How Do Credit Cards Work?
Alex Kosuth-Phillips - 10+ Years Financial Exp. | 20th October, 2022
They are used for over a billion transactions in the UK each month but how do credit cards work? It’s important to understand the process behind credit cards and how they differ from debit cards.
What Are Credit Cards?
Credit cards can be used to pay for goods or services or to withdraw money from a cash machine.
Please note that if you use a credit card to withdraw cash form an ATM you will be charged a withdrawal fee and incur interest on that amount of money you withdraw.
They are used in the same way as debit cards but with a crucial difference. When you spend using a debit card, the money comes directly from your bank account. When you use a credit card, you are borrowing money from the card issuer until you pay off your balance.
Below, we answer the question: How do credit cards work? We also look at some ways to avoid the pitfalls.
How Do Credit Cards Work? The Basics:
When you buy something using a credit card, the amount you spend is added to your account. You’ll receive a statement each month which adds up all the spending on your account and tells you how much interest you have incurred and how much the minimum repayment is and when it needs to be paid by.
The total amount you have spent and any interest incurred on your card is called your balance. Your account will have a credit limit, which is the maximum balance set by the card issuer.
If you have a balance on your card, you’ll have to make a repayment. The statement will give a date by which your payment has to be made. You’ll have to make at least the minimum repayment, which is usually between 1% and 5% of your balance. However, this can vary dependent on the provider.
How Do Credit Cards Work? The Costs:
The provider sets the rate of interest and must tell you clearly what it is, quoting an annual percentage rate (APR). This is the total rate of interest and fees over a year and allows you to compare the costs between providers. Dependent on the provider, usually they have the right to change the APR you are charged at any time.
If you pay less than the full balance, interest is usually added to the balance you carry across to your next statement.
If you pay your balance off in full by the payment date on your statement, you are usually not charged interest on your next statement. However, for some transactions like cash withdrawals, there may be no interest-free period and there may be additional charges for a cash withdrawal.
You may be offered a promotion with a low rate of interest or no interest at all for a specific period. These can be balance transfer promotions or purchase rate promotions. This can be attractive but there may be fees applied that you’ll need to consider. Always be sure to review any promotions so that you are clear on any fees that may occur and when the promotional period ends.
There may be additional fees to pay in some circumstances. These include penalty fees if you break the terms of the credit agreement, for example by being late with a repayment. Some cards, especially those offering rewards such as air miles or cashback, have annual fees. There also could be a fee for using your card abroad or if you use your card to withdraw money from an ATM.
How Do Credit Cards Work? Using Your Card:
Here are tips to avoid some of the potential problems of using credit cards:
- Always pay at least the minimum and never be late. If you are, you will be liable for penalty charges, and it can also impact your credit file.
- Try to keep well within your credit limit and not go over your credit limit. Low credit utilisation is a good sign of managing your money responsibly.
- If you think you might be tempted to spend too much, consider closing your account or asking the issuer to reduce your credit limit.
- Try to pay more than the minimum repayment and pay your balance off in full if you can.
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45.5% APR Representative (variable)
10+ years financial experience