How Do Credit Cards Work? All You Need to Know

A credit card can be a flexible and cost-effective way to borrow money but, before applying for one, it’s important to understand exactly how they work and what costs you could face.

Rebecca Goodman, Rhiannon Philps Last updated on 24 February 2022.
How Do Credit Cards Work? All You Need to Know

Credit cards can be confusing. With so many different types available, as well as interest rates and minimum payments to think about, it isn’t always easy to understand how credit cards work and what costs are involved.

However, once you understand how they work and what charges may apply, credit cards can be a useful tool to help you spread the cost of purchases and borrow money.

How to use a credit card

Credit cards can be used to buy goods and services in store and online, just like a debit card or any other payment card. Many credit cards are now contactless, so you can pay simply by tapping the card on a shop’s card reader.

However, while you can generally use them in the same way, there is a key difference between debit and credit cards. With a debit card, you are spending money that’s already in your account, whereas with a credit card you are borrowing money from the credit card company to pay for your items.

You will then need to repay this money at a later date, either in full or in instalments.

The credit card company will send you a statement each month telling you how much you owe (including any interest and fees) and the minimum payment you need to make by a certain date.

You can make your credit card payment in a number of ways, including via online banking or a banking app, over the phone, or by setting up a direct debit, for example.

Pay for something worth over £100 but no more than £30,000 with a credit card, and you will be protected under Section 75 of the Consumer Credit Act. This means, if there is a problem with the goods or services you’ve purchased, you have the right to claim the costs back from your card provider.

Bear in mind that credit cards, or cards from certain providers, won’t be accepted everywhere.

Types of credit card

Credit cards can be used for more than just making purchases. There are several different types of cards that are designed for specific purposes, including:

  • Balance transfer cards: You can move a balance from an existing credit card to a balance transfer credit card that will hopefully charge lower interest. Although you will often need to pay a fee, which will usually be around 2% to 4% of the balance you’re transferring, some lenders offer fee-free cards too.
  • Credit builder cards: These are an option if you have a poor credit history, or no credit history at all, and struggle to get a standard credit card.
  • Money transfer credit cards: You can use these cards to transfer money into your bank account, for a fee.
  • Travel credit cards: These are specifically designed for people travelling abroad so, unlike most standard credit cards, these cards won’t charge foreign transaction fees.
  • Rewards credit cards: Some cards offer you cashback or reward points when you spend with the card, which you may be able to put towards flights, attractions, shopping and more.

» MORE: How do balance transfer credit cards work?

What are minimum payments?

Minimum payments are the minimum amount you have to pay on your credit card each month.

These payments are set by your card provider and will be at least 1% of your outstanding credit card balance, but usually they will be between 3% and 5%. Sometimes a fixed minimum amount, perhaps of £5, may also apply.

When you receive your credit card statement, you will see what the minimum repayment is and the date you need to pay it by.

You need to pay at least the minimum payment each month. If you don’t, you are likely to face penalty charges, your credit score could be affected, and you could lose any promotional offers, such as a 0% interest rate.

However, while you have to pay at least the minimum payment, you should always try to pay more than this.

If you only pay the minimum payment, interest can mount up and it will take a long time to pay off your credit card balance.

By paying more than the minimum each month, your credit card balance will reduce (assuming you don’t spend anything else using the card) so you will pay less interest.

» MORE: Credit card minimum payments explained

What is a credit limit?

A credit limit is the maximum amount you can spend on your card in total.

The credit card company sets the limit when you apply for the card, using your credit history and financial situation to decide what it will be.

Typically, the lower your credit score, the lower the credit limit you qualify for.

Depending on how you manage your credit card, you may be able to increase your credit limit or, alternatively, the provider may lower your limit.

» MORE: What are credit card limits?

How does credit card interest work?

Whatever kind of credit card you use, you need to know about the interest that could be charged.

If you pay off your credit card balance in full before the date specified in your statement, you won’t need to pay any interest.

However, if you don’t clear your credit card balance by the deadline, you will be charged interest.

Interest is charged as a percentage of the amount you owe, and you can find the exact interest rate you’ll be charged on your monthly credit card statement or other documents from your provider.

Providers will decide what interest rate to charge when you apply for a credit card. As part of the application process, they will run a credit check and look at your financial situation to decide how much of a risk you present.

Typically, the better your credit score, the lower the interest rates you can get.

When you compare and apply for credit cards, you will see something called the APR, or annual percentage rate. This tells you the cost of using a credit card, taking into account interest charges and standard fees, over one year.

However, bear in mind that the APR is based on several assumptions and, depending on how you use the card, you may end up paying more or less than the APR indicates.

Some credit cards will come with a 0% interest period, which means you won’t need to pay any interest for the specified period. If you pay off your credit card balance in full before the 0% rate ends, you can avoid paying any interest altogether.

After this period, providers will start charging interest on any outstanding balance on the card.

» MORE: Guide to credit card interest rates

Are there any credit card fees?

Interest isn’t the only cost you could face when you use a credit card. Providers may also charge a variety of fees, including:

  • Annual fees: Many cards won’t charge an annual fee, but some will.
  • Late payment fees: You will get a penalty fee if you miss the deadline on your credit card statement.
  • Fees for going over your credit limit: The provider may also lower your credit limit or ask you to repay your card in full.
  • Cash withdrawal fees: This will usually be a fixed minimum charge or a percentage of the amount you withdraw. You can also start being charged interest as soon as you withdraw any cash.
  • Balance transfer fees: When you move existing credit card debt on to a balance transfer card, you might need to pay a fee. This is usually a percentage of the total balance.
  • Money transfer fees: When you transfer money from your credit card to your current account the provider will charge a fee.
  • Foreign transaction fees: Most standard cards will charge fees to use a credit card abroad, unless you have a specialist travel credit card.

Each credit card company has a different fee structure. So if you take out a credit card, make sure you are fully aware of all the fees you could face.

» MORE: What credit card charges and fees are there?

Applying for a credit card

Once you understand how credit cards work, you are in a better position to decide if you should get a credit card and what credit card to choose.

When you apply for a credit card, the provider will want to know details about your finances and it will also run a credit check to see how you have managed credit in the past. This check will be visible on your credit history.

Before you formally apply for a card, it’s a good idea to see which cards you are eligible for. To do this, you will need to give the provider certain information and they will run a soft credit check to see what deals they can offer you. This check won’t affect your credit score.

You can then find out the credit cards you are likely to qualify for, reducing the chances of having your application rejected.

» COMPARE: Check your eligibility for credit card deals

Image source: Getty Images

About the authors:

Rebecca Goodman is a freelance journalist who has spent the past 10 years working across personal finance publications. Regularly writing for The Guardian, The Sun, The Telegraph, and The Independent. Read more

Rhiannon is a financial writer for NerdWallet, with a particular interest in personal finance and insurance guides for consumers. Read more

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