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 that 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.
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 (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 that your card’s APR can change over time, though the Credit Card Accountability, Responsibility, and Disclosure (CARD) Act of 2009 sets strict guidelines on when credit card companies can and can’t raise your rate.
Credit Card Fees
With credit cards come various fees—not just the interest rate. Other fees can include balance transfer fees, or fees charged for transferring your balance to another card. These fee is usually a percentage of the balance transferred, such as 2%.
There may also be over-limit fees, which are charged if you go over your card’s limit. Of course there are late fees, which are charged if you don’t make the minimum payment by the due date. Note that if you’re late on a payment, the issuer may also revoke any introductory rate you had.
Credit Cards vs. Debit Cards
A credit card and a 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 (they’re not exactly the same as a prepaid card). 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.2
Many credit card issuers offer a $0 fraud liability guarantee automatically, meaning that you aren’t responsible for any fraudulent charges made with your card.
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 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 cards 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.
The biggest advantage of using a credit card is the ease of use and safety. If your card is lost or stolen, you will likely be reimbursed for any fraudulent charges. You may also be able to get an 0% introductory rate for a set period (such as 18 months) that will allow you to make a large purchase and pay it off over time without incurring interest charges.
You’ll also get rewards or cash back with most cards, which is a free incentive to use the card. Credit cards can also help boost your credit score if used responsibly.
On the flip side, credit cards can come with high interest rates, which can be expensive if you don’t pay your balance in full monthly. With credit cards, it can also be easier to spend more money than you can reasonably pay off in a short period of time.
If your debt spirals and you can’t make minimum payments on your cards, your credit score will take a hit. You will also rack up late fees and likely be subject to an even higher interest rate.
Credit Card Pros & Cons
Pros
- Ease of use
- Safer than cash
- Rewards and cash back
- Can boost credit score
Cons
- High interest and fees
- Potential debt spiral
- Can hurt credit if payments are missed
Why You Should Use a Credit Card
Overall, the pros of having and using a credit card outweigh the cons (for most people). They’ll help you build credit—if used responsibly. Good credit helps lower the interest rates you’ll pay for other loans, such as home or car loans. Credit cards can also help with budgeting, either through the budgeting tools that the issuer offers or by allowing you to track and categorize spending.
And of course, credit cards tend to offer rewards or cash back. If you have a high amount of spending, such as on dining out or flights, you can take advantage of cards that offer high rewards rates in those categories.
But perhaps one of the biggest reasons to use a credit card (over, say, cash or a debit card) is the fraud protection. If there are fraudulent charges made on your card, or if it’s lost or stolen, you’re protected from fraud liability.
Analysis
As a young person who got her first personal credit card in the last year (I know I’m late to the game, but perhaps my inexperience might give me a different perspective), I’ve found the entire system to be quite confusing. I’ll have my credit card company pay my bill now so that I can pay them for paying that bill later! Despite the rewards and convenience, that mentality still doesn’t quite make as much sense to me as debit cards do. They still seem like an evil plan to trap everyone in interest debt. And on top of it all, the government offers more fraud protections for credit cards than debit cards. It’s almost as if the system is rigged so that everyone has to use and build credit?
I see the positive side to credit cards too, though. With a credit card, you are not spending your money, so should an incident happen where it gets stolen, your bank account is safe. The same cannot be said for debit cards. It’s easier to track your spending with a credit card, since you can see the statements at the end of every month. Plus, lots of credit card companies offer incentives to make using their cards more enticing. For example, my student credit card offers cash back based on my purchases. But this solution seems like a pretty complicated way to tackle a relatively simple idea. Plus, most credit card companies (and banks) profit off of the interests of their users falling victim to debt. Can the credit card system become more streamlined? More human-centric? Can it be simplified?
Source
Lake, R. (2023, April 28). How do credit cards work?. Investopedia. https://www.investopedia.com/how-do-credit-cards-work-5025119
