Credit cards are complex financial tools that allow you to borrow money with a standard line of credit provided by a bank. Credit cards can help you build credit and earn rewards when used responsibly, but they also have some drawbacks, like high interest rates and fees. However, if you navigate your credit card journey correctly, you can typically avoid all the pitfalls.
What is a credit card?
Banks offer credit cards as a type of loan with a revolving line of credit. Credit cards are embedded with a 15- or 16-digit number that lets you make purchases in person or online. You can make purchases with your credit card just like you would with a debit card, but instead of the amount being subtracted from your account, you are borrowing the funds against your credit limit from the bank. As long as you pay your balance off in full each month, you won’t have to pay interest on the amount you owe.
How does a credit card work?
Lenders determine your credit limit based on a few things, including your credit score, payment history, credit history and income. These factors measure your overall creditworthiness, or how likely you are to pay back what you owe. A lender may feel more inclined to offer you a higher credit limit (and lower interest rate) when your history is more favorable.
Each credit card has a billing cycle that lasts between 28 and 31 days. This time period defines the amount of time between the last statement closing date and the next. Credit card companies also offer a grace period between the end of the billing cycle and when your bill is due, usually about three weeks long. You won’t face interest charges during this period, but that’s only the case if you manage to pay your statement balance on time and in full.
On every credit card statement, you will see two terms that are not necessarily interchangeable but important to understand: statement balance and current balance. Your credit card statement balance includes all transactions and payments made during your most recent billing cycle. On the flip side, your current balance is the real-time view of all purchases, credits, interests and fees since your most recent statement.
Pros of credit cards
- You can build credit: Using credit cards responsibly is an excellent way to build credit. Your credit score, a summary of your credit history, helps lenders, employers and other organizations assess your likelihood of repaying debts. You will likely need a good credit score to qualify for a car loan, mortgage or another big-ticket loan.
- They’re secure: Most credit card issuers offer zero-liability fraud protection if you report the charges within 30 days. And in compliance with the Fair Credit Billing Act, liability is limited to $50 for fraud.
- Some offer rewards and cardholder benefits: Many credit cards allow you to earn cash back, points or miles on everyday purchases. And some cards offer additional protections, like extended warranties, which can save you money. Some credit cards offer welcome bonuses as an incentive to spend money using your new card.
Cons of credit cards
- High interest rates: One of the most significant drawbacks of credit cards is the high interest rates or annual percentage rates. If you carry a balance from month to month, interest charges will start to pile up. You can avoid interest charges by paying off your balance in full and on time each month. One way to do this includes setting up automatic payments and using a calendar reminder.
- They often have fees: Most credit cards charge an annual fee, and some charge a foreign transaction fee for purchases made outside the US. And if you miss a payment on your credit card, you’ll be charged a late payment fee.
- Every application comes with a hard inquiry: Every time you apply for a new credit card, the lender performs a hard credit check to assess your creditworthiness. And every time you apply for a new credit card, a new hard inquiry is added to your credit report. Hard inquiries ding your credit score but also raise red flags to lenders.
- It may be easier to overspend: It can be easy to overspend with a credit card, but you should use it only for necessary purchases and bills. To avoid digging yourself into a hole and damaging your credit, only spend what you can afford to pay back at the end of the month.
The bottom line
In order to make your credit card work best for you and your financial goals, it’s essential to understand credit card basics. Credit cards are useful financial tools for building credit, but they can quickly become a burden if you don’t use them properly.
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Correction, 7:30 a.m. PT Jan. 25: A previous version of this article stated that each credit card has a billing cycle that lasts between 28 and 30 days. The article has been corrected to clarify that billing cycles last between 28 and 31 days.
