how do credit cards work

How Do Credit Cards Work with Complete Guide

Credit cards are a convenient mode of payment when you wish to purchase goods and services on credit. Not only are credit cards convenient, but they also often let you earn lucrative rewards. You can earn rewards like travel discounts and cash backs on stuff you would have purchased anyway, even without using a card. Although credit cards allure everyone, you need to monitor them closely. Overspending using credit cards may lead to excessive interest charges, mounting debts, bad credits, and late fees. Thus it is crucial for you to understand how do credit cards work so that you can make the best use of the benefits offered by your credit card without having to take the unwanted risk.

Additionally, once you understand how a credit card transaction takes place, you would be able to use it more profitably.

What Is a Credit Card

A credit card is a physical rectangular card that the cardholder can use to pay bills, make purchases, and in some cases, withdraw cash as well. For our understanding, we can conveniently call a credit card, a kind of loan taken for a short time period. 

On opening a credit card account with a company, the credit card company gives the cardholder a set credit limit. Typically, this is the exact amount that you can use to make payments and purchases. As you keep charging things to the card, the credit available for you reduces. After the stipulated time period, you pay back to the company whatever you have spent from your credit limit. 

How Do Credit Cards Work

how do credit cards work

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You can use credit in various ways, like entering your account information for an online transaction, tapping, swapping, or inserting your card in the payment terminal, or using a mobile wallet such as Samsung Pay or Apple Pay. If you are new to the world of credit cards, you may be interested to understand how do credit cards work. Let’s understand how they work and how you are liable for the card you hold. 

Every credit card is generally linked to a revolving credit account, usually a bank. Through your credit card, you can make purchases by borrowing money from your issuer. The scope of using a credit card is very wide. You can use it to make purchases of goods and services with any merchant with the provision of accepting credit card payments. Additionally, you can also use the card to get cash in advance. 

Once your issuer bank approves your credit card, the bank will set the upper cap credit limit. It is the maximum amount that you can utilize on your card. There are various factors that lead to deciding this limit including, your debts, credit history, income, etc. 

When you make use of your credit card to make purchases or pay bills, the details of your credit card send to the bank of the involved merchant. After this, the credit card network gives authority to the bank to process the transaction. After this, your card issuer verifies the information, and your transaction is approved or declined. 

Things To Know:

If your card issuer approves the transaction, the payment done is forwarded to the concerned merchant. The credit available on your card for further use is simultaneously reduced by the transacted amount on the card. The issuer of your credit card will forward you a statement at the end of your billing cycle. This statement exhibits: 

  • all the transactions made by you in that month 
  • the previous balance you had on your card 
  • the new balance after the transactions 
  • the minimum amount of payment due on your card 
  • the due date for the payment. 

You get a grace period of a minimum of 3 weeks to make this payment. The period is calculating from the end of your billing cycle. Grace period is the time period between the date you made a purchase on the credit card and the due date for payment listed in the statement. There will be no interest if you pay your full bill in this time period.

However, if you fail to make the payment by the due date, your card issuer can charge interest to you. The bill will be carried out next month. The Annual Percentage Rate, commonly known as APR, shows you the cost incurred by you on carrying a balance on your credit card on a yearly basis. The APR includes the interest rate, the annual fee on the card, and other costs if there is one. 

When you pay the due amount on your credit card, you can get more credit.

How to Use a Credit Card

how do credit cards work

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Your easy-to-use and lucrative credit card can actually turn out to be dangerous if you are not aware and responsible enough while using it. Let’s understand how you can use your credit card wisely to get the maximum benefit out of it:

Let’s understand how you can use your credit card wisely to get the maximum benefit out of it:

  • Purchase what you can afford: It often happens that credit cardholders get tempted to spend money they don’t actually have while using their credit card. A good trick to stay safe from falling prey to this habit is purchasing only what you can pay back using the money in your account. 
  • Keeping the charges way below the card limit: If you manage to keep your credit card utilization ratio below 30%, it will give a good boost to your credit score. However, if it exceeds 30%, it can adversely affect your score. For example, if your collective limit on all the credit cards you hold is $10,000, make sure you don’t have more than $3,000 as charges at a particular given point of time. 
  • Always pay full settlement: It is a healthy practice to pay the full settlement amount every month on your credit card. If you carry a balance, you will have to pay interest on it which will compound on a daily basis.
  • Get access to rewards: Credit cards come with the additional benefit of rewards for their customers. Along with their basic features of a short-term and interest-free loan, credit cards also offer additional benefits like providing a cover on stolen items and built-in purchase protection.
  • Review your credit card statement: Always review your statement to ensure that the charges on your statement are correct. If you find them to be illegitimate, immediately inform your credit card issuer. Never make the mistake of ignoring an unrecognizable charge, however small it may be. Cons and thieves often test the credit card numbers stolen by them by making small purchases before charging more to become successful.

How to Build Credit on Your Credit Card

how do credit cards work

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Once you have received your credit card, you should use it in a careful manner. It will help you improve your credit score. You can enhance your credit score using the following ways:

  • Timely payment: Paying your time is the best tool to build your credit score. A card holder’s payment history is the most important factor while determining your credit score. A history of timely payments will fetch you an excellent score. 
  • Check your FICO score: FICO is the most popularly accepted and used credit score. It is advisable to check your FICO score at regular intervals. It will help you to know that you are progressing in the right direction. Some credit cards come with FICO trackers. For those that don’t, you can use free online platforms to check your credit score. 
  • Keep your balance low: Avid using too much of the available balance and try not to use more than 30% of the available credit.
  • Go for a credit limit increase: Once you have charged up balances and paid them in full for about 9 to 12 months, you can make a request for a credit limit increase on your credit card to your issuer. It would be easier for you to keep the credit under 30% if the credit limit is higher. 
  • Keep your account active: Several banks have the provision of closing an account if it remains inactive for a period of 6 months. Hence, it makes sense not to let the account stay idle for too long. 

Also Read: 5 Common Credit Card Mistakes to Avoid Making in 2021

The Bottom Line

Credit cards are of immense use to you whether, 

  • you are in the process of building credit to obtain a loan for a car, or home
  • or else you wish to earn rewards and save money on your spendings, or 
  • you need to make payments towards an unplanned expense
  • you need to make a large purchase at once. 

Credit cards are an excellent method to get interest-free financing and paying off high-interest debts. However, it is advisable to understand how does a secured credit card work before actually getting yourself one to steer clear of the risks associated with it. 

For more finance-related concepts you can have a look at the FinanceShed, and stay tuned for more updates.