There are over 300 million credit card accounts in the United States alone, and it’s estimated that 79% of consumers have at least one credit card or charge card. Yet, many people don’t have a firm grasp on the basics of what a credit card is and how credit cards work.
If you have a credit card account, or plan on ever using one, it’s important to understand the fundamentals of credit cards. Read on to learn what you need to know so you understand how do credit cards work.
What Is a Credit Card?
A credit card is a type of payment card that is used to access a revolving line of credit.
Credit cards differ from other types of loans in that they offer a physical payment card that is used to make purchases.Traditionally, credit cards are made of plastic, but an increasing number of credit card issuers now offer metal cards, usually for their premium accounts that offer travel rewards.
But a credit card account is much more than a plastic or metal payment card. A credit card account is a powerful financial tool that can serve many purposes. For starters, it can be a secure and convenient method of payment anywhere that accepts credit card payments. It also can be used to borrow money in a cash advance or to complete a balance transfer.
Additionally, credit cards can offer valuable rewards, such as cash back and travel rewards like points or miles. Cardholder benefits can also include purchase protection and travel insurance policies.
If used responsibly, a credit card can help you to build your credit score and history, which can open up new borrowing opportunities. Of course, credit cards can also damage your credit when used irresponsibly. If you rack up debt on your credit card, it can be hard to get it paid off and back in the clear (here, for instance, is what happens to credit card debt when you die).
How Credit Cards Work
Credit cards offer a line of credit that you can use for a variety of purposes, including making purchases, completing balance transfers, and taking out cash advances. You can borrow up to your credit limit, and you’ll owe at least the minimum payment each month.
You can apply for a credit card from any one of hundreds of credit card issuers in the U.S. Card issuers include national, regional, and local banks, as well as credit unions of all sizes. Card issuers will approve an application based on the credit history and credit score of the applicant, among other factors.
Thankfully, there are credit cards designed for people with nearly every credit profile, from those who have excellent credit to those with no credit history or serious credit problems. As with any loan, those with the highest credit score will receive the most competitive terms and benefits.
Once approved, the credit card user will likely receive a credit limit that represents the most that they can borrow. The average credit card limit for Americans was $30,365 in 2020, according to a recent report by the credit bureau Experian. However, individual credit card limits can vary depending on a variety of factors, and can be as low as $300.
The credit card is then mailed to the account holder and must be activated before use. You can activate a credit card online or over the phone. So long as your account remains in good standing, it will be valid until the credit card expiration date.
Once activated, the card can be used to make purchases from any one of the millions of merchants that accept credit cards. Each card is part of a payment network, with the most popular payment networks being Visa, Mastercard, American Express, and Discover. When you make a payment, the payment network authenticates the transaction using your card’s account number and other security features, such as the CVV number on a credit card.
Every month, you’ll receive a statement from the card issuer at the end of each billing cycle. The statement will show the charges and credits that have been made to your account, along with any fees and interest changes being assessed. For example, some credit cards charge an annual fee, and there are other fees that some card issuers can impose, such as foreign transaction fees.
Your credit card statement will also show your balance, minimum payment due, and payment due date. It’s your choice whether to pay your minimum balance, your entire statement balance, or any amount in between. Keep in mind that you will owe interest on any balance that’s not paid back.
If you don’t make a payment of at least the minimum balance on or before the due date, then you’ll usually incur a late fee. And if you pay more than your balance, you’ll have a negative balance on your credit card.
How Does Credit Card Interest Work?
The charges you make to your credit card are a loan, and just like a car loan or a home loan, you can expect to pay interest on your outstanding balance.
However, nearly all credit cards offer an interest-free grace period. This is the time between the end of your billing period and the payment due date, typically 21 or 25 days after the statement closing date. If you pay your entire statement balance before the payment due date, then the card issuer will waive your interest charges for that billing period.
If you choose not to pay your entire statement balance in full, then you’ll be charged interest based on your account’s average daily balance. The card issuer will apply your account’s interest rate to your account’s average daily balance. Currently, the average credit card interest rate in the United States is approximately 15% APR. APR stands for annual percentage rate, and the card issuer will divide this number by 365 (the number of days in the year) to come to a daily percentage rate that is then applied to your account each day.
So, for example, if you had an APR of 15.99%, your daily interest rate that the card issuer would apply to your account each day would be around 0.04%.
Credit Cards vs Debit Cards
Although credit cards and debit cards look almost identical, they’re very different financial instruments.
With a debit card, you can only spend the funds that you’ve already deposited in the checking account associated with the card. Any spending done using your debit card is drawn directly from the linked account. Because debit cards aren’t a loan, your use of a debit card won’t have any effect on your credit, positive or negative.
But since it isn’t a loan, you also won’t be charged interest with a debit card, nor will you need to make a minimum monthly payment. You will, however, need to make sure you have sufficient funds in your linked account before using your debit card.
Another key difference between credit cards vs. debit cards is that credit card users are protected by the Fair Credit Billing Act of 1974. This offers robust protections to prevent cardholders from being held responsible for fraud or billing errors. Debit card transactions are subject to less powerful government protections.
Lastly, debit cards rarely offer rewards for spending. They also don’t usually feature any of the travel insurance or purchase protection policies often found on credit cards. You likely won’t be on the hook for an annual fee with a debit card, which is a fee that some credit card issuers do charge, though you could face overdraft fees if you spend more than what’s in your account.
Really, the only thing that debit cards and credit cards truly have in common is that they’re both payment cards. They both belong to a payment network, and you can use them to make purchases.
Credit cards | Debit cards | |
---|---|---|
Can be used to make purchases | Yes | Yes |
Can be used to borrow money | Yes | No |
Must deposit money before you can make a purchase | No | Yes |
Must make a minimum monthly payment | Yes | No |
Can provide purchase protection and travel insurance benefits | Often | Rarely |
Can offer rewards for purchases | Often | Rarely |
Can help or hurt your credit | Yes | No |
Can use to withdraw money | Yes, with a cash advance | Yes |
How to Compare Credit Cards
Since there are hundreds of credit card issuers, and each issuer can offer numerous individual credit card products, it can be a challenge to compare credit cards and choose the one that’s right for your needs. But just like purchasing a car or a pair of shoes, you can quickly narrow down your choices by excluding the options that you aren’t eligible for or that clearly aren’t right for you.
Start by considering your credit history and score, and focus only on the cards that seem like they align with your credit profile. You can then narrow it down to cards that have the features and benefits you value the most. This can include having a low interest rate, offering rewards, or providing valuable cardholder benefits. You may also value a card that has low fees or that’s offered by a bank or credit union that you already have a relationship with.
Once you’ve narrowed down your options to a few cards, compare their interest rates and fees, as well as their rewards and benefits. You can find credit card reviews online as well as user feedback that can help you make your final decision.
Important Credit Card Terms
One of the challenges to understanding how credit cards work is understanding all of the terms. Here’s a small glossary of important credit card terms to help you to get started:
Annual fee: Some credit cards charge an annual fee that users must pay to have an account. However, there are many credit cards that don’t have an annual fee, though these cards typically offer fewer rewards and benefits than those that do.
APR: This stands for annual percentage rate. The APR on a credit card measures its interest rate and fees calculated on an annualized basis. A lower rate is better for credit card users than a higher rate.
Balance transfer: Most credit cards offer the option to transfer a balance from another credit card. The card issuer pays off the existing balance and creates a new balance on your account, nearly always imposing a balance transfer fee.
Card issuer: This is the bank or credit union that issues the card to the cardholder. The card issuer the company that issues statements and that you make payments to.
Cash advance: When you use your credit card to receive cash from an ATM, it’s considered a cash advance. Credit card cash advances are usually subject to a much higher interest rate and additional fees.
Chargeback: When you’ve been billed for goods or services you never received or that weren’t delivered as described, you have the right to dispute a credit card charge, which is called a credit card chargeback. When you do so, you’ll receive a temporary credit that will become permanent if the card issuer decides the dispute in your favor.
Due date: This is the date that you must make at least the credit card minimum payment. By law, the due date must be on the same day of the month, every month. Most credit cards have a due date that’s 21 or 25 days following the statement closing date.
Payment network: Every credit card participates in a payment network that facilitates each transaction between the merchant and the card issuer. The most common payment networks are Visa, Mastercard, American Express, and Discover. Some store charge cards don’t belong to a payment network, so they can only be used to make purchases from that store.
Penalty interest rate: This is a separate, higher interest that can apply to a credit card account when the account holder fails to make their minimum payment on time.
Statement closing date: This is the last day of a credit card account’s monthly billing cycle. At the end of this day, the statement is generated either on paper or electronically, or both. This is the day on which all the purchases, payments, fees, and interest are calculated.
Apply for a SoFi Credit Card Online and Earn 2% Cash Back1
Now that you’ve read up on the basics of credit cards and have a clear understanding of how a credit card works, you may feel more ready for one of your own. Did you know that SoFi offers a credit card that allows you to earn cash back? The SoFi Credit Card offers 2% cash back on all purchases when you redeem your rewards to pay down eligible debt, save, or invest with SoFi. Or, you can receive 1% cash back when you redeem your rewards for a statement credit.
The new SoFi Credit Card is also the first card that allows you to redeem your rewards directly for cryptocurrency. You’ll earn 2% cash back on all purchases, and you can redeem your rewards directly into crypto with your SoFi active invest account.
Learn more and apply for a SoFi Credit Card today!
FAQ
How does a person shop for a credit card?
To shop for a credit card, start by looking at your credit score to determine what cards you may be able to qualify for. Then, decide what kind of card is best for your needs, such as a card that has a low interest rate, one that will allow you to build credit, or a card that offers rewards. Finally, compare similar products from competing card issuers to assess which is the most competitive offer available to you.
Can I use my credit card abroad?
Yes, most credit card payment networks are available in most countries. As long as you visit a merchant that accepts cards from the same payment network that your card belongs to, then you’ll be able to make a purchase.
Can I get a joint credit card?
Joint credit card accounts used to be common, but they are now extremely rare. However, you can make someone an authorized user on your account. With an authorized user, the primary account holder will always be responsible for making payments, not the authorized user.
1See Rewards Details at SoFi.com/card/rewards.
Checking Your Rates: To check the rates and terms you may qualify for, SoFi conducts a soft credit pull that will not affect your credit score. A hard credit pull, which may impact your credit score, is required if you apply for a SoFi product after being pre-qualified.
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Source: sofi.com