How Do Credit Cards Work?

How do credit cards work? If you have ever wondered what a credit card is and how it functions, you are not alone! Credit cards are a widely used financial tool that allows consumers to make purchases using borrowed money. While they offer convenience and flexibility, it’s important to understand how credit card payments work, as well as the potential risks. This is essential to avoid falling into debt. In this post, I will break down the key components of credit cards. Including credit limits, interest rates, and billing cycles, while also highlighting some of the main credit card advantages and disadvantages to help you make better informed financial decisions.

What are credit cards and how do they work?

Credit cards are tied to a revolving credit account at whatever financial institution you have your credit card through. Whenever you make a purchase using your credit card, you are essentially taking a loan from this institution to make the purchase. The bank pays the store the money for your purchase and you will pay the bank back later. This is not through the goodness of their hearts. Their hope is that you will pay interest on this purchase -which is how they make money off of credit card users. We will get into how you can avoid falling into credit card debt and paying interest later in this post.

How do credit cards work when it comes to spending limits? All credit cards have something that is called a credit limit. A credit limit is the maximum amount of money (or credit) that the lender allows you to spend using that specific credit card without paying your bill. So if you have a $10,000 credit limit, you can only spend up to $10,000 on that credit card until you pay some of it off. However, you will have to pay interest on the amount you spend, unless you pay off the full statement balance every month. More on this later on.

Interest

Another foundational credit card concept to understand is interest. Interest is the amount the credit card companies charge you on what you owe – or in other words on your balance. Most companies offer a grace period. A grace period is the period between the end of a billing cycle and the date your payment is actually due. For example, your billing cycle may end on the 25th of every month but your payment is not actually due until the 20th of the next month. In this case, your grace period would be from the 25th of the current month to the 20th of the next month. During this time, the credit card company will not charge you interest.

Another important concept to understand when figuring out how credit cards work is your APR, or your annual percentage rate. This is the annual cost of borrowing money to use the credit card. This can get a little confusing because as a credit card user, you actually pay daily interest – once your grace period ends. If you want to figure out your daily interest you divide your APR by 365 and multiply it by your balance.

Example:

(APR / 365) x Balance = Daily Interest Accrued

You have an APR of 23% and a balance of $5,000 on your credit card account. To find your daily interest you take 23% / 365. This will give you ~.063%, this is your daily interest rate. Next, multiply the daily interest rate times your balance. .063% x $5,000 = $3.15, now you have found the interest accrued that day. This will leave your new balance at $5,003.15, assuming you do not make any more charges on the card.

Now here is where credit card interest can get really dangerous. The next day the credit card company will charge your daily interest (in this example, .063%) to your new balance of $5,003.15. Now your balance is $5,006.30 . The next day the same daily interest rate will charge you again. Now on the larger balance of $5,006.30, which will now increase to $5,009.45. This continues every day until you pay off your balance.

The example above shows the main way credit card companies make their money, interest accrued is extremely profitable for them. They only loaned you $5,000 but they make money with your daily interest rate. Everyday you don’t pay your credit balance (outside of the grace period), you go further into the hole and the credit card company makes more money.

Credit card interest or debt can be extremely dangerous and a vicious cycle to fall into. In fact, credit cards usually have some of the highest interest rates when it comes to borrowing money. So, it is important that you understand what your interest rate is and that you make all your payments on time.

Payments and Billing Cycle

Part of how a credit card payment works is receiving a credit card statement each month. Understanding how to read the credit card statement is a key part in understanding how credit cards work. The statement will always show you your total balance, minimum payment, and your payment due date. See the example credit card statement below. I break down how to read each section of the statement and what to look out for.

1. Activity Summary:

The activity summary is a summary of all the transactions made on your account during the billing cycle. Below is each line item broken down.

• Previous account balance: This was the balance that you had on your previous statement.
• Credits or payments: The credits or payments will often have a (-) next to the number. This means it has deducted this amount from your previous balance.
• Purchases: This line item shows the total amount of new purchases or transactions you have made for the current billing cycle.
• Advances: Meaning cash advances. If you took out any cash using your credit card. This could be from an atm or possibly using the ‘cash back’ option when making a purchase.
• Fees Charged: If there are any fees incurred during the billing cycle. This can include things like promo fees, transaction fees, late fees, etc.
• Interest Charged: This line item shows how much interest has been charged to your account. As mentioned above it accumulates every day based off your total unpaid balance (that has occurred after your grace period).
• New Balance: This is the sum of all the above line items. This tells you what you currently owe on your credit card for the current billing cycle.
  • Note: Your new balance may look different than your current balance. Your ‘new balance’ or ‘statement balance’ is the balance on your bill. Your current balance is all outstanding purchases you have made on your card.
• Credit Access Line: This will show you your total credit limit amount.
• Available Credit: Shows you how much credit you are still able to use on your credit card. This is simply the credit limit minus the balance.
• Cash Access Line: This is the amount available to you for a cash advance on your credit card. Keep in mind this is part of your credit limit and not an additional amount.
• Available for Cash: This is similar to the ‘Available Credit’ as it shows how much cash you are still able to withdraw using this card. It is simply subtracts how much cash you have already withdrawn from your ‘Cash Access Line’ .

2. Payment Information:

This section is a restatement of your monthly balance.

• Payment Due Date: This is the date that you must make your payment in order to avoid any late fees. Please note that this is the date after your grace period. If you want to avoid any (or additional) interest, you need to pay the full statement balance by this time.
• Balance: This amount should be the same as the ‘New Balance’ in the ‘Activity Summary’. This is the balance of your statement or credit card account for this billing cycle.
• Minimum Payment: This shows the minimum payment you need to make to avoid any late fees.
  • Note: This number will often be much smaller than your total balance. While you will avoid late fees only paying this amount, you will pay much more interest going forward. It is always better to pay the full statement balance, if you’re able.

3. Important Messages:

• This section will shows updates or changes that will be made to your account. It will also usually show tell you information regarding your interest rate. Depending the credit card company, the heading of this section will differ. Some other names it might fall under could be ‘Account Notifications’ or ‘Notices of Changes to Your Account’.

4. Transactions:

• This section will show the separate transactions you made throughout the billing cycle. It will often include a reference number, the date, the amount, and a summary of what the purchase was. It’s important to pay attention to this every month to make sure that you made each transaction. If you don’t recognize one of the transactions, you should call your credit card company immediately. Inform them of the problem and a possible credit card theft, hack, or scam.

It’s likely your credit card statement will include a lot more information than the example listed above. However, these sections will be provided on every single statement. While all information on a statement is important, these are the foundational items that you need to understand.

Payment and Billing Cycle – Tips

Now that you know the foundations of a credit card statement, I want to mention some important points.

DO NOT get stuck in the toxic cycle of credit card debt. The main way people do this is by paying only the minimum payment that is due. Avoid doing this at all costs, unless it is absolutely necessary. This is a very expensive thing to do as you will pay a lot more money in the long run. For example, let’s say you have a statement balance of $250 but your minimum payment is only $35. You make the $35 minimum payment, it is likely that only ~$5 is going towards your principle balance ($250) and the other ~$30 is paid towards interest. As you can see, it will take you a very long time to pay off that $250.

If possible, always pay the full statement balance before or on the ‘Payment Due Date’. This way you will not only avoid paying late fees but also avoid the high interest rates that always accompany credit cards. Knowing how credit cards work also means knowing how to avoid interest and fees.

If you are to take anything from this post, it would be this. At all costs, avoid falling into credit card debt, it is a vicious cycle that is very hard to get out of. Pay the full statement balance every month by the due date.

Credit Card Advantages and Disadvantages

While discussing credit card advantages and disadvantages, it is important to note both the financial benefits and potential pitfalls. Many people have heard so many horror stories about credit cards and the debt cycle it costs people to get in. In fact 48% of Americans report having credit card debt. This can be a very real and dangerous cycle to fall into. This can be especially easy because you are not required to have the money at the time you make the purchase. However, as I mentioned above, there are ways to avoid falling into credit card debt and use your card responsibly, while getting to reap the benefits that come with credit cards!

Advantages of Credit Cards

If you are able to pay off the full statement balance every month and use your credit card responsibly, it can have a lot of benefits to you! These benefits can include building your credit score, security, rewards, and purchasing power just to name a few.

• You can increase your credit score by paying off your balance in full every month. Further, having a longer length of credit open helps to increase your credit score. Learn more about what a credit score is, what makes it up, and what is considered a good score.
• Credit cards are great for security – especially for riskier purchases, such as online shopping. Many credit card companies offer safeguards and protections to help protect you from fraud. If your credit account was hacked, most companies will not charge you or hold you liable for unauthorized purchases. This is as long as you report it within 30 days.
• Rewards are one of the greatest advantages of using credit cards. If used wisely you can get ‘free money’! Many credit cards offer cash back, gift cards, or miles for travelling. In order to fully maximize these benefits, you should research multiple different credit cards to see which rewards best match your monthly budget and spending habits.
• Having a big or multiple credit limit(s) gives you greater purchasing power. This is the fancy financial way of saying that you are able to make big purchases, even if you don’t have the money available at that exact point in time. Although, it is recommended to only make purchases on your credit card if you have the money available. This is an easy and effective practice to avoid credit card debt.

Conclusion

You no longer have to ask yourself ‘how do credit cards work?’. Now that you understand the foundations of credit cards, you can make smarter financial choices when using them. Whether you are considering the benefits of building credit or the risks of accumulating debt, knowing how a credit card payment works and how interest accrues is crucial. These are powerful financial tools when used responsibly but the credit card advantages and disadvantages should be considered carefully. By managing your payments wisely and avoiding unnecessary charges, you can make the most of your credit card while staying in control of your finances.