Uncover what actually happens when you use your credit card.
Written by Daniel Gonzalez
Reviewed by Katie Boushall
Financial topics can often feel overwhelming due to the sheer amount of information (and misinformation) out there. Walk into any bookstore, and you’ll find a whole section dedicated to personal finance. Add to that the plethora of podcasts, blogs, and forums, and it’s easy to feel lost. If finance isn’t your passion, you might wonder: what are the essential basics I need to know for a healthy and fulfilling life?
IndeKnow’s financial literacy content is here to make understanding finances less stressful. We break down complex topics into small, digestible modules to build your foundational knowledge step by step. In this insight, we’ll cover the basics of credit cards. By understanding what credit cards are and how they work, you’ll be able to manage your finances with greater ease.
Let’s dive in so you can handle your finances with more confidence and less stress.
When someone signs up for a credit card, they receive a plastic card in the mail. This small piece of plastic gives them access to thousands of dollars. It’s exciting, but how often do people wonder where this money comes from?
When someone receives a credit card, the money available to them comes from their card issuer. Just as banks provide loans for big purchases like homes (mortgages) or cars (auto financing), credit card issuers offer smaller amounts of money for everyday purchases. Essentially, a credit card provides a cardholder with access to funds from the issuer.
When someone uses a credit card to make a purchase, the card issuer pays the merchant or service provider on their behalf. The cardholder then owes this amount to the card issuer, not the store.
When a credit card statement arrives, it shows a minimum payment and the option to pay the balance in full. When someone sees the bill, they might think, “I spent $653 last month, but my credit card issuer only wants me to pay back $40… score!”
But it’s not actually a “score.” Credit card issuers design their terms to make cardholders feel this way. Eventually, the cardholder will need to pay back the full amount they spent. If they don’t pay the full balance within the billing period (usually one month), the remaining balance carries over to the next billing period, with added interest.
“What’s the big deal?” someone might think. “I’ll get to it when I have more money.” Ah, but not so fast. Carrying a balance from month to month means accruing interest on top of the borrowed amount. This can quickly turn a small debt into a much larger financial burden.
Credit cards come with an annual percentage rate (APR), which is the interest rate charged on any outstanding balance. If the balance is paid in full each billing period, no interest is incurred. However, carrying a balance means being charged interest on the remaining amount. According to the Consumer Financial Protection Bureau, the average APR for credit cards is around 16%. To find the daily interest rate on a credit card balance, divide the APR by 365. This daily rate is then applied to the balance that carries over from one month to the next. This means that debt can grow rapidly if not managed carefully.
Let’s see how compound interest can impact a credit card balance using a story about Jane. Jane has a credit card from her bank with an APR of 18%. In her first month with the card, she spent $1,000 on various items and services. At the end of the month, she only made the minimum payment of $20. This means she carried a balance of $980 into the next month.
In the second month with her new credit card, Jane spent another $1000 but again only pays the $20 minimum. From Jane’s perspective, she only borrowed $1,960 from the credit card issuer. However, because of the 18% APR, interest starts piling up on the amount of money she spends.
By the beginning of her third pay period, her balance has grown to $2,019.24 due to interest. This means she owes an additional $59.24 on top of the amount she spent. Jane’s balance increases each day she doesn’t pay off the full amount, showing just how quickly interest can add up.
Each credit card comes with a credit limit, which is the maximum amount a person can spend. This limit is set when a person applies for the card and can be adjusted over time based on their history with the issuer. If they receive a significant raise or haven’t had a credit increase in 12 months (assuming they’ve maintained good payment habits), they can request a higher limit. The credit limit is determined by factors such as credit history and income. It’s important to stay within this limit to avoid incurring additional fees.
Let’s take a look at the different fees you might encounter with credit cards. Credit cards often come with various fees, such as annual fees for premium cards, late payment fees, balance transfer fees, and cash advance fees, among others.
Here’s a simple breakdown of what these fees mean:
Reading the fine print on your credit card is crucial to understanding all potential costs. Since each credit card is different, knowing the details helps you avoid surprises. Understanding how a credit card works allows a person to make the most of its benefits and avoid potential pitfalls.
In the United States, a credit card is worth the risk. To qualify for any loan – whether for a car or a home – a person needs a solid credit history and credit score. The easiest way to start building this credit history is by opening a credit card, using it responsibly, and making regular payments.
Good credit card habits show lenders that an individual manages money well, making it more likely they’ll be trusted with larger loans in the future. Remember, not all debt is bad. For example, a mortgage allows someone to buy property and build wealth over time, rather than spending their housing budget completely on rent. In essence, educated use of credit can be a powerful tool for building wealth in the long run.
This insight covers the basics of credit card use. Here are the key takeaways:
Understanding these basics can help you use credit cards to effectively take advantage of their benefits.
Luthi, B. (2021, November 28). What is a credit card issuer?. Experian. https://www.experian.com/blogs/ask-experian/what-is-credit-card-issuer/
Consumer Financial Protection Bureau. (2023, August 28). What is a credit card interest rate? what does APR mean?. Consumer Financial Protection Bureau. https://www.consumerfinance.gov/ask-cfpb/what-is-a-credit-card-interest-rate-what-does-apr-mean-en-44/
DeNicola, L. (2023, October 24). What is a credit limit?. Experian. https://www.experian.com/blogs/ask-experian/what-is-a-credit-limit/
McFarlane, G. (2023, December 12). Personal loans vs. credit cards: What’s the difference? Investopedia. https://www.investopedia.com/articles/personal-finance/041415/pros-cons-personal-loans-vs-credit-cards.asp
DeNicola, L. (2024, February 9). What is a credit card annual fee?. Experian. https://www.experian.com/blogs/ask-experian/what-is-an-annual-fee-on-a-credit-card/
Axelton, K. (2024, February 23). What is a balance transfer fee?. Experian. https://www.experian.com/blogs/ask-experian/what-is-a-balance-transfer-fee/
Fontinelle, A. (2024, March 15). Late fee: Definition, how they work, and how to avoid them. Investopedia. https://www.investopedia.com/terms/l/late-fee.asp#:~:text=Key%20Takeaways,can%20hurt%20your%20credit%20history
Luthi, B. (2023, March 21). What is a credit card cash advance fee?. Experian. https://www.experian.com/blogs/ask-experian/what-is-credit-card-cash-advance-fee/
