What is a Credit Card?
A credit card is an electronic, plastic card issued by a financial institution that lets an individual borrow money at the point of sale (i.e. checkout) to complete a purchase.
How Credit Cards Work
Credit cards are a convenient way for people to make purchases using borrowed funds from the bank. While a credit card allows a cardholder to instantly buy things either online, on the phone, or at a store, that's not the end of the story.
The cardholder (i.e. borrower) must repay the bank for what they've purchased, sometimes along with interest charges if they carry a balance on the card. A credit card balance is the amount the card holder owes for unpaid purchases.
Let's say you apply for and get approved for a credit card online or through your bank. After a month, you've charged $1,000 on your new credit card, so the bank will send you an invoice of all the purchases you made within the latest "billing cycle" (usually a 25-30 day period).
You would then have two options to repay. The first is to pay your balance in full and on time (by the invoice's due date), meaning you would repay the bank the entire $1,000 you spent on the card during the latest billing cycle. Paying in full and on time usually means you won't need to pay interest charges or late fees, assuming you don't owe any past debts on that credit card. If you use a cash-back rewards credit card, this can be the best way to rack up hundreds of dollars worth of annual rewards over time.
The second option would be to carry a balance by only paying the minimum payment due amount, which is a fraction of the total owed for the billing cycle. So if your bill were $1,000 for the billing cycle, you might only be required to pay 2% to 5% of the total balance (or $20 to $50) as the minimum payment due and pay back the rest of your balance over time. One more thing: If you as the cardholder do not pay for what you owe in full, the card's issuer will start adding interest to your balance, which will compound as long as you owe money on the card.
Credit Limit: How Much Can You Borrow on a Credit Card?
Credit cards have a maximum amount -- or credit limit -- the user can borrow during a given period. The credit limit is pre-determined by the card issuer based on the cardholder's credit rating and credit history.
What Determines the Interest Rate or APR on a Credit Card?
An individual's credit rating and credit history can influence their credit card's interest rate or annual percentage rate (APR), which could range between 10% to 25% or more. Lenders also may raise the APR if a borrower's credit score worsens or if national interest rates rise. There is no federal limit on the interest rates credit card issuers can charge, although many states impose different caps. Many card issuers offer "teaser rates" that start out very low and increase over time.
What Charges and Fees do Credit Cards Have?
Issuers use several methods to calculate interest (we'll get to that), so it's important for the cardholder to read and understand the issuer's disclosure statement in order to avoid unpleasant surprises.
In addition to interest charges, many credit cards also charge an annual fee, late payment fees, fees for going over the credit limit, cash-advance fees and foreign-currency conversion fees.
What's the Difference Between Debit Cards and Credit Cards?
Credit cards are a way to borrow money from a financial institution, while debit cards are a way to instantly take cash from your bank account in place of a check or auto draft (this is why debit cards are also called "check cards."
For example, if you have $100 in your checking account, and you use your debit card to buy $25 worth of groceries, your bank account balance would be reduced to $75 immediately upon purchase.
If you were to use a credit card to buy the $25 item, you would be borrowing $25 from the bank until your next billing cycle (25 to 30 days) or longer if you decided to not repay it and carry a balance.
Types of Credit Cards: Which Card is Right for Me?
All credit cards allow people to avoid carrying cash, but there are several types of cards to choose from that are each suited for unique individual needs.
A secured credit card may be a good credit-building option for those with no credit history or poor credit. Under this secured arrangement, the cardholder agrees to deposit a certain amount onto the card before they start using it, and they can't charge beyond that amount. Because this reduces risk for the card-issuing bank as they can collect an up-front deposit in case the cardholder can't repay, secured cards are the easiest to be approved for.
A rewards credit card gives cardholders a percentage of their purchase amounts back to them on a monthly or annual basis back in the form of cash or points that can be redeemed for airline tickets, hotel stays, travel expenses, gift cards and more. Cash-back reward cards can offer between 1% to 5% back on purchases (meaning cardholders could earn $1 to $5 for every $100 charged on the card)
A balance transfer credit card is ideal for those who carry a balance on one or more credit cards. The cardholder may transfer and consolidate existing credit card balances onto a balance transfer card, and may be able to repay that debt at 0% interest for a period of 10 months to almost two years.
How is APR Calculated on a Credit Card Balance?
A common way credit card issuers calculate your interest charges is by using the average daily balance method, which calculates the amount of interest you've accumulated by considering the balance owed at the end of each day of the period rather than the balance owed or invested at the end of the week, month or year.
Issuers use the following formula to calculate interest under the average daily balance method:
Average Daily Balance = (A / D) x (I / P)
A = the sum of the daily balances in the billing period
D = number of days in the billing period
I = annual interest rate
P = number of billing periods per year (usually 12)