How Do Credit Cards Work?

These days, most adults in the US — around 80% — have a credit card. Plastic credit cards may be a modern invention, but the concept arose in ancient Mesopotamia, around 3,000 BC.
 
Back then, people used earthen tablets or inscribed shells to conduct trade and provide credit. In the 1930s, the first true credit card, the Charga-Plate, popped up, resembling a military dog tag with a paper backing.
 
These days, plastic credit cards (and their digital versions) accomplish the same task, allowing people to buy now and pay later. Read on to learn how credit cards work and what they can be used for.

What is a credit card?

A credit card is a plastic card that gives you credit that you can use to pay for nearly everything — from groceries and movie tickets to locksmith service. You make the purchase today and pay the balance later. There are general-purpose credit cards, such as Mastercard® and VISA®, that are accepted nearly everywhere. There are also store credit cards that can only be used for a specific retailer.
 
Similar to a debit card, you make a purchase by swiping or tapping your credit card at a merchant’s register (or, for online purchases, by entering your card number). A credit card works differently than a debit card, though. When you use your debit card to buy a pair of jeans, the money is taken directly from your bank account. When you use a credit card, you’re using a credit line. That means you’re borrowing funds that will need to be repaid.
 
Financial institutions issue credit cards to consumers who qualify based on factors such as their credit score. As a cardholder, you’re given a specific credit line, such as $10,000. You can spend up to that limit, but it’s best to keep your balance at 30% (or less) of your available credit.
 
Credit cards offer revolving credit: when you make purchases, you pay that money back and can borrow more, within your credit limit. That’s different from an installment credit account, such as a mortgage. With installment credit, you borrow a specific amount and then repay that amount in installments over time.
 
As a credit card holder, it’s important to understand the extra costs of using a credit card. The card issuer usually charges fees as well as interest on your purchases. However, interest is only charged on any balance that’s carried over from one month to the next. So if you pay off your full credit card balance each month, you can avoid paying interest.
 
There are some significant upsides to credit cards. Using them responsibly can help build your credit rating. Some credit cards even offer purchase protection. So if you make a credit card purchase and something goes awry — say, the item is damaged or gets stolen — you may get a refund or replacement. Some credit cards even offer you rewards for using them.

Terms you need to know

When choosing a credit card, getting familiar with these terms will help you understand your credit card statement.

• Annual percentage rate or APR. The APR is the interest rate you pay on any balance that you carry over from one month to the next. Most credit cards have a variable APR, meaning that it rises and falls with market interest rates and other factors. Credit card issuers typically notify you before changing the rate, and the new rate applies only to new purchases.
• Previous balance. Some credit card issuers charge interest based on your previous balance, which is the balance amount at the beginning of the previous month. That means payments made during the current billing cycle wouldn’t be counted when calculating interest. The bottom line: you may still pay interest on a balance that has recently been paid down.
• Payments and other credits. Your credit card bill lists any payments you made during the current billing cycle as well as credits, including rewards or billing adjustments made in your favor.
• Minimum payment. This is the minimum payment you must make to keep your account in good standing, usually 5% of your balance or less.
• Purchases or transactions. Your bill lists any purchases or transactions you made during the most recent billing cycle. You’ll typically see the name of the vendor, the date you made the purchase, and the amount you paid.
• Fees. Some credit cards charge an annual fee, late payment fees, returned payment fees or other fees. These fees are detailed on your monthly bill.
• Cash advances. You can use your credit card to withdraw cash. When you do, you’re borrowing against your credit line. Most credit cards allow you to withdraw a certain percentage of your credit line. Cash advances are usually costly. You’ll likely pay a processing fee and a higher APR than you would when making a credit card purchase.
• Interest charged. This number represents the interest on your unpaid credit card balance.

How are credit card payments calculated?

Each month, you receive a credit card statement. It shows your balance (the total amount you owe) as well as your minimum payment (the amount you must pay this month). Your minimum payment depends on the credit card, but it’s usually between 1% and 4% of your balance, although it may be a flat amount. So if your balance is $2,000 and your card issuer sets the minimum payment at 2%, your minimum payment would be $40.
 
If you make a payment of $40, keep in mind that your balance won’t drop from $2,000 to $1,960, unless you have a 0% APR and pay no fees. Most cards charge interest and fees, which get added to your existing balance.
 
To calculate your interest, your card issuer divides your APR by 12 to get your monthly interest rate. That monthly rate is then multiplied by your average monthly balance. Some card issuers use a daily interest rate instead, so they divide your APR by 365 (days), then multiply that daily rate by your average daily balance for the billing period.
 
Your card issuer may also charge fees, which are added to your loan balance. Any fees will be listed on your credit card statement.
 
The best approach is to keep your credit card balance at 30% (or less) of your credit limit. While you’re only obligated to make the minimum payment, it’s best to make a larger payment. The more you pay each month, the quicker you’ll pay off your debt — and the less interest you’ll pay. If you pay off your balance every month, you won’t pay any interest at all.
 
It’s also a good idea to carefully review your monthly credit card statement. If you notice any unusual charges, contact your card issuer.

Thinking about canceling a credit card? Try this first.

If you’re thinking of ditching a credit card that has an annual fee or a high APR, contact the card issuer and let them know.
 
They might make you a retention offer. Hoping to keep you as a customer, they may waive the annual fee or adjust your interest rate.

What can and can’t you do with a credit card?

You can use your credit card for many things — but not everything. Every credit card (and merchant) is different, but here are some general guidelines.
 

Can you buy a car with a credit card?

Car dealerships don’t generally allow customers to use a credit card to pay for a car, because the dealer must pay a credit card transaction fee. That fee is a percentage of the vehicle’s price, such as 3%, which can be pretty steep for a large purchase. Some dealers may accept a credit card for a down payment, however.
 
If you’re able to find a dealer that accepts credit cards, think carefully before paying with plastic. First, make sure that the dealer’s car prices aren’t set higher for buyers who use a credit card. Also, be aware that a large credit card purchase will hike your credit utilization ratio, which is the amount of your available credit that you’re using. That can harm your credit score. And you’ll usually pay a higher interest rate than you would with a car loan.
 

Can you pay a credit card with a credit card?

Not directly. However, you may be able to do so indirectly.
 
You can use one credit card to get a cash advance, for example, then use that cash to pay your bill for another credit card. That can be an expensive way to pay your bill, though, because you’ll pay a fee that’s usually a percentage of the cash advance. You’ll also pay a higher interest rate on that cash advance than you do when making a purchase. Those extra costs can add up.
 
Another approach is to transfer your balance from one credit card to another. Some balance transfer credit cards offer a 0% interest rate — at least for a while. But read the fine print, because you may need to pay a transfer fee, such as 3% or even 5% of the balance being transferred.
 

Can you pay rent or a mortgage with a credit card?

If you’re a renter, you may be able to pay your rent with a credit card, depending on your landlord’s policy. Many larger property management groups accept credit card payments, while independent landlords tend not to accept them.
 
As a homeowner, you probably can’t use a credit card to pay your mortgage directly.
 
Whichever payment method you use, make sure you understand any charges such as interest rates and fees.
 

Can you pay taxes with a credit card?

Yes, you can pay with a credit card, although you’ll pay a fee. You can also use a credit card to pay California state taxes. There’s a service fee of 2.3%.
 

Can you buy a money order with a credit card?

Yes, you can use most credit cards to get a cash advance. You can then use that cash to buy a money order. However, this is a costly way to get a money order, because you’ll pay a processing fee and a fairly high APR for that cash advance. So do the math before making a decision.
 

Can you use a credit card at an ATM?

Yes, most credit cards can be used to withdraw cash at an ATM. You can usually withdraw a fraction of your credit limit, such as 25%.
 
Keep in mind that you’ll pay a processing fee when you get a cash advance. You’ll also pay a higher APR than you do when using your credit card to purchase goods or services — and your card issuer will start charging interest right away.