November 25, 2024

How Do Credit Cards Work? A Guide

Every day, Americans reach for their credit cards more than 150 million times. That's 104,167 transactions every minute.

You might take that little plastic card in your wallet for granted. For most people, it's simply there when you need it, ready to make purchases with a quick tap or swipe. But what goes on behind the scenes? How do credit cards work?

From exploring different types of cards to keeping your credit score in good shape, here’s a guide to credit cards. Learn the know-how you need to make informed decisions and use a credit card responsibly.

How credit card purchases work: The transaction process

What really happens when you tap your credit card at your favorite coffee shop? In just seconds, a complex dance of digital communication begins. Here's how it works:

1. Initial transaction

It all starts when your card details zip from the merchant's payment terminal to their bank. This kicks off a rapid series of checks and verifications through the credit card network. The credit card system instantly checks your limit and available credit to make sure you can make the purchase.

2. Security check

Next, your credit card issuer springs into action. Whether you’re using a plastic or virtual card, the issuer verifies that your credit card isn't expired or reported stolen, screens for potential fraud, and validates security features like your CVV code (that little number on the back of your credit card). Think of it as a lightning-fast security checkpoint for your account.

3. Authorization

If everything checks out, the authorization process begins. Your issuer sends an authorization request to the merchant with the transaction details and reduces your available credit by the purchase amount. That's why you sometimes see charges marked "pending" in your transaction history.

4. Settlement

The actual settlement happens a few days later. This is when the merchant receives the payment and the finalized transaction officially appears on your statement. If you left a tip at that coffee shop, it's during settlement that the final amount gets adjusted.

5. Wrapping up the billing cycle

The whole process wraps up when your monthly billing cycle closes. Your credit card issuer generates a statement showing all your transactions, any fees or interest charges, and your minimum payment amount. It also sets your due date, which usually falls on the same day each month.

How credit card payments work

Swiping or tapping at the grocery store is second nature. But what happens when it’s time to pay the bill? How do credit card payments work, exactly? Understanding the terminology is the key to clearing things up:

Grace period

A grace period gives you time to pay for your credit card purchases without getting charged interest. The grace period window typically starts on your statement date and ends on your payment due date.

But here's the catch: You only get a grace period if you paid your previous bill in full and on time. If you carry over a balance from last month, you'll start accruing interest charges on new purchases right away.

Statement balance and minimum payment

When the billing cycle ends, your credit card issuer creates a snapshot of your account called a statement balance. This includes all your credit card transactions from that billing period and the amount you'll need to pay to avoid interest charges. Some recent or pending charges might not show up until your next statement.

Your credit card statement shows a minimum payment amount, typically a small percentage of your balance. While paying this amount every month keeps your account in good standing, it's not ideal. Covering only the minimum means you'll rack up interest charges, and it might take months or even years to clear your balance.

Current balance

Your current balance is like a real-time counter of what you owe. It includes your statement balance plus any new purchases or pending charges. Issuers use the current balance to calculate your available credit and update it continuously as you use the card.

Payment methods

In the past, paying your credit card bill meant writing checks and finding stamps. Today, most people pay online through your issuer’s website or app.

Instead of paying manually, it's a smart move to set up automatic deposits. This way, you never miss a due date. You can choose to pay the minimum amount, the statement balance, or a fixed amount.

Payment timing

Payments can take a few business days to clear, so plan ahead to avoid late fees. If your monthly due date falls on a weekend or holiday, you typically have until the next business day to pay.

Payment processing

Once you make a payment, you receive a confirmation for your records, but your available credit won't update until the money fully clears. Some payment types might have temporary holds, especially large amounts or transfers from new sources.

Types of credit cards

Different types of credit cards are best suited to different circumstances and goals. Whether you're building credit for the first time or chasing a better interest rate, there's probably a credit card designed just for you. Let's take a look:

Unsecured versus secured credit cards

Most credit cards fall into one of two main categories: secured credit cards or unsecured credit cards.

Secured credit cards require a security deposit — an amount that usually becomes your credit limit too. This deposit reduces the risk for credit card issuers, which means you’re more likely to get approved. They’re a solid choice if you have a limited credit history or a less-than-stellar credit score.

The more common unsecured credit cards don't require a deposit. Instead, approval is based on your credit score and income. These cards often have higher limits and better perks, though they might charge an annual fee.

Balance transfer credit cards

Balance transfer credit cards save you money by offering low or zero interest rates on balances transferred over from other cards. While there's usually a balance transfer fee (often a percentage of the transferred amount), the interest savings can make it worthwhile. Double-check that the annual fee is reasonable to avoid ending up saving less than you think. And mark your calendar, because promotional rates usually come with an expiration date.

Student credit cards

Designed specifically for college students, these credit cards understand that you may be building credit for the first time. They typically have lower credit limits, but they also have more lenient approval requirements, since issuers don't expect students to have extensive credit history or hefty incomes.

How credit card interest and fees work

Credit cards have pros and cons. One of the biggest pitfalls is that if you don’t pay close attention to rates, fees, and limits, you could end up paying more than you realize. That’s one reason a debit card can be a better choice than a credit card.

Understanding these costs is essential for saving money and keeping your credit score in pristine shape:

Interest rates

Purchase APR. In most situations, the main interest rate you'll encounter is the purchase annual percentage rate (APR). Your credit card's APR is your yearly interest rate if you don’t pay off your balance in full every month. This rate varies primarily based on your credit score, and it only applies if you carry a balance beyond your grace period.
Balance transfer APR. Balance transfer APRs apply when you move debt between credit cards. While promotional rates can start as low as 0%, they bounce back to normal after the intro period ends.
Cash advance APR. A cash advance is when you use your credit card to take out cash from an ATM or bank. While it might sound convenient, it comes with a hefty price tag. Cash advance APRs are higher than most and don't have a grace period. If you're considering taking out a cash advance on your credit card, make sure you've exhausted all the more affordable options first.

Common fees

Annual fee. Many credit cards charge an annual fee, and for premium cards, it could be hundreds of dollars, so make sure you know what you’re paying. Some credit cards waive the annual fee for your first year.
Balance transfer fee. If you're considering a balance transfer, the fee is usually a small percentage of the transferred amount.
Cash advance fee. Cash advances don't just have a high APR. They also come with fees — usually a percentage of the amount you transfer.

How credit cards impact your credit score

Your credit card usage is one of the biggest factors that affects your credit score. Understanding what goes into it will help you build credit more effectively:

Payment history

Making payments on time has the biggest impact on your credit score. Late payments damage your credit history, though the impact lessens over time. The good news is that you're building credit with each on-time payment you make.

Credit utilization

This measures how much of your available credit limit you're using. Lower is better because it shows lenders you aren’t over-relying on your card. Here’s a pro tip: Because it raises your available credit, requesting a credit limit increase can keep your utilization low — as long as you use the extra credit responsibly.

Length of credit history

This factor considers your oldest and newest credit card accounts, plus their combined average age. The longer your credit history, the better. Keeping old credit card accounts open, even if you rarely use them, boosts your credit score by showing a longer track record.

Credit mix

Having different types of credit also improves your score. If you have a car or home loan in addition to your credit card, it shows lenders that you know how to handle debt responsibly.

New credit

Each time you apply for a new credit card, it's likely to trigger a small but temporary drop in your credit score. Multiple credit card applications in a short time can signal risk to lenders, so apply for new credit sparingly.

Track your credit for smart decisions with EarnIn

Understanding how credit cards work is just the beginning. With EarnIn, you can track your credit score for free. Avoid late payments and interest charges by making informed decisions, all while keeping your credit in check.

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Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.

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