Last Updated on July 28, 2021 by pf team
In this article we’ll explore how do credit cards work, including some of their useful features and some of the potential pitfalls to avoid. Credit has become a deep-rooted part of modern life, woven into nearly every transaction and even at the heart of our currency.
However, credit and cash, while they can both be used to pay for goods and services, can have very different effects on our personal finances. Credit cards have many benefits and can be a powerful tool, but like all tools, should be used responsibly.
Credit card debt continues its rise, reaching nearly $800 billion in the US in 2018, about 20% of the nation’s total household debt.
Revolving debt, most of which is credit card balances, recently topped $1 trillion, according to the Federal Reserve. Big numbers can create alarming headlines, but credit can be a good thing as well.
What is a credit card?
To understand credit cards and how they work, it’s useful to understand a bit of their history.
The use of credit dates back thousands of years with some of the earliest examples of credit being documented in the Code of Hammurabi, named after the Babylonian king, Hammurabi, who ruled from 1792 B.C to 1750 B.C.
Credit in later years came in several forms, including both written and verbal agreements, and even some industry-specific cards, like air-travel cards, first introduced in the 1940s.
However, credit cards didn’t reach the universally accepted pocketable portability we now know until the 1950s, when Diner’s Club introduced its credit card, a card that was accepted by many retailers in various industries, but which had to be paid in full each month.
Most credit cards work differently than the original Diner’s Club card. Almost all cards now allow you to carry a balance, although accruing interest charges on carried balances.
Modern credit cards can be for use at a specific store or group of stores, or they can be more universal, like widely accepted Visa, MasterCard, American Express, or Discover cards.
When you make a purchase with a credit card, in most cases, you’re able to pay back the balance in full without having to pay interest.
However, the payment has to cover the entire outstanding balance and must be paid by the due date to avoid interest charges and late fees.
The cost of credit card interest varies based on a number of factors but is usually much higher than the interest cost for other types of credit, like mortgages or auto loans.
Most popular types of credit cards
Credit cards come in several types, sometimes bringing money saving advantages and with some designed to help you build credit or even just provide a secure way to make purchases.
- Unsecured credit card: This is what most of us think of when we think of a credit card. There is no deposit or collateral required. Credit limits are typically determined by credit scores, income, and other relevant criteria.
- Secured credit card: sometimes used as a way to build or rebuild credit, a secured credit card utilizes a deposit amount to establish a credit line.
- Prepaid credit card: similar to a secured credit card, a prepaid credit card limits spending by the amount you've deposited into your card account. Unlike secured credit cards, prepaid credit cards aren't useful for building a credit history because their payment history and usage aren’t reported to the credit bureaus.
- Travel rewards credit card: Many credit card companies provide rewards for using their card. Among the most popular types of rewards cards are travel rewards cards, which allow you to earn points toward airfare or other travel expenses.
- Gas rewards and cash-back rewards credit cards: Similar to travel rewards, gas rewards cards pay rewards based on purchase volume. As rewards accrue, you may have the option to redeem your rewards in the form of a check or direct deposit, as an account credit, or gift cards.
- Student credit card: Typically offered with a low starting credit line, student credit cards are targeted at young consumers and are a common way to begin building credit or add to a thin credit history. In some cases, rates for student credit cards are considerably higher than the average APR for other types of cards, but with some shopping, better rates may be available.
- Retail credit card: Before the popularization of student credit cards, retail credit cards — limited to use at one store or chain, were a common first step in building a credit history. Often, these cards are offered with 90-days-same-as-cash or similar promotions.
Some types of cards are better describes as marketing initiatives. You might even find these marketing offers combined with another type of credit card, like a rewards card.
- Balance transfer credit card: While not necessarily a type of card, per se, balance transfer offers are a popular way to entice new customers with low or no interest charges on transferred balances during a promotional period. It’s common for balance transfers to charge a percentage of the transferred amount up front, adding the balance transfer fee to your balance.
- 0% intro APR credit card: Introductory offers are common for credit cards. Be sure to read the fine print, however. Rates won't stay low forever and other costs may apply.
How is credit card interest calculated?
The interest rate (APR) for credit cards is usually most heavily driven by two factors: the prime rate, an interest rate benchmark, and your credit or payment history.
Because both factors can change, credit card interest is variable and can change if the prime rate changes or if your payment history — even elsewhere — takes a turn.
Credit cards use compound interest when applying finance charges to carried balances. With many other types of loans, like most mortgages and auto loans, simple interest is used which helps to minimize the cost of borrowing.
Most credit cards, however, use compound interest, which means that interest can be applied to balances, fees, and prior interest.
Compounding is one of the factors that helps investment accounts grow over time, but when applied to debt, it can create balances that are difficult to escape because they can grow even if you haven’t purchased anything new with your credit card.
Credit card companies use the average daily balance as a base to which they apply interest.
A simplified example of credit card interest
Let’s say you had a balance of $500 at the beginning of the billing cycle. You had that balance for 5 days, after which your statement payment reduced the balance to $250.
In this example, you have a balance of $500 for 5 days and a balance of $250 for 25 days. You might think that you’re only paying interest on $250, the ending balance.
The average daily balance can vary from the ending balance, however.
The math would look like this:
$500 x 5 = $2500
$250 x 25 = $6,250
Total = $8,750
Fortunately, you won’t have to pay interest on nearly $9,000. The number is then divided by 30 to compute the average daily balance.
$8,750 / 30 = $291.67
Interest is then applied to the average daily balance of $291.67. Let’s say your APR is 18%. Many credit card companies use a divisor of 360 to represent the number of days in a year.
The APR is then divided by 360. Again, some credit card companies use 365 and some use 360.
.18 / 360 = .0005
.0005 is the daily periodic interest. This is multiplied by the average daily balance of $291.67.
$291.67 x .0005 = .1458
.1458 is the daily finance charge, which is only about 15 cents because the balance is relatively low.
The daily finance charge then needs to be applied for each day in the billing cycle. Just multiply by 30 to calculate the monthly finance charge.
.1458 x 30 = $4.37
Credit card providers do the math for you, but it’s useful to understand how the credit card interest is calculated — especially if your balance is higher or the interest rate is higher.
It’s also interesting to note that if you make your payment earlier in the billing cycle, interest costs are reduced because you have more days with a lower balance after your payment is applied.
Following the same math, if you make a purchase later in the month, the interest cost is reduced slightly because you’ll have fewer days with a larger balance.
There may also be separate interest rates depending on how the balance came to be. Your interest rate for purchases is the one most commonly used, but you might also have a separate interest rate for cash advances and another for balance transfers.
In our example, the interest charges for the month were only $4.37 because the balance was so low. The numbers for most households look much different.
According to Experian, one of three credit bureaus in the US, the average credit card balance in 2018 is $4,293, as reported in their annual State of Credit report.
Using the same interest rate of 18% and assuming a fairly static daily balance, the monthly interest cost is $64.40, or nearly $800 per year — and that’s for one credit card. Many of us have more than one card.
What is minimum payment?
Your credit card company provides you with a minimum payment amount, which is usually about 2% of the balance but can vary. For small balances, a fixed minimum amount may be used, like $10.
Paying the minimum balance can provide flexibility when money is tight, but always making the minimum payment cause the balance to outlive whatever you used the money to purchase.
For example, if your credit card balance was the average amount of $4,293 at 18% interest, making a minimum payment of 2% comes to about $86 per month.
At the same time, the interest charges are still accruing, creating a headwind that prevents the balance from going down as quickly as you might hope.
The balance of $4,293 will take over 30 years to pay off and you’ll pay nearly $11,000 in interest charges. Credit card debt is one of the most expensive types of debt in most households.
Whenever possible, consider prioritizing credit card debt by making larger payments.
Amounts that exceed the interest charges are applied to the balance, reducing the balance as well as future interest charges — and helping you to pay off the balance faster while saving money.
What happens if you miss a payment?
It’s wise to make on-time payments for every type of credit but credit cards can become much more expensive if you miss a payment.
The first consequence you can expect for a late credit card payment is a late fee, which is usually in the range of $25 to $35. In addition to a late fee, it’s possible that a late payment can trigger some other events:
- Penalty APR: For many credit cards, there is an additional APR that may apply if you have late payments. This APR, called a penalty APR, can replace your lower APR, costing you more interest on any remaining balance or future balances. The penalty APR can be as high as 29.99%, so it’s important to avoid late payments.
- A negative item on your credit report: In some cases, a late payment will be reported to the credit bureaus. Negative items can remain on your credit report for up to 7 years — even if future payments are on time.
- Lower credit score: Credit scores have many moving parts, which makes it difficult to know the full impact of negative items on your credit report. In addition to the three credit bureau scores, MyFico also compiles information from the three bureaus and issues FICO scores for individual types of credit. It’s possible for a late payment to affect both broad scores and your FICO credit card score.
How credit cards impact your credit score?
The three main credit bureaus now use a scoring method called VantageScore, which rates individuals using a scale from 500 to 990. You also have a FICO score, which is the credit score utilized by most lenders.
Lastly, you have FICO credit scores for each type of borrowing, like a mortgage, auto loans, and credit cards.
Each scoring system prioritizes different credit factors in its own way, but there are some key considerations that often have a larger effect on credit scores.
- Credit utilization: This measurement compares the amount of credit you have available to the amount of credit you’ve used. If you have a credit card with a $5,000 credit line and you have a balance of $4,500, you have 90% credit utilization. Generally, lower utilization is better for your credit score, although it’s also considered wise to keep utilization above 0% and below 30%.
- Age of credit accounts: The age of your credit account can also play a role, with an older average account age usually helping your score. If you’re thinking about closing old credit card accounts, consider just not using them instead and storing the card securely. Those old accounts are probably helping your score by raising the average age of credit and by keeping your overall credit utilization down when they aren’t being used.
- Payment history: Your credit card payment history plays a large role in your credit score as well. Late payments can lead to higher rates on new credit, like auto loans, mortgages, or other credit cards. Conversely, good payment history is helpful to your credit score.
The information on your credit reports can affect more than your interest rates.
It’s common for employers to request credit reports — although they can’t see your credit score because they aren’t creditors — and it’s also common for insurers to use the information in credit reports as one of many rating factors used to set premiums for insurance.
How to protect yourself from credit card fraud
About a third of identity fraud complaints involve credit card fraud. Other recent sources put the number even higher. In some cases, the fraud came as the result of data breaches at retailers or service providers.
In other cases, the fraud came as the result of online activity, phishing schemes, credit card skimmers, or other schemes targeting individual consumers. Untangling the mess if you are a victim of credit card fraud can be time-consuming and even costly.
Take some extra steps to protect your credit card information:
- Store your credit cards out of harm's way
- Shred documents that have your credit card information
- Avoid giving out your credit card information over the phone or online
- Report lost or stolen credit cards
- Develop online credit card safety habits
- Use strong passwords to protect your online accounts
- Review your billing statements to verify transactions
- Check ATM machines and gas station pumps for skimmers
When it’s best to use credit cards?
Even in cases where you have the money to pay for goods or services, there are times when using a credit card may be a better choice.
Don't use debit cards
Debit cards are subject to the same risks as credit cards and debit card information can be stolen and used in the same way that credit card information can be used fraudulently.
If a debit card is stolen or compromised, however, the incident can empty your bank account, leaving you without a way to pay the mortgage, rent, or cover other living expenses.
According to an annual consumer study done by the Federal Reserve, 40% of Americans can’t cover a $400 emergency without borrowing or selling assets.
Credit cards are much safer to use
Using a credit card instead is safer in many cases because, if the card number becomes compromised, the balance is on the credit card and you’ll have time to sort out the details with your credit card company and dispute the charges.
The same breach if a debit card is involved could set off a financial avalanche in many cash-challenged households.
Get credit card points
Many credit cards also offer points or rewards based on your purchases. If you don’t carry a balance and therefore don’t have to pay interest, these promotions are like found money.
In effect, you’re earning money for purchases you would make anyway.
Select credit cards also offer purchase protection, which can extend warranties or protect against other mishaps with newly purchased items.
Take advantage of credit card price protection
Some cards even offer price protection, which can help cover the difference in price if you find an item you purchased for less elsewhere within a specified period of time.
While this perk is becoming less common, it’s still available from a number of credit card providers.
Consider credit cards that offer roadside assistance
Your credit card may even be able to provide coverage for roadside assistance or provide coverage for damage to rental vehicles if you have an accident.
These are all perks that you won’t have with cash, checks, or debit card transactions.
Basic definitions of common credit card terms
- Credit card account: A credit card account is a revolving line of credit, which means you can continue to use the credit line again and again as opposed to one-time loans. The credit line can be used anywhere that accepts that type of credit card.
- Credit limit: When you open a credit card account, the credit limit defines the maximum amount you can borrow.
- Credit balance: The actual amount you’ve borrowed and haven’t yet repaid is your credit balance.
- Available credit: The amount of credit you haven’t yet used from your credit limit is your available credit.
- Credit card interest rate (APR): The annual percentage (APR) rate represents the percentage of interest you’ll pay on carried balances on an annualized basis. Interest charges are actually calculated using a daily periodic rate, which is based on the APR.
- Credit card fees: Credit cards can come with a variety of fees — in addition to interest charges. Fees can range from simple card-member fees that allow you to become a cardholder with a given card to penalty fees for late payments or fees for going over the credit limit.
- Billing cycle: The billing cycle for credit cards or other types of credit is a monthly interval between billings for your account and is used to determine final balances and interest due. For example, your billing cycle might run from the 15th of one month to the 15th of the next month.
- Statement due date: After a billing cycle has ended, a credit card statement is sent which details your activity for the month. If there is a balance, a minimum payment is due to avoid late payments and possible negative information on your credit history. By law, the due date has to remain the same from month to month even if the billing cycle date varies.
- Minimum payment: The method of calculation can vary, but if you carry a balance, you’ll usually be required to pay a minimum amount by the statement due date. Often this amount is about 2% of the outstanding credit balance at the end of the billing cycle.
Some terms describe elements that are used to calculate the interest due on carried balances:
- Average daily balance: Credit card companies don’t charge interest based on the ending balance shown on your credit card statement. Instead, they use a daily average to calculate interest. This average balance may be higher or lower than the closing balance.
- Daily periodic rate: In calculating the interest charges for the month, the average daily balance is multiplied by the daily periodic rate, which is based on the APR. Many credit card companies use a formula that divides the APR by 360, although some use 365 as the divisor.
Final thoughts on how do credit cards work
Over the years, credit cards have gotten a bad rap. Some of the negative perceptions associated with credit cards may have been well deserved. After all, it’s difficult to find a type of credit that has interest rates as high as the average credit card.
As consumers, on average, we pay a large percentage of our after-tax income to credit card companies and other lenders in the form of interest. However, it doesn’t have to be this way.
When used cautiously, credit cards can be a money-saving tool that can also make transactions safer and offer additional benefits, like product protection or roadside assistance.
If you choose to use a credit card, be mindful of due dates but also try to pay the balance in full to avoid finance charges.
If a credit card offer requires an annual fee, carefully consider the benefits before applying because you’ll have to pay the fee even if you don’t use the card.
As a whole, credit cards are neither good nor bad; they are simply a tool, so use them with care.