How Credit Cards Work

Image of credit cards

If used responsibly, credit cards can be a very helpful purchasing tool. But, you'd be surprised at how many of us simply don't understand how they work? How is interest calculated? What's a credit limit? We will try to provide this basic information on such a powerful purchasing tool.

Sometimes mistaken as "free money", credit cards are one of the most powerful financial tools that someone can have. A credit card allows you to purchase items with money that you don't necessarily have at the moment of the purchase. It's crucial that you understand exactly how a credit card works before you can fully appreciate what it can do for you - and how you can get into trouble with one!

What is a credit card?

A credit card is a revolving charge account. What this means is that your creditor allows you to borrow a specific amount of money and, as it is repaid, allows you to borrow it again. In exchange for your borrowing or credit limit, your creditor charges you a fee. Depending on your creditor, there are different fees that may apply.

  • Annual Percentage Rate - This is the most common fee that you will have when dealing with credit cards. There are two basic APRs: a fixed rate, which doesn't change; and a variable rate, which may change due to economic indicators or indexes. Rate changes in these indexes cause your interest rate to either rise or decrease. The type of APR you have should be disclosed to you prior to opening an account with your creditor.
  • Annual Fee - This is basically a membership fee you pay to use a particular company's brand of credit card.
  • Transaction Fees and Miscellaneous Charges -These fees have to deal with factors within your account such as cash advances, late payments, and over the credit limit violations. There is also a standard monthly fee.

Types of Credit Cards

Banks issue credit cards for people with a variety of different financial profiles. For example, a person with a 750 credit score will qualify for a credit card with a lower annual percentage rate, a high spending limit, and maybe even no annual fees. Conversely, a person with a 600 credit score will likely pay a much higher interest rate, have a lower spending limit, and will probably have to pay an annual fee. It all comes down to the level of risk that the bank is taking when extending credit. If a consumer is a higher risk, the bank will want to reduce the amount of money they stand to lose in the event of a charge-off. Click here to Learn what a charge-off is.

Banks will even offer cards to consumers who have a very poor credit history in order to help them rebuild their credit. These cards will most likely have a very high interest rate and a very low spending limit. However, when the consumer illustrates that they can use that card responsibly (by making all of their payments on time for a certain period of time) they'll either increase their spending limit or even offer them a new card with a lower interest rate/higher spending limit.

Another card that banks will offer consumers with a poor credit history is a secured card. These cards are secured by funds that you deposit into the card's account, but it functions like a normal credit card in terms of how you use it to purchase items. They are primarily used to, again, help build a person's credit history and most banks will offer a credit-limit account once the consumer shows that they can use the secured card responsibly.

Are credit card fees and charges avoidable?

Fees and interest are how the banks make money on credit card accounts, and they can vary quite a bit from card to card. Some cards will offer to give you a card with "no annual fees", which can be enticing, depending on the interest rate. However many credit card fees, and even interest charges, can be avoided by always making your payments on-time and in the correct amounts, and making sure that you always stay within your credit limit.

We always recommend that you pay your credit card balances in-full every month. If you do this, you will avoid paying interest on the amount of money that you used for that period. However, if you cannot afford to do so, you must at least pay the minimum monthly payment due prior to the due date to avoid late fees. Let's say you have a card with a credit limit of $1,000 and your current balance is $990. If you make your minimum monthly payment late (even by a day), the bank will charge you a late fee of, for example, $35. Now, your balance is $1025, putting you $25 over your spending. Now, guess what? You're going to get hit with another fee for going over your limit.

If you can't or don't wish to pay your credit card immediately and plan to make payments over a longer period of time, you will be subject to your creditor's balance computation method. The Average Daily Balance method is the most common. To figure the balance that is due on the account, the creditor totals the beginning balances for every day in the billing period and deducts any credits posted to the account that day. The daily balances are totaled and divided by the number of days in the billing period. The resulting number is your Average Daily Balance. After your Average Daily Balance has been determined, your finance charge will be calculated and added to your balance.

Another technique is the Adjusted Balance method. In this process, the balance on your account is determined by subtracting payments and credits during your current payment period from your previous ending balance. For further explanation of the calculations used to derive your balances and fees, check your statements. The specific details are normally printed on the back.

As you can see, there are many, many factors to consider when choosing a credit card. Although it's easy to accept a credit card offer (usually just by calling a toll-free number or clicking on a link to a website), you really have to do your homework. A good resource that we recommend is By entering some basic information, this site will give you several potential options for you and will list the benefits of each type of card, including fees and interest rates. At very least, read the fee and interest rate disclosures to make sure that you're getting a fair deal and the card won't end up costing you more than you thought in the long run.