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Credit cards can be confusing if you’ve never owned one before. How do credit cards work? Once you understand how credit cards work, they are one of the most valuable financial tools you can use to build a positive credit history. More importantly, you can even earn cash or travel rewards. Besides learning the ins and outs about credit cards, you’ll also learn how a credit card can build your credit too.
How Credit Cards Work
A credit card follows the “buy now, pay later” model. Unlike debit cards that automatically withdraw the money from your bank account, credit cards keep a running balance like your electric bill or water bill.
When your credit card application is approved, the credit card company assigns you a credit limit. If your limit is $10,000, you can spend up to $10,000 before your transactions will be declined.
Although you can make daily balance payments if you decide, each month you will receive a monthly statement that tells you how much you owe on the statement closing date. You improve your credit score by paying your payments every month on or before the due date.
Each month, your credit card company reports your payment history to the credit bureaus. On-time payments improve your score and missed or late payments damage your score. You can access your free credit score and use the score simulator to see how each credit event affects your credit score.
Your credit card may also charge an annual fee. Credit cards that charge an annual fee usually offer better rewards or card benefits, but there are plenty of no annual fee credit cards that let you build your credit score for free!
Terms To Know To Understand How Credit Cards Work
There are four terms you need to become familiar with if you have a credit card.
Statement Closing Date
The last day of your 30-day billing period. The closing balance on this date is the total statement balance due on or before the next payment due date.
Payment Due Dates
The deadline to pay your statement balance to avoid late fees or interest charges. This due date is usually 28 days after your statement period ends.
The total amount due by the payment due date.
Minimum Payment Due
If you can’t repay the entire statement balance on or before the payment due date, you must pay the minimum payment to avoid a late payment fee and keep your account in good standing. Remaining in good standing means you’ll receive credit for an on-time payment and receive your monthly purchase rewards.
You will still pay interest on your unpaid balance after the payment due date. Always pay your balance in full to avoid paying interest. The interest rate is steeply higher than the value of your purchase rewards.
Making On-Time Credit Card Payments
You should only use a credit card if you can pay your balance in full every month. Timely payments let you maximize your credit score and earn cash or travel purchase rewards that you can use to save money on future purchases.
Tip: If you’re not sure if you can pay your balance in full, only charge your core monthly expenses that earn bonus points to the card so you know you can always afford the payment. You can also use a free service like Debitize to automatically pay your balance in full each month so you never miss a payment or accidentally damage your credit score.
Late Credit Card Payments
If you miss your payment due date or can only make a partial payment, you will most likely have to pay a fee or interest charges.
Here are some of the fees you might have to pay.
Late Payment Fee
If you miss the payment due date, your credit card company can charge you a late payment fee that can be up to $25 plus any interest you pay on your unpaid balance.
Some credit cards offer a grace period where you aren’t charged this fee until several days after the payment due date.
The interest rate you pay on your monthly purchases if you don’t pay off the balance before the payment due date. On most credit cards, this interest rate is between 15% and 20% APR.
Balance Transfer APR
If you transfer a balance from an existing credit card, this interest rate can be different than the Purchase APR. A transferred balance also counts against your total card’s credit limit. You may also have to pay a 3% balance transfer fee too.
Cash Advance APR
If you use your credit card at an ATM instead of your debit card, you will need to pay interest until you repay the balance. It’s usually cheaper to pay the ATM withdrawal fees for your debit card.
Earning Credit Card Rewards
Besides building your credit score with on-time payments, you can also earn rewards points with each purchase and for a sign-up bonus is standard with most travel credit card offers.
Flat Rate Rewards Credit Cards
Your credit card will either be a flat rate rewards card or a tiered rewards card. Flat-rate rewards credit cards earn the same number of points on every dollar spent. For example, the Capital One Venture Rewards Credit Card earns at least 2 miles for every dollar spent.
Tiered Rewards Credit Cards
For tiered credit cards, you need to choose a card that earns the most points on your frequent purchases. If you constantly stay at Hyatt hotels, you might get the Hyatt Credit Card. Or, if your largest monthly expense is grocery purchases, you might choose a card that specializes in grocery rewards.
Redeeming Credit Card Rewards
How you redeem your credit card rewards is just as valuable as how you earn them.
Every credit card has different rewards options, but you can usually have the following redemption options:
- Cash Rewards
- Travel Rewards
- Gift Cards
Cash rewards and travel rewards are usually the most valuable redemption options for most credit cards.
With a cashback credit card, you can either request a statement credit or a bank deposit. If you request a $5 statement credit, your statement balance will be $5 less for example.
Travel rewards points have more flexibility depending on which card you choose. Some travel credit cards offer three redemption options:
- Travel Statement Credits
- Book Future Travel
- Point Transfers to Your Airline or Hotel Loyalty Account
Additional Credit Card Benefits
If you have a credit card without an annual fee, you might not have many additional credit card benefits to speak of besides zero liability protection for unauthorized purchases.
One benefit of having a card with an annual fee (especially travel rewards credit cards) are additional card benefits that help you save money each year. Some of these additional benefits may include:
- Free annual hotel night certificate
- Waived checked baggage fees
- Global Entry or TSA Precheck Application Fee Reimbursement
- Free 2-Day ShopRunner Shipping on Online Purchases
You will need to decide if these additional benefits are worth the annual fee or even the credit card application for that matter.
Quick Tips to Properly Use a Credit Card
Credit cards can be an extremely valuable tool when used correctly. Follow these tips to maximize your credit card usage:
- Always pay your monthly balance in full
- Pick a card with the best ongoing purchase rewards and redemption options for your spending habits
- Use an annual fee credit card if the additional benefits are worth it
Summary of How Do Credit Cards Work
So how do credit cards work? Credit cards help you build your credit score and earn purchase rewards in the process. You don’t enjoy these privileges by using cash or debit cards exclusively. Remember to always pay your credit card balance in full every month and you’ll be just fine. Hopefully, you have a better idea of how credit cards work.