How Do Credit Cards Work?

Credit cards allow you to borrow money to pay for items you aren’t able to pay cash for. They can be helpful for making big purchases, like airline tickets or new appliances, or for covering daily expenses like groceries. A credit card can be a convenient financial tool, but using one isn’t free. You can wind up owing a credit card company a lot more than the amount you borrow if you aren’t careful.

Understanding how credit cards work and how to choose one will help you stay in control of your finances.

How credit cards work

A credit card is a piece of plastic or metal issued by financial institutions to approved consumers looking for a line of credit. Cards often have different qualifying criteria. Approval might depend on your income, your credit score or your previous credit history.

Your credit card is assigned a credit limit, which is the maximum amount of money you can borrow to pay for goods or services. Any money you spend using a credit card must be repaid at a later date.

The exact rules governing how a particular credit card works, including limits, interest rates, benefits and fees, are found in its terms and conditions document.

How credit card interest works

Whenever you use your credit card, you risk paying back the borrowed amount plus interest.

The interest rate, also called the annual percentage rate, or APR, can be quite high. For a credit card that offers rewards, like cash back or points, the interest rate is likely to be around 21%, according to NerdWallet analysis.

Some credit card companies offer an interest-free grace period for purchases. These grace periods typically last 21 days. Grace periods begin on the last day of your monthly billing cycle. You won’t owe any interest if you pay your balance in full before the next billing due date.

How credit card payments work

You can make payments against your credit card charges at any time, either in-person, online or through your bank or credit card company’s app. The sooner you pay off the amount you owe, the less interest you’ll pay.

At the end of each billing cycle, which typically lasts a month, you’ll receive a credit card statement. Your statement includes a list of monthly transactions and how much money must be repaid. The unpaid amount is known as your credit card balance.

If you aren’t able to pay the full balance, you can make a minimum payment or a partial payment. If you choose either of these options you’ll incur interest charges, which increase the overall cost of your purchases.

Credit card payment example

Say you use your credit card to book a $500 flight. It’s the only thing you charge to your card that month, and you don’t have an outstanding balance.

Before your next billing period begins, you make a $50 payment to your credit card. You start your next billing period with a $450 balance, which now begins to accumulate interest at a rate of 19% APR.

If no additional payment is made within the next 30 days, the $450 balance will generate $7.08 of interest over the statement period.Your $500 flight has now cost you $507.08.

How credit cards build (and hurt) your credit history

If you use a credit card responsibly, your credit score generally increases. A higher credit score can make it easier to borrow larger sums of money, like a mortgage, at lower interest rates.

But if you fail to make your credit card payments, your credit score will suffer. Creditors will question your ability to pay them back and either charge you higher interest rates or reject your loan applications altogether.

Creditors know this information about you because of your credit report. Credit card providers (and utility companies and some landlords) report financial activity to Canada’s two major credit bureaus, Equifax and TransUnion, who store this information and use it to calculate your credit score.

Other activities that contribute to your credit score include:

Note that an overpaid credit card, one that has a negative balance, does not have a negative impact on your credit score.

» MORE: See how credit card interest is calculated

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4 common credit card fees

Every credit card charges fees, but they’re not always obvious. Here’s what to look out for:

1. Annual fees

Many credit cards charge a yearly fee. Cards with better rewards typically have higher fees. Some credit card fees are charged monthly instead of annually.

2. Interest charges

Every credit card has an interest rate for purchases and cash advances. The rates for these two types of transactions may differ. You may also be charged a penalty interest rate if you fail to make your credit card payments on time.

Make sure you know how these rates work before you apply for a card.

3. Balance transfer fees

A balance transfer is when you move your existing credit card balance to a different card, usually one with a lower interest rate.

Some cards that offer balance transfers charge fees. In most cases, these fees are around 1% to 3% of the balance being transferred.

4. Foreign transaction fees

Many credit cards in Canada charge a foreign transaction fee of 2.5% on any purchase that’s not made in Canadian dollars.

You may be able to avoid paying foreign exchange or transaction fees if you get an international credit card.

Credit card benefits and risks

Benefits

Risks

Nerdy Tip: Getting the most out of a credit card often means keeping track of what you spend and spreading out your major purchases. If you’re carrying a balance from month to month, and it’s not getting any smaller, it’s time to investigate your spending habits.

Types of credit cards

Although all credit cards work in similar ways, different credit cards offer competing benefits and rewards. The kind of credit card you pick should depend on your needs and spending habits.

Rewards credit cards

If you have a good credit score (generally 660 and above), rewards credit cards may be appealing as you’ll get something back for every purchase you make.

Just be sure the rewards you earn outweigh any costs you pay for the card, like an annual fee.

Generally speaking, there are four kinds of rewards cards to consider.

Cash-back cards

Cash back credit cards pay you back a fixed percentage of what you spend. You might earn 3% cash back when you use a particular card on gas or grocery purchases, for example.

Pay close attention to a card’s payout details. You could receive your rewards monthly, yearly or when you’ve earned a minimum amount of cash back.

Airline or hotel cards

Airline and hotel credit cards are suitable for people who like to travel and participate in specific loyalty programs, like Aeroplan, WestJet Rewards or Marriott Bonvoy.The points you earn may be used for free flights or nights at hotels.

General travel cards

Instead of being loyal to one specific brand, you can get a general travel credit card. Travel rewards programs tend to have more flexible redemption options but may not offer as much value as airline or hotel rewards.

Store credit cards

Many stores have their own credit cards that allow you to earn points from the retailer’s rewards program. These cards can be appealing, but the benefits have a limited scope. Make sure it is a good fit for your shopping habits before applying.

Most credit card purchases are assigned merchant category codes (MCCs) that can impact the points or cash back you earn. So it doesn’t hurt to check your statements to review the rewards earned on your monthly purchases and how your card categorizes spending.

Low-interest credit cards

As the name implies, low-interest credit cards have low interest rates, often in the range of 9% to 13%, which is significantly lower than the typical credit card interest rate of 20%. A low-rate card can be advantageous if you usually carry a balance.

Some low-interest credit cards offer a balance transfer option with a promotional rate. This type of promotion allows you to move your debt from an existing credit card to your new one at a lower interest rate for a fixed period.

Credit cards for no/bad credit

If you don’t have a credit history or you’ve made choices that lowered your credit score, you may not qualify for a traditional credit card. If that’s the case, you may want to consider a secured or prepaid card that doesn’t require a credit check.

Secured cards

To qualify for a secured credit card, you’ll deposit security funds. The amount you deposit usually determines your credit limit. As you make purchases and pay off your balance, your history will be reported to one of the credit bureaus. Eventually, you might qualify for an unsecured credit card.

Prepaid cards

Prepaid cards are a practical option for those who want to limit their spending or who may not qualify for a credit card. These cards only offer access to funds added to the card’s account — similar to a debit card. Only a few prepaid credit cards report to the credit bureaus, though, so choose wisely if you hope to build your credit.

How to compare credit cards

The right credit card for you will depend on your spending habits and lifestyle. When selecting a card, consider the following:

6 highly effective credit card habits

New to credit cards? Avoid beginner credit card mistakes by practicing these habits of successful card use:

Credit card versus debit card

A debit card lets you make purchases with the funds available in your chequing account. You don’t pay interest on your purchases and your credit history isn’t impacted by what you spend.

A credit card lets you borrow money from a financial institution up to a certain limit. Whatever you borrow must be repaid with interest. The way you use your credit card can impact your credit score because your card issuer reports your payment history to the credit bureaus.