Your Guide to Understanding How Credit Cards Work

Credit cards have become the preferred method of payment for many Americans and much of the world. It seems like you cannot go anywhere without using your card to make a purchase. In fact, there are many businesses that do not accept cash or check, and will only accept a credit card to complete a transaction. Even when paying for an item or service online, credit cards are still the most common form of payment over processing services such as PayPal and Square.

For many people, whether they were too young to own a credit card or were simply not knowledgeable in the use of one, credit cards remain a mystery. They think that a credit card gives them complete financial freedom, without understanding the responsibility that comes with it. These people do not know the best practices for using a credit card. If you are one of these people, don’t worry. You are not alone. But we are going to change your understanding of how credit cards work.

The purpose of this guide is to inform you of just that: how a credit card works, from the very first step, to beginning to pay on your balance. In doing so, you will also learn some of those best practices mentioned to help you properly maintain a credit card.

What is a Credit Cardcredit card

First, let’s explain exactly what a credit card is. It is a revolving line of credit; it is a means of accessing borrowed money. The credit card company, during the application process, will determine a credit limit. This is the maximum amount of money you can borrow from them in a one month period. When you make a monthly payment, you are paying back the credit card company for the amount (or partial amount – more on that later) that you used. This amount then resets and becomes available to you for future use.

Credit cards do not provide you with free money. You will have to pay it back. If not, or if you struggle to repay the borrowed amount, then you could face financial and legal problems in the near future.

Fill Out the Application

So, you have decided that you want to take advantage of a credit card company’s financial services. This could be to make a purchase that you would have otherwise been unable to pay for on your own, or you intend to use it to build your credit history and improve your credit score. Either option is good, as long as you use the card properly. You first start with the application.

During this process, you will have to provide the credit card company with your personal information (name, address, social security number) as well as your income. You will need to show the card company that you hold a job, and that your job provides you with enough income to pay back the debt you accrue from using their card. If they determine that you will be able to make the monthly payments on your card balance, then the card company will move on to the next step.

Your Credit Score is Checked

The information collected on your credit application will be used to reference your credit score and the accompanying credit history. Your credit score is the first indication of your credit trustworthiness. It is a number compiling all of the information on your credit history into a single identifier. This is why it is so important to maintain a healthy credit history. Make payments to your debtors on time and do not use too much of the credit extended to you; this will help keep your credit score in a position credit card companies and lenders prefer.

If you are someone who does not have a credit score, then you will have to look into options to establish a credit history, so that a score can be determined, before you seek out a credit card. Most card companies will not accept the risk someone without a score represents.

You are Offered a Credit Card

Once the credit card company has determined that your income and credit score match their criteria, they will extend to you an offer for a credit card. This offer will include the Terms and Conditions attached to the card. There is a lot of small print in these terms, so be sure to read through them before accepting the card.

There are two crucial items in the terms that you will need to pay close attention to:

  • First is the Interest Rate. This is the percentage the card companies will add to your debt if the balance that you used is not paid off in full at the end of the month. This is why it is best to only charge small amounts on your credit card, or amounts you can pay back in full when the bill is due. If not, you are going to have to pay extra for using the card.

  • The second item is the credit limit (previously discussed). You need to know how much you have available to spend so that you do not go over that limit. Some companies will allow you to go over the limit but will charge you an additional fee to do so. Manage your debt carefully so that you do not have to pay more for the money you are borrowing.

If you are trying to rebuild your credit, you cannot expect the best of either of these terms. You represent an increased risk to the card company so, if they are willing to extend you credit, be just as willing to accept lower credit limits and higher interest rates. That does not mean you shouldn’t shop around for the best of what is available to you, however.

Make Purchases/Make Payments

This is where the revolving cycle begins. You make a purchase or a couple of purchases. When the bill comes due at the end of the month, you should pay back those purchases in full. If you do, you will not have to pay anything extra for borrowing the money. If it is necessary, you can make just the minimum payment. Doing this will reduce the amount you need to pay back that month, but then the interest rate will kick in and you will have an additional amount added to your balance. If at all possible, pay the card off in full each month.