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Credit cards: How they work and how to get one

At a glance:

  • How credit cards work

  • Types of credit cards

  • Types of interest rates and APRs

  • Credit card fees

  • Protections for credit card holders

  • Unauthorized credit card charges

  • Summary of credit cards

Credit cards — those little plastic cards that can open so many privileges in the consumer world, are more common than they once were because credit rules have loosened over the past few decades.

They’ve become the preferred method of making purchases. They have advantages not only for users like you but also the merchants who sell you their goods and services.

Getting a credit card used to be a rite of passage for many people, meaning that they had arrived at a point in their lives when banks and other institutions were willing to give them a revolving line of credit.

In modern decades, credit cards lack that aura, and defaults have grown greatly with the availability of easy credit.

Credit cards are pictured in a wallet in Washington, February 21, 2010. (Photo: REUTERS/Stelios Varias)
Credit cards are pictured in a wallet in Washington, February 21, 2010. (Photo: REUTERS/Stelios Varias)

How credit cards work

A credit card is a small plastic card that draws on a line of credit made available by a bank or credit union. Cardholders can use the card to purchase goods and services from merchants who accept that card.

Once a purchase is made, the cardholder is bound by his or her contract with the card to pay back the money, with any interest required. Many merchants now use electronic verification systems to determine whether the card is valid and has sufficient credit for the purchase.

In addition to purchases, a cardholder can take out a cash advance from the card's line of credit. Any amount spent, whether for a purchase or a cash advance, is considered a short-term loan made to the user.

Revolving credit

Because you can draw on your credit limit over and over within your credit limit, credit cards are known as revolving credit. This differs from standard loans, which loan you a set amount of money with no revolving use.

Every month, the cardholder receives a statement showing the purchases made, any fees levied, interest charges, and the total amount owed. The cardholder must pay the minimum payment in order to avoid a penalty. If the balance is not paid in full, it will carry over to the next month and will accrue interest.

Why your credit risk matters

Your ability to use a credit card is based on your credit risk, which the issuing company assesses before offering you a credit card.

If you are deemed a good risk, you will be offered credit. If you are deemed a very good risk, you may qualify for a lower interest rate or additional perks. One popular perk is rewards, in which your purchase of goods earns you points that you can redeem for goods and services or else receive as cash.

Though your credit risk affects your ability to enjoy a credit card, your credit card will in turn affect your credit risk. The balance on your card(s) compared to your credit limit is noted by the credit reporting bureaus, as is your history of paying on your debts.

If your balance is high, or if you have a lot of late or missed payments, your credit score will go down. (The ideal balance is about one-third of your credit limit: e.g., a $1,000 balance on a $3,000 credit limit.)

Credit card ownership

Credit card ownership takes several forms.

There is individual credit, in which you alone are responsible for its use and payback. There is joint credit, in which you and another person are responsible for its use and payback. There is also authorized usership, in which someone else has the use of the card.

However, with authorized usership, you alone are responsible for paying back the debt. In all these forms of ownership, the credit that is extended to you is based on your income, your assets, and your credit history.

Benefits to merchants

Credit cards are ubiquitous partly because merchants like them.

For one thing, payment is secure because the bank that issued the card will pay the merchant. This is not always the case when you write a check to the merchant. Even with cash, which may seem like a shoo-in, there is the possibility of it being counterfeit and thus unusable.

Another advantage to merchants is that people tend to spend more freely with credit than cash because they do not need to pay it back just yet.

Costs to merchants

Of course, there are costs to merchants.

They are charged a small commission for each purchase made by a credit card. There may also be an interchange fee paid between the merchant's bank and the card user's bank.

Because these fees can eat into a merchant's profit margin, some will offer a discount to you if you pay with cash instead.

Types of credit cards

Credit cards come in different forms.

This Nov. 29, 2018, photo shows are credit card logos posted on a store's door in Philadelphia. (AP Photo/Matt Rourke)
This Nov. 29, 2018, photo shows are credit card logos posted on a store's door in Philadelphia. (AP Photo/Matt Rourke)

General credit cards

General credit cards are the most common type. They are issued by a bank or other financial institution and are used in any place of business that accepts them. They come with a limited line of credit.

Secured cards

A secured card is a general card with one difference: you must deposit money with the financial institution that offers it. That money then becomes its credit limit.

The money is a form of collateral that protects the institution if you should default. Because of this collateral, secured cards are relatively easy to get, as opposed to unsecured cards. They are an option for those seeking credit for the first time or those seeking to rebuild credit.

Store cards

Store cards are general credit cards that are offered by particular retailers. They can be used only at those retailers.

Co-branded credit cards

Co-branded cards are general credit cards that have a special relationship with a company or organization. Ebay and Amazon, for example, issue co-branded cards. You can use these cards where you would use a general credit card, but they give you extra rewards if you use them with the company that co-brands them.

Charge cards

Charge cards are the same as general credit cards with one exception: you must pay your balance in full every month. If you fail to, you will incur high late fees and restrictions on further use. Charge cards typically do not come with a limited line of credit.

Types of interest rates and APRs

For the privilege of buying things on credit, you will be required to pay interest. The amount you pay depends on the size of your credit card balance.

The annual percentage rate

The interest rate is a charge that you will pay on any balance that is still open on your card.

This rate is called the annual percentage rate (APR). It is the rate that you would pay over the course of a year, not what you would pay each month. What you pay each month is 1/12 of the APR; thus, if your annual percentage rate is 12%, you will pay 1/12 of that each month, which is 1%.

Variable rate

Most credit card APRs are variable, meaning that they change.

They are tied to a specific foundation interest rate, such as the Prime Rate, a rate that banks charge to their most creditworthy customers. Added to the Prime Rate is the card's own rate, so that the result is noted like this example: Prime + 6.9%.

The variable rate can change as the Prime Rate changes periodically. The way it changes will be described in the credit card agreement that comes with your card.

Most credit card companies still offer grace periods, in which the interest that normally accumulates is waived if you pay your bill in full each month. Savvy card owners like to ensure that their cards have grace periods.

How interest is calculated

Interest is calculated on your balance in a number of different ways; the method used is identified in your account statement. The balances used are these:

  • Average daily balance. With this method, your credit card company adds up each day's balance in the billing cycle and averages all of them.

  • Beginning balance. With this method, your credit card company uses the balance at the beginning of the billing cycle. This means that any purchases and payments made during the month do not factor in.

  • Adjusted balance. With this balance, any payments you make during the month are subtracted from your beginning balance.

  • Ending balance. The credit card company uses the balance at the end of the billing cycle. This means that any purchases and payments made during the month do factor in.

A customer inserts a credit card to buy gas in Haverhill, Mass. (Photo: AP Photo/Elise Amendola, File)
A customer inserts a credit card to buy gas in Haverhill, Mass. (Photo: AP Photo/Elise Amendola, File)

A word about double-cycle billing: double-cycle billing calculates interest by taking the average daily balance from the previous billing cycle and factoring it into the current one, thus using two billing cycles instead of one. The recent Credit Card Act bans this.

And a word about trailing interest: also called residual interest, this is interest charged when the card company reaches back into your previous billing cycle and charges interest on balances already paid off.

So, if you charged $2,000 and then paid off $1,999 during the grace period, on the next billing cycle you will be charged interest on the full $2,000. This practice is not used by all card companies, however.

APRs and how they work

Know the types of credit card Annual Percentage Rates (APRs) and how they work.

Promotional (introductory) interest rate

Also called a teaser rate, this is a low or zero rate designed to attract new customers.

The promotional rate may apply to purchases, to balance transfers, or to both. Only in rare cases does it apply to cash advances. The promotional rate lasts only a certain amount of time, after which it rises to the regular APR.

But if you should unfortunately make a late payment during the introductory period, the card company has the right to end the promotional rate and increase it to the default rate (discussed below). Situations like this are spelled out in the credit card agreement.

Regular APR

This rate is the regular rate you are charged for purchases, cash advances, and balance transfers. Each of these uses may have its own regular APR.

Default APR

The default rate is a higher rate that kicks in if you violate some aspect of the credit card agreement.

Violations include going over your credit limit, making a payment late, and other actions spelled out in the card agreement. The default rate can also be activated if you default on debts to another creditor.

This is called universal default, and it applies only to future balances. Though this may seem unfair to the cardholder, the company's rationale is that it wants to identify high-risk cardholders and cover its risk accordingly.

Because default APRs are quite high, cardholders would be wise to make their payments on time and keep an eye on their balances.

Tiered APRs

These are different rates for different levels of balances. For example, a card with tiered APRs may charge 15 percent on balances up to $2,000 and 14% on any balance above that. Tiered APRs are rare.

Credit card fees

For the privilege of buying things on credit, you may be required to pay fees; most fees occur when you do something you shouldn't do, like make a late payment. Here are the most common fees:

  • Cash advance fees. These are charged when you take cash out of your credit card.

  • Convenience check fees. These are charged when you fill out the convenience checks that are sometimes mailed to you. These checks are essentially cash advances.

  • Overlimit fees. These are charged when you spend more than your credit limit allows. Recent legislation has now made overlimit fees optional.

  • Payment processing fees. These fees are for certain actions such as making payments over the phone and making stop-payment requests.

  • Foreign currency fees. These are charged if you make a purchase or cash advance in a foreign currency.

  • Membership fees. These fees are charged monthly or yearly simply for having the credit card. Yearly fees are also called annual fees.

  • Late fees. These are charged when your monthly payment arrives late. They are also charged if your payment arrives on time but does not meet the minimum payment amount.

  • Balance transfer fees. These fees are charged when you transfer a balance from one credit card to another. The receiving credit card is the one that charges the fee, which is usually a certain percentage of the amount transferred.

Fees are charged in a variety of different ways.

Though they occur only once per incident, they are not all posted in the same way. For example, cash advance fees are posted to your balance in the billing cycle in which they occur.

Membership fees are posted when you open your account and again whenever your membership is renewed (yearly or monthly).

Modern ways to keep tabs on your credit card activity

Those who are not as conscientious about their credit cards as they would like to be might benefit from signing up for automatic alerts.

These are alerts sent via email or phone that tell you when a due date is approaching or what your current balance is.

Check with your credit card company to see what types of alerts they offer. Another option that many find useful is automatic bill pay, in which your credit card company automatically pays your monthly bill from a bank account that you designate for it.

Both automatic alerts and automatic bill pay can save you a lot of money in fees and stop damage to your credit report.

Protections for credit card holders

As a credit card holder, you now enjoy some consumer protections that you did not in years past. The Credit Card Act that passed in 2009 set down some protections for credit card holders.

Here are the main points:

Interest rate hikes

Credit card annual percentage rates (APRs) may rise only under limited conditions.

These include when the cardholder makes a late payment, when a promotional rate ends, if the card has a variable rate, and when the cardholder defaults on or ends a temporary workout arrangement. Major changes require 45 days' advance notice on the card company's part.

Card issuers may not increase the interest rate on a new card during the first year except in the cases noted above. Those are exceptions.

Different interest rates

If your card has more than one balance and uses more than one interest rate, such as one for cash advances and one for regular purchases, any payments you make in excess of the minimum must go toward the balances with the highest rates first. Previously, excess payments went to the balances with the lowest rates.

Due dates

Card companies must mail your bill at least 21 days before it is due. The due date must be on the same date each month. Card companies must stick with 5 pm for the time of day when payments must be received. Deadlines falling on holidays or weekends must be due on the next business day.

Disclosures and minimum payments

Card issuers must disclose certain things on your monthly statement:

  • The amount of interest and fees you've paid in the current year

  • How long it will take to pay off your existing balance if you make only the minimum payments

  • The monthly payment required to pay off the whole balance in 36 months

  • The fee for late payments

  • The due date for the next payment

Card issuers must also disclose their credit card agreements on the Internet.

Fees and billing

  • Overlimit fees. The card company cannot automatically let your account go over the limit. In order to go over your credit limit, you must opt in to this arrangement.

  • Late payments. For occasional late payments, late fees are capped at $25. If you are late more than once in a six-month period, the fees are allowed to rise.

  • Double-cycle billing. This is no longer allowed. Double-cycle billing calculates interest by taking the average daily balance from the previous billing cycle and factoring it into the current one, thus using two billing cycles instead of one. The recent Credit Card Act bans this.

New protections for young adults

Credit card companies cannot issue cards to anyone under 21 unless those people have adult co-signers or they can provide proof of sufficient income to repay their balance.

Card companies must stay at least 1,000 feet from college campuses if they are offering free food or gifts to attract customers.

Subprime cards

Cards for those with bad credit may come with fees just for opening the cards. These fees are now limited.

Final caveat

These recent changes do not provide full protections to card owners. For example, business credit cards are not covered by the new law. Also, there is no maximum cap on interest rates. Inactivity fees are still allowed, and cash advance and balance transfer fees are not capped.

These are ways that the credit card industry has gotten around the limitations imposed by the Credit Card Act. It therefore pays to read all credit card offers as well as your credit card agreement very carefully.

Unauthorized credit card charges

Credit card fraud occurs when your card is used in a manner that is not allowed by your credit card agreement. In most cases, it happens when someone else uses it without your permission, such as during identity theft.

If you act quickly and properly, you can limit your liability for unauthorized charges.

If you lose your card, your liability is very limited, provided that you notify the card issuer that it is lost. The same goes for theft. If you notify the credit card issuer:

  • Within 30 days, you are not liable for any of the charges made after the notification.

  • After 30 days, you may be liable for all charges before you made the notification (but not after).

The maximum you are responsible for paying is $50. Some banks and other credit card issuers even waive this amount as a courtesy.

Providing notice

You must provide your notice in writing. The day you deposit your notice in the mail or take it yourself to the card company is legally considered the day you made notification. If you are ill or there is another extenuating circumstance, the notice deadline may be extended for you.

Summary of credit cards

That little piece of plastic in your wallet can be a godsend when you don't have cash and you find yourself needing to buy something. But be careful. Know how they work and what can happen if you don't play by the rules.

Credit card use can be a part of a sound financial strategy rather than just a way to buy things today and worry about paying them off later. Credit cards are an effective way to build up your credit score.

Using them regularly and paying off the balance fully each month shows the prospective lenders that you are a good credit risk. This will come in handy if you want to take out a mortgage, a car loan, or a business loan in the future.

With this in mind, let's look at some strategies you can adopt right now to make your credit excellent.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

Read more information and tips in our Credit cards section

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