valuable when used toward travel and accommodations. Some higher-tier travel credit cards offer other benefits like annual travel credits, airport lounge access and TSA PreCheck®/Global Entry fee reimbursement.
Why get a credit card?
Credit cards offer a variety of benefits whether or not they charge annual fees. Here are some examples:
- Sign-up bonuses: Also known as new cardmember bonuses, sign-up bonuses are offered by many cards. Issuers may pay you a one-time bonus for spending a certain amount within a period after you open the account.
- Rewards: Credit cards help you earn rewards that can be redeemed toward travel, gift cards, cash back and more.
- Balance transfers: A card may offer a promotional APR on balance transfers for a period of time, giving you time to pay off debt. You might also want to consider consolidating other credit card balances this way.
- Introductory purchase APRs: When you open a new credit card, it may offer an introductory APR on purchases for a period of time. This could help you pay for large purchases or manage a credit card effectively.
- Building your credit score: Using a credit card responsibly and paying off your monthly balance on time is an important factor in improving your credit score. A higher score can help you obtain better rates and terms on future lines of credit.
How to apply for a credit card in 4 steps
Here's how to get an excellent credit card for yourself:
- Prequalify: take advantage of pre-qualified credit card offers that you may receive in the mail, as they may reduce hard inquiries. You might find card offers like this in your mail.
- Complete the application: Once you've decided on a credit card, you'll need to provide basic info about yourself and estimate your income.
- Authorize the hard inquiry: Give the issuer permission to take a formal look at your credit history.
- Receive a decision and activate: The issuer evaluates your credit and sends their decision within 30 days. If the account is approved, you'll receive your card in the mail. Your card will come with instructions on how to activate it. You can usually do this in a minute or two online or by phone.
Tips for using a credit card
Credit cards can cause damage to your finances and credit when used irresponsibly. Follow these tips, so your credit card helps improve your credit score instead of harming it:
- Set a budget: Avoid credit card debt by setting and sticking to a budget. Make sure your spending stays below your income.
- Pay your full balance on time every month: If you don't carry a balance, you may not be charged interest.
- Use your card for everyday purchases: You may have to buy things like gas and groceries, and many cards offer rewards on those purchases.
- Monitor your score: Check your credit score regularly using Chase Credit Journey to see how you're progressing. Make sure you don't see any errors that could be harming your score, and if you do, report them promptly.