A detailed processing cycle follows any credit card transaction, so get to know that cycle. (GETTY IMAGES) Credit Cards Work
Key Takeaways
- Credit cards allow you to buy purchases on credit and pay for them later.
- You don’t have to pay interest on purchases if you pay the balance in full by the due date.
- If you carry a balance, you pay compound interest, which makes debt grow quickly.
- Rewards credit cards allow you to earn rewards on purchases in the form of cash back, miles or points.
Why do you need to know how credit cards work? Because once you get a grip on the life cycle of a credit card transaction, you’ll have a clearer idea of how to use credit cards responsibly and stay out of debt. You’ll also know how to use credit cards to your benefit.
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It’s like mastering any other topic. Learn it from the ground up, and you’ll know how to tinker with it without breaking it.
What Is a Credit Card?
In a galaxy far, far away, there was a time when you only had to master a plastic rectangle when you wanted to use a credit card. Today, defining a credit card is more complex.
Yes, you can still use plastic to pay. But nowadays, paying with a credit card could involve using your smartphone as a virtual wallet or tapping your contactless credit card on a payment device. Despite the new options for using credit cards, the process that takes place behind the scenes is pretty much the same.
When you get approved for a credit card, you’ll still receive a card in the mail and be given a credit limit. As you use your credit card for purchases, your credit limit decreases. When you make a full payment, your credit limit is restored.
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How Do Credit Cards Work?
Let’s say you’re at the mall and your bill comes to $100. You insert your Chase Visa rewards credit card into the payment device, and that starts the payment cycle.
Here’s what happens next:
- Your credit card details are sent to the retailer’s bank, which is called the acquiring bank. Let’s say the acquiring bank is Wells Fargo. This bank has to get payment authorization from the credit card network, which, in this case, is Visa.
- This request is also routed through the credit card issuer, Chase, to validate the number, credit limit and CVV (security code). Note that Visa, Mastercard and Discover have a three-digit CVV, but American Express cards have a four-digit CVV. Chase either approves or declines the transaction and sends this response to Visa and to Wells Fargo.
- After Wells Fargo gets authorization to accept the payment, your issuer, Chase, puts this amount on hold on your account, which decreases your available credit.
- The retailer includes your transaction with a batch of all the other transactions for the day and sends it to Wells Fargo.
- Next, the clearing process starts. Wells Fargo sends the batch to Visa for processing.
- The Visa network then sends the transactions to Chase. Chase responds and sends the payment amount (less interchange fees) to the Visa network.
- Visa then pays Wells Fargo, less applicable fees. After fees, the retailer receives about $97 to $98 as a reimbursement for your $100 purchase.
- Chase sends you a bill for the purchase amount, $100, which you pay in full and by the due date to avoid interest.
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How Does Credit Card Interest Work?
When you use your credit card to buy an item, you get a grace period, which is the length of time between the date of your purchase and the due date on your statement. It varies by credit card issuer, but most grace periods are between 21 and 25 days. Assuming you aren’t carrying a balance from the previous month, if you pay your bill in full by the due date, you don’t have to pay interest.
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A credit card, when used responsibly, is basically a short-term, interest-free loan. It’s a good deal unless you carry a balance to the next month. When you do that, it’s called revolving a balance, and you’re charged compound interest on the balance at the purchase APR.
All credit cards have interest rates that are shown as an APR, which stands for annual percentage rate. The APR measures the annual cost of borrowing. It excludes extra costs, such as an annual fee.
Most credit cards use a variable APR, so your interest rate will vary based on the fluctuations of the prime rate, which is set by the Federal Reserve. For example, if the prime rate is 8% and the credit card’s base rate is 15.74%, you’ll have a variable APR of 23.74%. When the prime rate goes up, your credit card’s APR goes up by the same amount.
Read: Best Rewards Credit Cards.
Interest rates are higher right now because the Federal Reserve has raised the prime rate several times recently. Just remember this: Compound interest is a good thing when it’s a savings account. But it’s a bad thing when it comes to your credit card balance, especially when you have a high APR.
Read: Best Rewards Credit Cards.
Common Credit Card Fees
The Truth in Lending Act (Regulation Z) requires every credit card offer to disclose its rates and fees. These laws are designed to protect you when you apply for a credit card. But it’s still up to you to research the different types of credit cards online. And when you apply for and receive a new card in the mail, read all the disclosures that come with your credit card. Yes, all the fine print!
Purchase APR. This is the interest rate you’ll pay on purchases if you carry a balance. Note that rewards credit cards tend to have higher APRs.
Balance transfer APR. If you transfer a balance from one credit card to a balance transfer card, you’ll be given an APR for the amount transferred. If you have good credit, you might qualify for a balance transfer card with a 0% introductory APR.
READ: Best 0% Introductory APR Credit Cards for 2023
Balance transfer fee. Most balance transfer credit cards charge this fee, which is usually between 3% and 5% of the amount transferred.
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Cash advance APR. If you use your credit card to get cash, you’ll be charged at a higher APR for the amount withdrawn. A cash advance APR can average around 26% or even higher. With most credit cards, the interest on a cash advance starts accruing right away, so try to avoid getting cash this way.
Cash advance fee. Most credit cards charge around 5% of the amount withdrawn.
Annual fee. Some credit cards charge an annual fee for the use of the card. The amount varies according to the rewards and features offered with the card.
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Penalty APR. Some cards will charge a higher APR if your bill payment is at least 60 days late. Some issuers charge a penalty APR, which can go as high as 29.99%. That should be enough incentive to pay your bill on time!
Foreign transaction fee. If you make a purchase in a foreign country, you might be charged this fee, which averages around 3%. There are many credit cards that no longer charge this fee, so if you travel often, get a credit card that waives foreign transaction fees.
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Late fees. You’ll be charged this fee if you are late with a payment. The amount varies based on how often you’ve been late. A credit card issuer can charge you up to $40 for late payments. Some card issuers don’t charge late fees, but pay your bill on time because it gives you a strong credit history.
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Types of Credit Cards
Here are the most popular types of credit cards.
Plain vanilla credit cards. These cards usually have lower APRs but don’t offer rewards. Hence, the vanilla label. This type of card is good for a financial emergency. If you had to carry a balance for a few months, using a card with a low interest rate could save you money.
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Rewards credit cards. These are popular because you can earn rewards on your purchases. Within this category, there are many different types, including cash back cards, travel rewards cards, and hotel- and airline-branded cards.
To truly profit from rewards credit cards, you need to look at your spending patterns. What do you spend your money on? Do you travel often?
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Be sure to look at the fees and the rates. Rewards credit cards tend to have higher APRs, so never carry a balance on a rewards card. You can use these cards strategically and save money with your cards.
Balance transfer credit cards. If you have a balance on a card with a high APR, then transferring the debt to a balance transfer credit card with a 0% introductory APR can save you money.
Many credit cards charge a 3% balance transfer fee on the amount transferred, but read the terms to confirm the fee. And be sure you consider that fee since it increases the balance you will owe. Also, note how long the intro period lasts. Once the intro period ends, your rate will increase to your purchase APR.
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Student credit cards. Student cards are designed for college students who have limited credit. These cards vary, but many offer decent APRs and rewards. If you’re younger than 21, you have to get a co-signer unless you can prove you have sufficient income to pay back any debts you incur.
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Secured credit cards. If you have either no credit or bad credit, getting an unsecured card can be challenging. A secured card is designed for consumers who need a little help to build or rebuild their credit history.
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With these cards, you’re required to make a security deposit, which is usually your credit limit. As long as you pay your bill on time, you can build credit and eventually qualify for an unsecured credit card.
Business credit cards. You can also get a credit card for your small business. You can get a variety of rewards with these cards, so choose the business card that matches your spending needs.
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Credit Cards vs. Debit Cards
There’s a major difference between credit cards and debit cards. A credit card is considered revolving credit. This means you have a credit limit, and you can purchase items on credit and pay it back by the due date.
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If you don’t pay it in full by the due date, you’re charged interest since you borrowed the money from your credit card issuer. The good news is that using credit cards responsibly helps you build credit because your issuer reports your credit history to the major credit bureaus.
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Debit cards, however, don’t help you build credit. Your debit card is linked to your own bank account. So you’re actually spending your own money, and that isn’t reported to the credit bureaus. Debit cards are certainly a payment option for those who don’t have – or don’t want to use – a credit card.
For online spending, though, it’s best to use credit cards. They offer more consumer protections than debit cards. Plus, it can improve your credit score.