How Credit Cards Work

·10 min read

Remember the good old days when you only had to master a plastic rectangle when you wanted to buy something on credit?

These days, it could involve using your smartphone as a virtual wallet or tapping your contactless credit card instead of swiping or inserting it. Despite the new options for using credit cards, the process that takes place behind the scenes is pretty much the same.

Why do you need to know how credit cards work? Because once you get a grip on the life cycle of a credit card transaction, you'll have a clearer idea of how to use credit cards responsibly and stay out of debt. You'll also know how to use credit cards to your benefit.

It's like mastering any other topic. Learn it from the ground up, and you'll know how to tinker with it without breaking it.

Up ahead:

-- How do credit card payments work?

-- How to take advantage of the grace period.

-- How does credit card interest work?

-- Common credit card fees.

-- Types of credit cards.

-- Credit cards vs. debit cards.

[ Read: Best Cash Back Credit Cards. ]

How Do Credit Card Payments Work?

Let's say you're at the mall and your bill comes to $100. You insert your Chase Visa rewards credit card into the payment device, and that starts the payment cycle.

Here's what happens next:

1. Your credit card details are sent to the retailer's bank, which is called the acquiring bank. Let's say the acquiring bank is Wells Fargo. This bank has to get payment authorization from the credit card network, which, in this case, is Visa.

2. This request is also routed through the credit card issuer, Chase, to validate the number, credit limit and CVV (security code). Note that Visa, Mastercard and Discover have a three-digit CVV, but American Express cards have a four-digit CVV. Chase either approves or declines the transaction and sends this response to Visa and to Wells Fargo.

3. After Wells Fargo gets authorization to accept the payment, your issuer, Chase, puts this amount on hold on your account, which decreases your available credit.

4. The retailer includes your transaction with a batch of all the other transactions for the day and sends it to Wells Fargo.

5. Next, the clearing process starts. Wells Fargo sends the batch to Visa for processing.

6. The Visa network then sends the transactions to Chase. Chase responds and sends the payment amount (less interchange fees) to the Visa network.

7. Visa then pays Wells Fargo, less applicable fees. After fees, the retailer receives about $97 to $98 as a reimbursement for your $100 purchase.

8. Chase sends you a bill for the purchase amount, $100, which you pay in full and by the due date to avoid interest.

[ Read: Best Student Credit Cards. ]

How to Take Advantage of the Grace Period

The grace period is the length of time between the date of your purchase and the due date on your statement. It varies by credit card issuer, but most grace periods are between 21 and 25 days. Assuming you aren't carrying a balance from the previous month, if you pay your bill in full by the due date, you don't have to pay interest.

Here's where people mess up. They decide it doesn't matter if they carry a balance just this one time. But once you go down that rabbit hole, you fall in deeper and deeper. If you don't believe you can get into debt trouble in a hurry, read the next section.

How Does Credit Card Interest Work?

All credit cards have interest rates that are shown as an APR, which stands for annual percentage rate. The APR measures the annual cost of borrowing. It excludes extra costs, such as an annual fee.

Most credit cards use a variable APR, so your interest rate will vary based on the fluctuations of the prime rate, which is set by the Federal Reserve. For example, if the prime rate is 4.75% and the credit card's base rate is 10.74%, you'll have a variable APR of 15.49%.

Now, if you carry a balance, you end up paying compound interest. Compound interest is a good thing when it's a savings account. But it's a bad thing when it comes to your credit card balance. I'll show you an example so you'll get a clear picture of what can happen.

Let's say you have a $5,000 balance with a 20% variable APR. We'll assume your initial minimum payment is $133.33 (including interest plus 1% of the balance). If you pay the minimum amount each month, it will take you 277 months to pay it off. That's more than 23 years! And you'll pay $7,723.49 in interest alone for a grand total of $12,723.49 for your comparatively small balance of $5,000.

A 2019 U.S. News survey showed that more than 11% of consumers still believe you have to carry a balance to build a good credit score. This is entirely false. You can earn a great score without incurring interest charges. Just pay your balance off every month and pay it on time. Only 41% of respondents understood that interest is charged if they don't pay their balance in full.

Tip: If you do find yourself in debt, your goal should be to at least double the minimum payment. In the above example, if you pay about $266 per month, you'll be out of debt in 23 months and pay $1,045.44 in interest.

The rule for using credit cards? Pay your balance in full by the due date every month. You'll pay zero interest on purchases and get an interest-free loan during the grace period.

If you can't follow this rule, don't use credit cards. I'm serious. Revolving a balance will lead to stress and financial disaster.

[ Read: Best Secured Credit Cards. ]

Common Credit Card Fees

The Truth in Lending Act (Regulation Z) requires every credit card offer to disclose its rates and fees. These laws are designed to protect you when you apply for a credit card. But it's still up to you to research the different types of credit cards online. And when you apply for and receive a new card in the mail, read all the disclosures that come with your credit card. Yes, all the fine print!

Purchase APR. Credit cards have an average APR of between about 17% and 24%, according to U.S. News data. But the rate you get could be higher or lower than average, depending on your creditworthiness. Note that rewards credit cards tend to have higher APRs.

Balance transfer APR. If you transfer a balance from one credit card to a balance transfer card, you'll be given an APR for the amount transferred. If you have good credit, you might qualify for a balance transfer card with a 0% introductory APR.

Balance transfer fee. Most balance transfer credit cards charge this fee, which is usually between 3% and 5% of the amount transferred.

Cash advance APR. If you use your credit card to get cash, you'll be charged at a higher APR for the amount withdrawn. A cash advance APR can average around 26% or even higher. With most cards, the interest on a cash advance starts accruing right away, so try to avoid getting cash this way.

Cash advance fee. Most credit cards charge between 2% and 5% of the amount withdrawn.

Annual fee. Some credit cards charge an annual fee for the use of the card. The amount varies according to the rewards and features offered with the card.

Penalty APR. Some cards will charge a higher APR if your bill payment is at least 60 days late. Some issuers charge a penalty APR, which can go as high as 29.99%. That should be enough incentive to pay your bill on time!

Foreign transaction fee. If you make a purchase in a foreign country, you might be charged this fee, which averages around 3%. There are many credit cards that no longer charge this fee, so if you travel often, get a credit card that waives foreign transaction fees.

Late fees. You'll be charged this fee if you are late with a payment. The amount varies based on how often you've been late. A credit card issuer can charge you $28 for your first delinquency. Some card issuers don't charge late fees, but pay your bill on time because it gives you a strong credit history.

Types of Credit Cards

Here are the most popular types of credit cards.

Plain vanilla credit cards. These cards usually have a low APR but don't offer rewards. Hence, the vanilla label. This type of card is good for a financial emergency. If you had to carry a balance for a few months, using a card with a low interest rate could save you money.

Rewards credit cards. These are popular because you can earn rewards on your purchases. Within this category, there are many different types, including cash back cards, travel rewards cards, and hotel- and airline-branded cards.

To truly profit from rewards credit cards, you need to look at your spending patterns. What do you spend your money on? Do you travel often?

Be sure to look at the fees and the rates. Rewards credit cards tend to have higher APRs, so never carry a balance on a rewards card. You can use these cards strategically and make a profit from your cards.

Balance transfer credit cards. If you have a balance on a card with a high APR, then transferring the debt to a balance transfer credit card with a 0% introductory APR can save you money.

Nearly three-quarters of credit cards charge a 3% balance transfer fee on the amount transferred. Be sure you consider that since it increases the balance you will owe. Also, note how long the intro period lasts. Once the intro period ends, your rate will increase to your purchase APR.

Student credit cards. Student cards are designed for college students who have limited credit. These cards vary, but many offer decent APRs and rewards. If you're younger than 21, you have to get a co-signer unless you can prove you have sufficient income to pay back any debts you incur.

Secured credit cards. If you have either no credit or bad credit, getting an unsecured card can be challenging. A secured card is designed for consumers who need a little help to build or rebuild their credit history.

With these cards, you're required to make a security deposit, which is usually your credit limit. As long as you pay your bill on time, you can build credit and eventually qualify for an unsecured credit card.

Business credit cards. You can also get a credit card for your small business. You can get a variety of rewards with these cards, so choose the business card that matches your spending needs.

Credit Cards vs. Debit Cards

There's a major difference between credit cards and debit cards. A credit card is considered revolving credit. This means you have a credit limit, and you can purchase items on credit and pay it back by the due date.

If you don't pay it in full by the due date, you're charged interest since you borrowed the money from your credit card issuer. The good news is that using credit cards responsibly helps you build credit because your issuer reports your credit history to the major credit bureaus.

Debit cards, however, don't help you build credit. Your debit card is linked to your own bank account. So you're actually spending your own money, and that isn't reported to the credit bureaus. Debit cards are certainly a payment option for those who don't have -- or don't want to use -- a credit card.

For online spending, though, it's best to use credit cards. They offer more consumer protections than debit cards. Plus, it can improve your credit score.

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