What Is a Credit Card? How Does It Work?

September 28, 2020

When trying to get to grips with personal finance, it's best to start with the basics. Today we're going to be discussing what credit cards are, and how they work. Let's get started

What Is a Credit Card?

There's essentially two types of money, credit, and debit. Debit is money that comes from a personal bank account, and credit is money that is lent to you by a bank or other credit issuer. If you are approved for a credit card, then you can use the card to make purchases at merchants who accept them as payment. You borrow money to make purchases up to a set limit, and this money must be repaid at a later date.

How Does a Credit Card Work?

Credit cards can be thought of as short term loans. When you open a credit card, you have then been approved for a line of credit. You can borrow money to make purchases, on the condition that you pay the money back, plus any interest or other agreed-upon charges.

Let's break down how credit cards work by looking at some common credit card vocabulary. You will come across these terms when you are researching credit cards, so it's a good idea to familiarize yourself with them. 

  • Credit limit - The amount of money you can spend before your card is "maxed out." Your limit is set by the issuer and will depend on several factors such as your income, credit history, length of financial relationships, and more. Collectively, Americans are using 23% of their available credit limit[1]. Experts recommend that you should not use more than 30% of your credit limit because this shows lenders that you are financially responsible[2].

  • Available credit - This is the amount you can spend before hitting your credit limit. For example, if your credit limit is $1200, and your balance is $400, then your available credit is $800.

  • Balance - How much money you have spent on the card but haven't yet repaid.

  • Billing cycle - A defined period where you make purchases (for example, one month). You receive a bill once the period is over.

  • Statement due date - The date by which you must at least pay the minimum payment. Credit cards allow you to pay a fraction of your debt at each statement due date, this is known as a minimum payment and it will be significantly less than your balance. However, you pay interest on anything you don't pay off.

How Does Interest Work?

Interest is essentially the fee you pay for the privilege of borrowing money. Interest is typically expressed as annual percentage rate (APR) and is only charged on the money you owe at the end of each month. The average interest rate in the US is 14.52%[3].

You should always try to pay your balance off in full each month to avoid paying interest, rather than just make the minimum payment. If you only make the minimum payment, then your balance can quickly spiral out of control and it can be difficult to get back on top of your finances. However, sometimes paying the balance isn’t an option. If you can't pay the balance, then you should always ensure you make the minimum payment to avoid a hit to your credit score.

Rahul Iyer

[1] https://www.fool.com/the-ascent/research/credit-card-debt-statistics/#:~:text=The%20average%20credit%20card%20interest,14.52%25%20as%20of%20May%202020.&text=If%20we%20just%20consider%20accounts,according%20to%20the%20Federal%20Reserve.

[2] https://www.nerdwallet.com/article/finance/30-percent-ideal-credit-utilization-ratio-rule#:~:text=How%20close%20are%20you%20to,available%20credit%20on%20any%20card.

[3] https://www.fool.com/the-ascent/research/credit-card-debt-statistics/#:~:text=The%20average%20credit%20card%20interest,14.52%25%20as%20of%20May%202020.&text=If%20we%20just%20consider%20accounts,according%20to%20the%20Federal%20Reserve.