How Do Credit Cards Work?

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A credit card is a line of credit granted by a retail business, a bank or a credit card company that you can use anywhere that accepts the card. If you pay the entire balance for all purchases made during each 25 to 30 day billing period, there won’t be an interest charge. However, if you pay between the minimum payment due and the full balance, you’ll pay interest on the outstanding balance.

You commit to paying the amount you charged each time you sign for a purchase. If you renege on a promise to pay, you stand to lose your credit privileges.

Despite what often amounts to significant differences in features such as interest rates, fees and card benefits, all credit cards work in much the same way. For example, all offer a predetermined line of credit, require a minimum monthly payment and charge interest on any outstanding balance -- unless you’re a new cardholder taking advantage of an interest-free introductory period.

Tip

  • The mix of account types in your credit profile accounts for about 10 percent of your credit score. A good mix includes both credit cards and installment loans, and while installment loans are important, the Fair Isaac Corporation says that lenders tend to view applicants who have no experience with credit cards as riskier than those who do.

Credit Cards vs. Charge Cards

A credit card and charge card may appear similar but are not the same thing. The main differences between the two involve spending limits and the option to carry an outstanding balance from month-to-month. A credit card has a predetermined spending limit and allows you to revolve an outstanding balance. In contrast, a charge card may come with no preset spending limit and usually requires payment in full at the end of each billing cycle.

A Typical Billing Cycle

The card issuer extends a preset line of credit based on your credit score and information in your credit profile that you can draw from to purchase goods and services or get a cash advance. Every time you use the card, the issuer pays the merchant and then bills you for the purchase. If you use the card to get a cash advance, the card issuer issues you a short-term loan.

At the end of each monthly billing period, you’ll receive a statement that lists monthly purchases, identifies the interest charge for the month as well as any applicable fees, recalculates your new outstanding balance and specifies the amount of the minimum monthly payment and the payment due date. The minimum payment usually is a fraction of the outstanding balance.

Tip

  • Use an online calculator to see how long it will take, and how much it will ultimately cost, to pay off a credit card balance by making only the minimum payment.

Transaction Processing

Credit card processing is a two-step process. In the first step, the merchant transmits information about your purchase to the issuer and receives an authorization or a denial. At the end of the business day, the merchant then settles all transactions for the day and the purchase posts to your account.

Credit Card Fees

Interest may not be the only additional fee on your credit card statement. According to CardHub, some of the common add-on fees are

  • Monthly or annual membership fee
  • Balance Transfer
  • Cash advance
  • Late payment
  • Over-the-limit
  • Returned payment

The Credit Card Accountability Act regulates the information a credit card company must provide to every customer. Mandatory disclosures make for transparency in disclosing and explaining credit card fees, and make it easier to understand both billing practices and how issuers charge and apply interest to purchases.

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