How Do Credit Cards Work? The Basics Made Simple

Credit cards can benefit or damage your financial success. It all depends on how you use them. If you swipe your prized piece of plastic carelessly and avoid payments, you could harm your credit score and rack up some nasty debt. On the other hand, if you wield your card wisely and make consistent payments, you can boost your credit and reap the full benefits a credit card has to offer.

To get the most out of your credit card, you need to understand how these cards work and what they can offer you. Consider this post as Credit Cards 101 for beginners and anyone looking to maximize their credit card benefits.

What are credit cards, and how do they work?

This article starts with the basics. When you get a new credit card, or any other form of credit, you enter an agreement with a financial institution, promising to pay back the money you borrow from them later.

Banks, credit unions and lenders attach an interest fee to your agreement. If you fail to pay the minimum payment due at the end of each month, they’ll charge you interest. That’s why it’s crucial that you make timely payments. If you do, a credit card is a key financial asset.

Benefits of credit cards

When you use your credit card smartly, you can expect several rewards:

Building your credit: One of the quickest ways to boost your score is for a financial institution to approve a credit card for you. Consistent, responsible use will further strengthen your score and solidify a strong credit history on your report.
Accessing lower rates: As well as improving your credit score, using your card in the right way can help you access other types of credit in the future and score lower interest rates.
Earning rewards: Some credit card rewards are obvious. Many cards come with cashback rewards on purchases, such as gas and groceries. Others give you travel miles, rewards points or discounts.
Getting emergency coverage: When things go wrong and repairs, unexpected surgeries or other emergencies arise, a credit card is often a real lifesaver.

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How to get a credit card and use it in the right way

The following is a quick breakdown of the credit card process, from applying for a card to making payments:

Credit card application

Credit card offers are everywhere; they can appear on your favorite morning radio show or in your mailbox. You can apply for a credit card from many institutions, such as your local bank, credit union or an online lender. During the decision-making process, they will look at your credit score, credit history and income to decide whether to approve your application.

A platform like Credit Karma can help by providing you with free access to your credit score and your credit card approval odds. If the institution approves your credit card application, it will set a credit limit, which is the maximum amount of money you can borrow. It will base your credit limit and interest rate on a variety of factors in your application.

Using your credit card

Once you receive your card in the mail, you are responsible for following the activation instructions, which usually entail a quick phone call or online setup. You're then free to use your card at places such as doctor’s offices, stores, restaurants and online, just like a debit card.

Many people fall into the trap of using an ATM to get a cash advance from their credit card. This isn’t a good idea. The credit card company will charge you even higher interest rates for cash advances. When the time comes to pay your first bill, you’ll have a few options, the first of which is to pay the minimum.

What happens when you pay the minimum balance?

This is the minimum amount the institution requires you to pay to keep your account in good standing. However, keep in mind that only paying the minimum will cost you in interest. The ideal strategy is to pay off the full balance whenever you can, which will allow you to sidestep interest altogether.

Reporting your credit card use

As you use your credit card, the card issuer will report your payment activity to the credit bureaus that calculate your credit score. With 35% of your credit score resting on your payment history, making payments on time is critical. As already mentioned, just making the minimum payment will ensure your credit card use doesn’t harm your score. Stable credit card payments will improve your score, so be sure to make that 35% count.

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Debit card versus credit card

Debit and credit cards are comparable in that you use them to make purchases, but their similarities end there. You must apply for a credit card. Your credit report determines your approval, your borrowing limit, the type of card you’re eligible for and your interest rate.

To get a debit card, you need a checking account. Rather than borrowing money from a lender, you take money directly from your bank account each time you swipe or insert your card. Because debit cards pull money from your account and not from a lender, credit bureaus don’t receive a report of your card use, and they don’t affect your credit score.

Types of credit cards

Not all credit cards operate in the same way. There are several card types, each with their own benefits and purposes. The following are some of the main types of credit cards on the market, with a little insight into what they have to offer:

Secured credit cards

Approval for traditional credit cards depends on your credit history, whereas secured credit cards are ideal for borrowers with lower credit scores and short credit histories. You pay a deposit upfront that determines your borrowing limit, and then you use the card to build your score. Once your credit score is in shape, you can apply for better cards to maximize your rewards.

Rewards cards

Speaking of rewards, credit cards offer many benefits to cardholders. For example, when you use cashback cards to buy groceries, eat out or purchase gas, you can earn back some of what you spend; and when you make purchases with travel cards, you earn points that you can redeem for air travel and hotel stays. Business credit cards with travel rewards are great if you travel a lot.

Student credit cards

If you’re in your late teens or early 20s, institutions probably bombard you with offers for this type of credit card. These cards can help students build a strong credit history if they use them responsibly. These cards come with a low interest and often have no annual fee.

Balance transfer cards

It’s all in the name with these credit cards, which let you transfer high-interest debt from other cards and sources of credit to secure a lower interest rate. If you want this type of card to help with your debt repayment, you’ll need an impressive credit score. The best balance transfer cards come with an introductory 0% APR for a set period, such as one year.

Weigh the pros and cons of each type of card and make sure you know what you’re signing up for in terms of rates and fees. Then choose the card that will benefit you the most, and take advantage of the awesome perks these cards have to offer.

6 tips to get the most from your credit card

The following pointers will help you maximize the benefits of your card and minimize the risks:

Keep costs in mind: Interest isn’t the only expense to consider when you shop around for the right card. Look out for annual, late payment and balance transfer fees when you review your options.
Focus on your score: Do what you can to build up your credit score, so you can qualify for advantageous rewards cards.
Consider credit utilization: How much of your available credit you use will determine 30% of your credit score. Aim to keep that number at 30% of your maximum borrowing limit or less to get the best results.
Keep your cards open: Closing out a credit card can hurt your credit utilization and credit history, ultimately damaging your score. If there’s no fee and the card has a high credit limit, it’s wise to keep the account open.
Always pay on time: Strive to pay at least the minimum every month no matter what. If that means spending less, so be it. The potential fees and damage to your credit score aren’t worth it.
Track your score and account: Log in and check your account activity regularly to make sure that any purchases that appear are yours. Likewise, check your credit score. If it drops unexpectedly, it may indicate identity theft or a miscalculation by the credit reporting agencies.

Bonus Tip: If you ever misplace your credit card and don’t know if you left it in your friend's car or at the last restaurant you ate at, notify the credit card company immediately. It’s much easier to call back if you find your card and ask them to unfreeze the account than dealing with someone using your stolen card and filing a claim for purchases they make with it.

Use credit cards responsibly

Learning how to use credit cards in the right way can transform your personal finances. If you use them responsibly, you can reap the rewards they deliver, such as boosting your credit, unlocking higher borrowing potential and earning rewards you can use today.

If you don’t know your credit score, take a few moments to access it, then you can start shopping for credit cards. Once you find the ideal card, start using it to build your financial future, and enjoy the rewards in the meantime.

Disclaimer: This story was originally published on July 24, 2019, on BetterCreditBlog.org. For more information on credit cards please visit: https://money.com/search/?q=credit+cards.