How Do Credit Cards Work? - Learn the Basics of Credit Cards

A credit card is basically a plastic card issued by a financial institution, which allows the cardholder to borrow funds from the issuer. Whenever you use your credit card for a purchase, you take a small loan from the card issuer. You have to repay the money within a preset date each month.

How Do Credit Cards Work?

When you wish to take a credit card, you approach a card-issuing company or a bank and submit an application. The lender refers to your credit report and your credit score to check if you are worthy of getting credit. If you qualify the requirements of the lender, a credit card is issued to you.

Once your application for a credit card is approved, the lender evaluates your financial health and accordingly sets a credit limit. Your credit limit is the maximum amount that you can borrow. Your credit report influences the range of your credit limit. As you use the credit card, the amount you spend is known as your credit card balance.

Each credit card has a billing cycle and a due date by which you must repay the money you owe to the lender. You could pay the balance in full or a portion of the balance as per the lender's policies. Payment networks like Visa, MasterCard, etc. oversee and process these credit transactions.

Paying off the balance in full ensures that you don't pay any interest on the borrowed amount; in case you decide to pay the minimum amount required, you should be prepared to pay a high interest as well.

All credit card issuers report your activities to credit bureaus. Credit bureaus are companies that prepare your credit report. TransUnion, Equifax, and Experian are the three most popular credit bureaus. These bureaus use a complex mathematical algorithm to evaluate your financial activities and assign you a credit score, which is a three-digit number, typically ranging from 350 to 800, which determines your creditworthiness.

A small financial mistake, such as forgetting to pay your credit card bills within the due date, can reduce your credit score.
Costs Involved in Owning a Credit Card

There are various fees and charges that come with credit card use. If you learn to spend and repay responsibly, you can evade some of these costs.

APR: APR stands for Annual Percentage Rate. There are different types of APRs - the normal APR applies to the balance that you carry forward after paying the minimum balance in every billing cycle. The penalty APR is imposed on your balance when you miss a payment.

Annual Subscription Fees: Some credit cards charge an annual fee, whereas some don't. You should pay an annual fee only when the card in question offers outstanding perks and benefits. If not, go for a credit card without annual fee.

Late Payment Fees: When you make a delay in repayment or fail to pay within the due date, the bank or the card issuer can impose a late fee on the balance due. These charges are generally quite high and vary from company to company.

Balance Transfer Fees: Balance transfer cards usually have a low rate of interest, but a few cards might ask you to pay a fee whenever you transfer a balance. You should check with the issuer before getting a balance transfer card.

Why You Should Get a Credit Card

• First and foremost, credit cards help you build your credit history, which gives you access to more credit opportunities in the future.
• Many cards give you sign-up bonuses or shopping vouchers.
• Rewards programs give you many benefits such as cash back and point redemption.
• Credit cards with a 0% or low-interest rate can come of use if you wish to make a high-value purchase.
• Credit cards give you flexibility regarding payment. It is ideal to pay off the full balance; however, you have the option to repay the money over time as well.
  

Credit Card Vs Debit Card

When you use a debit card to make a purchase, you are essentially using your own money, whereas using a credit card for purchase means borrowing the amount from the lender. Hence, your debit card is linked to your savings account and it pulls money out of your account.

Both credit and debit cards have perks and reward point programs, but credit cards generally have more lucrative offers. Credit cards also have strong fraud protection policies which debit cards lack. Hence, using credit cards is actually much more safe and reliable than debit cards. Additionally, credit cards build your credit history,  whereas debit cards don't.