What Is a Credit Card and How Do They Work?
Thinking about dipping your big toe into the wide world of credit cards? Then you’ve come to the right place. Getting your first credit card and all those credit card payments might sound intimidating, but it really doesn’t have to be.
In fact, once you know a bit more about what kind of credit card you want and how you plan to use it, you’ve already done most of the leg-work and are ready to open a credit card account.
Some of what you need to know about credit cards is what makes them different from debit cards, and how you can use one to boost your credit score. We’ve got all the details that you need to know about obtaining and using a credit card responsibly.
What Is a Credit Card?
A credit card is a physical plastic or metal card that can be used to make purchases, pay bills, or even withdraw cash (also called a cash advance). You can use a credit card the same way you would use a debit card, to shop online or in person. The main difference between credit and debit cards is that with a credit card you’re borrowing money.
While debit cards work by withdrawing money you already have from an account, your credit card takes money from a line of credit, which you will then be responsible for repaying at the end of each billing cycle, usually every 30 days or so.
Having a credit card and paying it off in full each month is a great way to build credit or improve your credit score, which is something you’ll need if you ever plan on applying for a bigger loan — like a car loan or a mortgage. Credit cards are also great for their rewards systems, since many will award points that can then be redeemed for cash back, gift cards or even travel rewards.
Because a credit card is a form of borrowing, it can also lead to debt when misused. Credit card interest rates tend to be higher than other loans, which is why it’s best to only spend what you can pay back each month. This guarantees you’ll reap all of the benefits of a credit card (better credit score, plenty of reward points), without falling into credit card debt.
How Do Credit Cards Work?
Credit cards work like small loans, allowing you to borrow from a line of credit and then repay the amounts you spend (plus interest) incrementally. The better your credit score, the better the credit card you’ll qualify for.
Customers with higher credit scores and longer credit histories (assuming it’s a good history) are more likely to qualify for a larger line of credit with a better rewards system. If you don’t have a substantial credit history, or have one that includes lots of missing payments or even late payments, it will be that much harder for you to get approved for a decent credit card.
The particulars of your credit card are determined by the terms of your lending agreement. This is an agreement set by your credit card company (which you get the chance to review before accepting a card) that dictates things like your credit limit, interest rate, how you’ll receive credit card rewards, and even your required minimum payment.
A minimum payment is the amount listed on your credit card bill that the credit card company requires you to pay back at the end of each billing cycle. Minimum payments are usually calculated as a flat rate (for smaller credit card balances under $1,000) or as a percentage of your credit card balance plus interest rates for larger balances — but the exact details on how your lender calculates minimum payments will be included in the lending agreement.
This agreement will also include details on your APR, or annual percentage rate. This is basically your interest rate for the entire year, but will also sometimes include annual fees set by the credit card issuer.
Keep in mind that some credit cards (particularly those with especially lucrative rewards) come with an annual fee, usually around $100. Other cards may offer what is called an “introductory APR” that expires after one year. This is most commonly seen in instances where lenders offer 0% APR, which then turns into a 16-24% APR after the first year — something worth noting if you carry a balance on your credit card.
Credit Cards vs. Debit Cards
Credit cards and debit cards work similarly: Both can be used to make purchases online (or in person) as well as to set up auto-pay or to pay your bills. The key difference between the two is in where the money comes from.
While a debit card withdraws your money from your account, a credit card draws on a line of credit — effectively borrowing that money from a bank or lender. This borrowed money can be used for purchases or for cash advances. Although you’ve been approved for a certain amount of credit (called a credit line), you’ll need to budget accordingly so that you can make payments at the end of each billing cycle.
Since with a debit card you’re using your own money, there won’t be any sort of payment schedule. You can budget your spending based on the balance in your account, which in some ways makes things a lot simpler. You’re also not required to have a certain credit score in order to qualify for a debit card. Because you’re simply using your own money, and not borrowing funds from a bank, anyone can have a debit card.
So why bother with a credit card at all? People get credit cards for all kinds of reasons, whether it’s to cover emergencies, rack up rewards points, or even to build a credit score. Having a good credit score is an important piece of the puzzle when it comes to qualifying for larger loans, like a mortgage or car loan.
How to Apply for a Credit Card
If you’re thinking of applying for a credit card, there are a few steps you’ll want to take.
The first thing to do when applying for a credit card is to check your credit score.
This can be especially helpful in knowing what kind of credit card you’ll qualify for. Like we mentioned earlier, the better your credit score, the better the card you’ll be able to get (and the higher the credit limit). Since you’ll want to shop around a bit for the best possible credit card, it’s helpful to know your credit score and understand what it means for your eligibility.
Once you understand a bit more about your credit score, it’s time to start applying for credit cards. Now’s also a good time to think about what you want to get out of a credit card. Are you looking for cash back rewards, travel rewards, low APR, or something else entirely? This will help determine what cards you should apply for and which ones you should skip.
Narrowing down your applications is also a good idea because applying for too many cards at once can actually lower your credit score. That’s because most lenders conduct something called a hard credit enquiry (or a hard pull) and having too many of these at the same time can signify to lenders that you’re trying to get too much credit at once. Pare your selection to a few cards that you’d actually be happy to have and that you think you’ll qualify for, then you can apply for them individually on each credit card issuer’s website.
When applying for a credit card you’ll need to have following information on hand:
- Your full legal name
- Date of birth
- Social Security number
- Annual income
If you’re applying for a joint credit card with your spouse, or if you’re applying for a business credit card, you’ll likely need to provide additional information (like your spouse’s income or details about your business). While most people apply for credit cards through the website of the credit card issuer, you can also apply via mail, over the phone or in person.
Tips for Improving Your Credit Score
After learning a bit more about your current credit score, you might be wondering how you can make it even better. Here are some general tips for improving your credit score.
- Make payments on time: Your credit score encompasses more than just your history with credit cards, it also takes into account any payments you’re making on an existing mortgage, car loan, or even a personal loan. Be sure you’re paying those on time each month and it will go a long way in improving your credit score.
- Don’t max out your credit line: Credit utilization is another thing the credit bureaus take into account when calculating your credit score. Credit utilization refers to how much of your available credit line you’re currently using, and lenders like to see that number stay under 30%.
- Make a plan to tackle your debt: One of the fastest ways to improve your credit score is to start aggressively paying down your debts. Make above-minimum payments and do your best to get those debts down to zero (or at least show progress) and your credit score will likely improve as a result.
There’s a lot to learn about credit cards — especially if you want to use them to maximize your rewards or improve your credit score. The best thing to do is start small with one credit card you really like, and ensure you can pay your credit card balance in full each month before adding any more credit cards to your repertoire. Remember, less is more when it comes to credit cards. Perfectly managing one credit card is always better than mismanaging several.
Contributor Larissa Runkle frequently writes on finance, real estate, and lifestyle topics for The Penny Hoarder.