Credit Cards Explained: How Does a Credit Card Work?
What exactly is a credit card, and how can you use one on a regular basis? They're an important part of your personal credit and a popular payment option, but it's common to have questions about how they work — especially if you've never had one before. With credit cards explained, you'll be ready to make smart decisions when making purchases while also managing your debt better.
How Do Credit Cards Work?
You may already be familiar with the mechanics of using a credit card: you slide, insert, or tap the card when paying, sign your signature if your purchase is of a certain amount (usually $50 and over), and the bill is paid. But behind the scenes, you are actually taking out a small loan from your financial institution that you then pay back at a later date. That's why your credit card application requires financial information and a credit check.
When you receive a credit card, it creates an account with a line of credit, which sets a certain amount you can borrow per month. When you use the card, you are borrowing money from your lender, which then pays the merchant directly.
This creates a credit card "balance," or the amount you owe the lender. You have several choices about how to pay back this balance. You can make minimum payments, pay off only a portion, or pay off the entire balance every month. The card interest rate is applied to the remaining balance at the end of the monthly cycle, which creates additional interest. This is why, if you're able to, it's important to pay off your balance in full each month as you'll avoid incurring any additional interest.
While there are several different kinds of credit cards available for different types of borrowers, there's a standard option offered by a financial institution that will likely be your starting point. For something a little more specialized, consider a secured credit card, like the Key Secured Credit Card®, which uses a cash deposit made by the buyer as collateral, making card requirements easier to meet. Additionally, a charge credit card requires full balance payments every month, and a retail card is offered by a retailer or company instead of a financial institution.
What Kind of Fees Are Associated with Credit Cards?
Credit cards may have fees you need to pay, in addition to paying back the balance. Important examples include:
- Annual Card Fees: These are annual fees you pay to use the card, usually around $50. It's important to pay attention to the annual fee because it can reduce other bonuses you may get with the card. Some cards, like the Key Cashback® credit card, do not have annual fees.
- Balance Transfer Fees: These are the fees you need to pay to switch a balance from one credit card to the new card. However, some cards waive balance transfer fees.
- Cash Fees: These are charges you have to pay if you're using your credit card to borrow cash instead of buying something directly.
- Foreign Fees: These fees occur when you make purchases in a foreign country.
How Does Credit Card Interest Work?
Every credit card has a yearly interest rate called the annual percentage rate (APR) and as of July 2020 was sitting at an average of 16%. However, your interest is constantly being calculated and applied, so looking at the monthly or even the daily rate can be useful.
At the end of the payment period, interest is calculated and added to your account based on your remaining balance. If you pay off half of your balance, the interest rate will only apply to the unpaid half. If you pay off your entire balance that month, you will accrue no interest.
What Does a Minimum Payment Mean?
"Minimum payment" is an important phrase that means the minimum amount that the user must pay back every month, without incurring late fees or your interest rate being raised. The minimum can vary between cards, and may even change on a monthly basis, but it's usually based on your balance or your outstanding interest.
While minimum payments help you avoid severe credit card penalties, they don't pay back much interest and they aren't always a good calculation for managing credit card debt. It could take many years to pay off even normal credit card debt using only minimum payments.
Instead, do your best to pay off your balance in full — or as much as possible — each month. If necessary, consider debt consolidation to help get a handle on your outstanding bills and make sure you're building a credit history to be proud of.