How Do Credit Cards Work?

The basics of credit cards.

Updated: May 21, 2024
Matt Crabtree

Written By

Matt Crabtree

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It might be intimidating to open a credit card account for the first time. But if utilised properly, they may give free security, an opportunity to rebuild credit, and the cheapest method to borrow money thanks to special 0% discounts.

To help you avoid being burned, this article discusses the various card options and what to look out for.

Exactly What is a Credit Card?

A credit card is a convenient way to make purchases. Instead of deducting funds from your account every time you make a purchase, your credit card company will cover the cost and give you a statement at the end of the month. If paid in full, no interest will be charged.

If you just pay the minimum each month, the remainder of your debt will roll over into the next month, and interest will continue to accrue on it (unless you're on a 0% APR promotion, about which more below).

Therefore, the phrase ‘credit card' isn't particularly useful, and it's best to refer to them as a ‘debt card' or a ‘borrowing card' instead. Instead of utilising available credit, any purchases made on the card will result in a debt that must be repaid.

Credit Cards: How They Work

Credit cards may be used for both in-store and online transactions, as well as bill payments. Your credit card information is sent to the business's bank if you do either.

The financial institution contacts the credit card company for approval before continuing with the transaction. The next step is for your card issuer to validate your details and authorise or deny the purchase.

If the transaction is authorised, the amount will be deducted from your available credit and paid to the merchant. Your credit card company will give you a monthly statement detailing all of your purchases, the change from the previous month's amount, the minimum payment required, and the due date.

Your grace period begins on the date of your purchase and ends on the date of your statement. If you pay your account in full before the due date, you won't be charged any interest during this grace period. 

But your card issuer might charge you interest if you often roll over debt from month to month. The APR on your credit card represents the annualised cost of holding debt. Your annual percentage rate incorporates not just your interest rate but also any additional fees, such as your card's annual charge.

The annual percentage rate of most credit cards is linked to the prime lending rate. Your card's APR may alter over time, however, credit card issuers are limited in how and when they may do so under the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009.

Types of Credit Cards…

Credit cards come in a wide variety, but the most common kind is the rewards card.

Credit cards that provide rewards may allow cardholders to redeem their points for airfare or hotel stays. Some kinds of purchasing might even get you bonus points. Some travel companies and hotels provide co-branded reward cards.

Cash-back credit cards are very similar to rewards cards, in that cardholders get a percentage of their purchases back in cash, often between 2 and 5 per cent. People with low or no credit histories might benefit from using a secured credit card.

Secured credit cards are an option for those with limited credit histories; the issuer keeps the security deposit as collateral.

Those with no credit history might also benefit from student credit cards. College students are the intended audience for these cards, which may not come with many perks.

Credit card costs

Credit cards have more than simply an interest rate (APR) or fees attached to them. Transferring a balance from one credit card to another may incur a balance transfer fee. These charges are often expressed as a percentage (say, 2%) of the amount being transferred. 

If you go above your credit card's limit, you may incur over-limit fees. Of course, if you don't pay at least the minimum by the due date, you'll have to pay a late fee. It's important to remember that the issuer might withdraw your promotional rate if you miss a payment.

Credit Cards: 5 Essentials You Should Know

We'll walk you through the fundamentals of applying for and using a credit card, but keep in mind that debt is like fire: it may be a valuable weapon in the right hands, but it can quickly become dangerous in the wrong ones (related alternative: UK Savings Apps).

📕 1. There will be a credit check involved.

Credit cards need a credit check, just like any other kind of credit. The lender may then evaluate your income and debts to determine your creditworthiness, or “risk”. You'll then get an acceptance or rejection message.

However, the criteria are confidential and may vary across lenders, making it possible that you might be approved by one but rejected by another. Eligibility checkers examine numerous card issuers and provide the likelihood of getting each card, thus using one before applying will greatly increase your chances of approval.

Even if your application is ultimately denied, it will still appear on your credit report, which might make it more difficult for you to get credit in the future (especially if numerous applications are made in a short period of time). 

📘 2. A predetermined credit line will be given to you.

The maximum amount you may borrow at one time is indicated on the back of every credit card. Keep in mind, too, that you'll have to pay back whatever money you borrow.

Keeping in mind customer defaults due to the cost of living being on the rise, you won't know how much of a credit line you'll be given until you've applied for the card, since the creditor decides that amount based on criteria including your income and credit history.

In most circumstances, you'll need to have used the card for a few months before you may seek a decrease or raise in your limit. You may choose not to accept an automatic increase in your limit that may be offered by your service provider.

📕 3. Always pay at least the minimum.

Always pay at least the minimum due each month by setting up a direct debit payment plan.

Your credit card company sends you a bill every month that contains a statement detailing your expenditures throughout that billing cycle. The entire balance, or the amount needed to pay off the debt in full, as well as the minimum payment and the due date will be shown.

If you can afford to do so, paying off your credit card balance in full and on the due date will save you the most money (interest will still be charged on cash withdrawals, though).

If you can't pay more than the minimum, at least pay that. If you don't pay up, you're breaching the terms of the agreement and will be charged a late fee of about £10 as well as having a missed payment recorded on your credit report, which may negatively affect your score for up to six years.

Set up a direct debit to pay off the minimum (or a higher/full amount if you can) every month to make sure you don't forget. As soon as you realise you won't be able to make a payment, call your service provider and negotiate with them to come up with a new repayment schedule.

What is the lowest payment that I can make?

Both the amount you owe and the policies of your credit card company will play a role here. 

A common minimum payment is between 1% and 2.5% of the total amount owed (including interest and levies like late fees), or £5 to £25.

One such condition set out by a lending institution reads: “Greater of 1% of balance plus interest or £5.” If the total amount due on your bill was £1,000 after interest and fees, the bare minimum payment due would be £10. This is the lowest possible repayment amount since it is more than £5. Since 1% is just £2, you'd have to pay back at least £5 if you owed £200.

📗 4. Avoid high-priced ATM withdrawals.

Avoid high-priced ATM withdrawals and interest charges by paying off your amount in full every month.

Credit card companies begin charging interest on unpaid balances on purchases made when the balance is less than zero.

This is typically calculated on the complete statement amount and the date each payment was made. In the event that you paid £350 towards a £400 debt but still owed £50, you would continue to accrue interest on the whole £400 balance until you paid it in full.

Withdrawals of cash are often handled differently, and immediate interest (sometimes at a higher rate) is frequently charged. You should also avoid using certain cards since they incur a fee of roughly £3 every time cash is withdrawn.

The interest rate is expressed as an annual percentage rate. The average APR is roughly 19%-22%, but it may go as high as 60% for those with weak credit.

For example, your purchase interest rate may be 19.9%, but your cash advance rate could be 23.9%. If this is the case, the ‘allocation of payments' will prioritise paying off the item on your bill with the highest interest rate first.

📘 5. Your credit history will be affected by how effectively you handle your credit card.

Your credit report will include information on your use of credit cards, such as the number of cards you have, your credit limit(s), whether or not you've made cash withdrawals, and your outstanding balance as of the last time your credit card provider reported it.

It also keeps track of your payment history, which is important. Making even the minimal payment (preferably more) on or before the due date has a beneficial effect on credit scores since it demonstrates a history of responsible borrowing to potential lenders.

However, this might be negatively affected if you have late payments, go over your credit limit, or make frequent cash withdrawals. As late payments may stay on your credit report for up to six years, this can have long-lasting repercussions.

How to Evaluate Your Credit Card

Whether you're looking for your first credit card or your fifth, it pays to shop around.

When comparing credit cards, it's important to keep in mind the following details:

  • The Typical Variable Purchase Interest Rate
  • Interest Rate for Borrowing Money and Getting a Cash Advance
  • Conditions of the introductory APR offer
  • Costs per year
  • Compensation plans
  • Specifics of the New Customer Bonus Offer

Consider the card's additional features and perks, if any. If you want to establish a travel credit card so you can earn miles or points towards airfare and hotel stays, you can also look for one that has perks like airport lounge access and airline charge refunds.

When deciding whether or not to pay an annual fee for a credit card, it is wise to weigh the value of the card's incentives and perks against the cost of the charge.

Summary…

If used wisely, a credit card may help you develop credit. Maintaining excellent credit requires timely payments, modest balances, and the use of credit cards only when absolutely necessary. Remember that paying your account in full each month is the greatest approach to both prevent interest charges and create a solid credit history.

Related Guides:

FAQs

Can you explain the key distinctions between using a credit card and a debit card?

How exactly can using a credit card help you improve your credit score?

Where does one even begin looking for a credit card?

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