When you need to make a purchase or pay a bill, credit cards can offer both convenience and the potential to save money if you're earning back some of what you spend in rewards. At the same time, you can also use credit cards to build credit history through healthy financial habits.
While credit cards and debit cards may look similar, they work very differently. If you're new to using credit, there are a few important credit card facts to know.
- Credit cards have a credit limit you can make purchases against. then repay at a later date.
- Carrying a balance on a credit card can trigger interest charges.
- It's important to read the fine print closely on credit card promotional offers.
- Some credit cards allow you to earn rewards on purchases in the form of points, miles or cash back.
What Is a Credit Card?
A credit card is a physical card that can be used to make purchases, pay bills or depending on the card, withdraw cash. The simplest way to think of a credit card is as a type of short term loan.
When you open a credit card account, your credit card company gives you a set credit limit. This is essentially an amount of money the credit card company allows you to use to make purchases or pay bills.
Your available credit is reduced as you charge things to the card. You then pay back what you spent from your credit limit to the credit card company.
Credit cards can be secured or unsecured. A secured credit card requires a cash deposit to open, which typically doubles as your credit limit.
How Credit Cards Work
Credit cards can be used to make purchases online or in stores and pay bills. When you use a credit card for either one, your card details are sent to the merchant's bank. The bank then gets authorization from the credit card network to process the transaction. Your card issuer then has to verify your information and either approve or decline the transaction.
If the transaction is approved, the payment is made to the merchant and your card's available credit is reduced by the transaction amount. At the end of your billing cycle, your card issuer will send you a statement showing all the transactions for that month, your previous balance and new balance, your minimum payment due and your due date.
The grace period is the period of time between the date of a purchase on your card and the due date listed on your statement. During this period if you pay your bill in full by the due date, no interest charges accrue.
But if you carry a balance month to month, your card issuer can charge you interest. Your credit card's annual percentage rate or APR reflects the cost of carrying a balance on an annualized basis. Your APR includes both your interest rate and other costs, such as an annual fee if your card has one.
Most credit cards have a variable APR that's tied to the Prime Rate. This means your card's APR can change over time, though the CARD Act of 2009 sets strict guidelines on when credit card companies can and can't raise your rate.1
Being 60 days late on making payments to your credit card can trigger a penalty APR, which can approach the 30% range.
Credit Cards vs. Debit Cards
A credit card and debit card may seem like the same thing but they're not. When you make purchases with a credit card, you're not actually spending any of your own money at that moment. Instead, you're spending the credit card company's money which you then have to pay back, potentially with interest.
Debit cards, on the other hand, are linked to your checking account. When you make a purchase with your debit card, the money is automatically deducted from your bank account as soon as the transaction is processed. There's nothing to pay back later since the money has already been taken from your account.
Debit and credit cards also differ in terms of their credit score impact. Using a debit card has no impact on your credit score because your bank account activity is not reported to the credit bureaus.
Credit cards, on the other hand, can impact your credit score directly. FICO credit scores, for instance, calculate your scores based on:
- Payment history
- Credit usage
- Credit age
- Credit mix
- Inquiries for new credit
Making credit card payments on time can help your score while paying late could hurt it. Similarly, keeping a low balance compared to your credit limit can have a positive impact while maxing out your card limits can detract from your score.
Another key difference between debit and credit cards lies in fraud protections. Federal law offers more fraud protections for credit cards than debit cards. This chart highlights your liability for unauthorized transactions with debit and credit cards.
|Debit Cards vs. Credit Cards|
|Debit Card Liability||Credit Card Liability|
Many credit card issuers offer a $0 fraud liability guarantee automatically, meaning you aren't responsible for any fraudulent charges made with your card.
How to Compare Credit Cards
If you're in the market for your first credit card or your next credit card, it's important to do some comparison shopping. Some of the key things to look for when comparing credit cards include:
- Regular variable APR for purchases
- APR for balance transfers and cash advances
- Promotional APR terms and conditions
- Annual fees
- Rewards programs
- Introductory bonus offer terms
It's also helpful to look at the card's other benefits and features, if any. For example, if you're interested in opening a travel credit card to earn miles or points toward flights and hotel stays you may also be interested in finding a card that comes with benefits such as airport lounge access or airline fee credits. If a card has an annual fee, it's helpful to compare the value of rewards and benefits to the fee to decide if it's worth it.
The Bottom Line
Credit cards can be a credit-building tool if used responsibly. Paying your bill on time, maintaining a low balance and only opening credit cards as needed can help you build and maintain good credit. Also, keep in mind that the best way to avoid interest charges is by paying your credit card bill in full each month.
Consumer Financial Protection Bureau. "CARD Act Report."