How credit cards work?

Knowing how credit cards work can save you money in the long run

Credit cards have become a must have in our everyday life. Their usage has increased continually since they were first introduced. Most probably you have at least one in your wallet, or you are planning to apply for one. There are numerous reasons that support the need for a credit cards. Thus, you should understand how credit cards work. Although they are useful financial product you should have, if not used properly, they could jeopardize your financial health. You could end up with a pile of debt, and worsen finances. Thus, knowing how credit cards work, could help you better manage your debt.

What is a credit card?

 A credit card is a product offered by banks and other financial institutions. A credit card can be viewed as line of credit (revolving credit), or short-term loan.  You are basically borrowing money every time you use the credit card to make a purchase (there are other ways to use it as well). The approved line of credit is the maximum amount of funds you can use as you desire. Thus, credit cards provide an easy way to borrow money for a short period of time. In its physical form, credit card is a plastic card. You can use your credit card to pay for different goods or services, or withdraw cash from ATM.  Keep in mind that when using your credit card you have the obligation to make the minimum payment on your balance defined by the issuer.

Difference between a credit card and a debit card

Before proceeding to the explanation of how credit cards work, there is a need to briefly explain the difference between credit and debit card. Because they are physically same, some people confuse one with the other. From the aforementioned, it is obvious that a credit card is a form of a loan. Every time you use your credit card to pay for something or make a cash advance at the ATM, you are basically borrowing money. You are obliged to repay these money at a later date, in accordance to the credit card agreement. Of course, you could be charged an interest for the balance used.

On the other hand, debit cards can be used in the same manner as the credit cards, but the difference is that you do not have the repayment obligation. This is so because debit cards are using the funds available on your checking account or savings account. Thus, in the very basic form of debit card, you can spend as much as you have on your accounts. Debit card offers you direct access to your checking account. Whereas, with the credit cards, you take a form of loan from the credit card issuer. In some cases, you could be approved an overdraft on your debit card.

How credit cards work?

After defining what are credit cards, and what is the difference between credit and debit card, what comes next is to see how credit cards work. There are some basic features of credit cards you should be familiar with. These are:

  • Credit card is a form of loan.
  • The credit card issuer will charge you an interest on the outstanding balance. Thus, you are paying interest on the money used.
  • You have the obligation and you should pay the minimum repayment amount each month, failure to do so will result in paying penalty APR.

As it was mentioned earlier, the funds available on you credit cards can be considered as a form of loan. Thus, whenever you use your credit card, you are borrowing money from the credit card issuer. This means that you should pay back the outstanding balance, within the next month or during couple of months or years (depending on the terms and conditions). If you choose not to repay the full amount owed (balance) within a month (within the grace period to be more precise), you will be charged an interest rate. This interest is added on your account, and you are obliged to pay it.

When trying to understand how credit cards work, you should also know what credit limit is and how credit card is approved.

Credit limit – represent the maximum amount you have available on your credit card. Stated differently, it is the maximum amount of funds i.e. credit limit you can use (borrow) with your credit card. The maximum credit limit is determined by the bank on the basis of your credit card application.

In order for a credit card to be approved, the bank is evaluating your current employment position as well as past employment. In addition, you are evaluated on the basis of your income, your credit report and your credit history. From the aforementioned you should realize that your ability to service a credit card is analyzed. So, in general, the process for getting a credit card is as follows:

  • Go through the numerous credit card offers.
  • Decide on the most appropriate credit card for you.
  • Read the credit cards terms and conditions.
  • Read the terms and conditions once more (to make sure that you didn’t miss anything.
  • Fill out the credit card application.
  • Credit card issuer will evaluate your ability to make payments on your credit card.
  • The evaluation is based on your credit history, bill paying history, current outstanding debt, your monthly income, and your overall financial health.
  • The credit card issuer makes a decision whether or not to approve a credit card.
  • If you are approved, you sign any additional documents, and voila, you are owner of a credit card.

You need to understand the process so as to avoid any uncomfortable situation, just because you didn’t bother enough to understand how credit cards work. While, the aforesaid describes the process of getting a credit card, you should also know what to do with your credit card after approval.

Because you can use your credit cards in multiple ways, you should know what your obligations for using them are. Firstly, let’s consider the different ways you could use your credit cards. You can use them for:

  • Purchases – pay for your everyday purchases.
  • Balance transfers – transferring your balance from an old credit card to a new credit card with lower APR.
  • Cash advances – where you can withdraw money from an ATM.

So after using your credit card in some of the ways listed above, you now have obligation each month. You should keep track of your items and purchases you have done during the month. This will ensure that you do not have any late payments, and get hit with a penalties. You can see all of your items for the past month in the monthly statement. Monthly statement – is recording your activity with your credit card. The monthly statement is sent by the credit card issuer. This report is sent on a monthly basis, and it shows all items i.e. activities for the previous month. Aside of the details about each amount spent, you can also see details about the interest charge added to your balance (as well as other charges). Moreover, you can see the minimum amount due, and the date it will be due. You can also see the billing cycle, and plan accordingly to benefit from the grace period.

Although credit cards are not complicated financial product, you do need to understand how credit cards work. This can ensure that you are using you credit card in the best possible manner. First, make sure you understand the specific credit card related terminology. Second, get familiar with the approval process. The most important thing, where many people have made a mistake, is the post approval period. The post approval period is the one where you actually use your credit card. Always have the adequate information before making any finance related decision.