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How credit cards work

They're more convenient than cash and they can help build your credit. But there are risks.

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Credit cards are a convenient alternative to cash and can be a useful part of your financial strategy -- as long as you use them responsibly. That's why before you sign up for a card, you need to have a solid understanding of how credit cards work. 

Using a card responsibly can improve your credit score if you demonstrate that lenders can count on you to repay your debt reliably and on schedule. But racking up bills you can't afford will hurt your credit, making borrowing more expensive down the road.

If you're new to the world of credit cards, here's everything you need to know about how they work, the different kinds that are available and all of the benefits and risks.

What are credit cards and how do they work?

A credit card offers you access to a line of credit for purchases, cash advances (a type of short-term loan) and sometimes, balance transfers (moving on credit card balance onto another card). Your credit card provider determines your credit limit, and you can borrow up to that amount.

Credit cards are a type of revolving credit, which means that as long as you make at least your minimum monthly payment -- don't let your balance go over the account limit -- you can borrow with the card again and again.

Each purchase you make adds to your account balance. Once a month, the card issuer sends you a statement summarizing your account activity for the most recent billing cycle and noting your total balance and minimum amount due. Many card issuers offer a grace period, which ends on your statement due date. If you pay the entire amount you owe during this grace period, you won't be charged interest. If you don't, the unpaid portion starts to accrue interest.

The way you use your credit card will reflect on your credit report. Using credit responsibly by not overspending and paying your balance in full can boost your credit score. Overspending, using your entire credit limit or making late payments can contribute to a lower credit score.

Credit card interest rates and fees

Credit card interest rates are called annual percentage rates. The higher your APR, the more interest you're at risk of paying. Your APR can also change. For example, if you fall behind on payments, the card issuer may charge you a higher rate known as a "penalty APR." That's on top of any penalty fees you might be charged, such as late fees. 

Credit cards also come with fees. Some common examples include cash advance fees, balance transfer fees (transferring a balance from one card to another) or foreign transaction fees (using the card in a foreign country). Some cards also charge annual fees.

Types of credit cards

There are many general-purpose credit cards, but some cards have special features or are meant for specific uses. 

  • Cash-back cards: These cards reward you with every dollar you spend. You earn a percentage of your purchases in cash or statement credits. Depending on the card you use, you'll typically get 1% to 5% back on each transaction.
  • Travel cardsSpending with a travel rewards card gives you points that you can redeem for future trips. Travel cards may come with benefits like admittance to airport lounges, insurance coverage for rental cars and savings on TSA PreCheck.
  • Airline and hotel cards: Some airlines and hotels offer credit cards that award points in their loyalty programs. You may get perks like priority boarding and discounted rates, but you're usually limited to redeeming rewards through the airline or hotel or its affiliates.
  • Store cards: Typically, you can use a retail card only at the store that offers the card. It's generally easier to get approved for a store card than other credit cards, but your interest rates may be high.
  • Balance transfer cards: You may be able to save money by moving a credit card balance to a balance transfer card. Depending on the terms, you might pay a lower rate or no interest at all on the balance during an introductory period.
  • Student credit cards: Student cards are intended for those in high school or college who may not have substantial credit histories yet. If you're under the age of 21, you'll need proof of income or an adult co-signer to be approved for a card.
  • Secured credit cards: These cards can help you establish a credit history. A secured card requires you to make a deposit and may give you a credit limit that's equal to or slightly higher than the amount you put down. Once you prove that you can use a secured card responsibly, you may be able to "graduate" to a standard credit card.

Credit cards vs. debit cards

Unlike credit cards, which don't directly draw on your savings, debit cards are connected to a bank account. Your debit card pulls funds from a checking or savings account and, since you aren't borrowing money, you aren't charged interest on purchases made. Debit card usage also doesn't contribute to your credit history. 

Credit cards and debit cards also offer different levels of fraud protection. If someone steals your credit card and charges purchases to it, you can't be held responsible for more than $50 and some card issuers won't ask you to pay a penny. With a debit card, your losses from fraud are capped at $50 if you alert your bank to the fraud within two business days. But if you don't report the fraud within that time, you could be out much more.

Credit card benefits

  • Security: Since a credit card doesn't pull funds directly from your bank account, you don't have to worry that your money will go missing.
  • Rewards and perks: When used responsibly, you can earn money and rewards when paying for everyday or big ticket purchases.
  • Flexibility: You can buy items in advance of your paycheck and pay them off by your due date, without incurring interest. This strategy can be risky though, so we try not to make it a routine spending habit.
  • Build credit: Paying your bill in a timely manner contributes to positive payment history. And if you hold onto a credit card long-term, it can have a positive impact on your average age of accounts or the length of your credit history, which may boost your credit score.

Risks to consider

  • You can accumulate interest quickly: If you carry a balance, your debt can grow rapidly as interest piles up. Failing to pay your full balance by the due date will add interest on top of your debt.
  • Credit cards may lead to overspending: When you have access to a credit line, you might find yourself overspending and unable to pay your full balance -- or even the minimum payment. And, thanks to accruing interest, you may find yourself in over your head with credit card debt.
  • You can damage your credit score: Missteps with a credit card will add negative information to your credit report, likely lowering your credit score. Using more of your available credit line can also affect your credit utilization ratio, which is the amount you owe divided by the amount you can borrow. A high ratio can lower your credit score, so it's smart to avoid borrowing more than 30% of your credit limit.

Tips for using credit cards responsibly

Before signing your name to a shiny new card, think about how you're going to use it. Logan Allec, a CPA and owner of the personal finance blog Money Done Right, said planning is key to keeping your credit card bill manageable. "As long as you set up a budget and you use your credit card to spend within that budget, you'll be OK."

Remember to pay at least the minimum due on time, as late payments will result in fees. And your credit score will likely take a hit if you miss the due date. But you should always strive to pay the full balance and not just the minimum. 

"If you just make the minimum payment, this balance will just grow, and grow and grow due to the interest," Allec said. Accumulating interest could make it feel impossible to catch up on credit card payments.

What to avoid when using a credit card

To get the most out of your credit card, watch out for these common mistakes.

Treating the card like free money

It's easy to overspend if you lose sight of the fact that each swipe of plastic adds to your bill. Allec recommends viewing your credit cards as cash. "If you have a $100 purchase, imagine pulling a Franklin out of your pocket before giving them your credit card." If you wouldn't make a purchase with cash, don't do the same with a credit card.

Not choosing the right card

You might choose a cash-back card in order to earn rewards for everyday purchases. Failing to maximize rewards can leave money on the table, but chasing rewards could also cause you to overspend.

Allec recommends first getting a card that offers flat-rate rewards on all your spending. "A good starter card is a card that gives you 2% cash-back on everything. That's a baseline," he says. Once you've mastered responsibly earning rewards with this card, you can look for a second card that offers higher rewards in a category that makes up a big part of your budget, like groceries or travel.

Be careful of annual fees, too. Sometimes they're worthwhile, but you'll want to do the math first. "Sometimes, when a card has an annual fee, you have to actually spend quite a bit to earn enough rewards to make up for the fee," Allec points out. Make sure that the rewards you're left with after paying the fee are higher than what you'd earn on a comparable card without a fee.

Applying for too many credit cards

Each time you apply for a new credit card, a new inquiry appears on your credit report, which could temporarily shave a few points off your credit score. Having too many inquiries at once could also make you look risky to lenders. 

"Every time you apply for a credit card, your credit score could get dinged a little bit," Allec says. He recommends spacing out your credit card applications, finding cards that match your credit score profile and only applying for a new card when you need one.