How do Credit Cards Work? What You Need to Know
A credit card can be a cost-effective way to borrow money, giving you the flexibility to pay for things you otherwise might not be able to afford at the time. However, debts can quickly mount up. Discover how credit cards work, including the main types and how much a credit card could cost you.
Use credit cards in the right way and they can really help you manage your finances. In addition to being a cost-effective way to borrow money, they can also provide extra benefits like consumer protection and cheaper foreign exchange rates. Use them incorrectly, however, and your debts can quickly spiral.
Here we explain what you need to know about using credit cards from how they work and when you should use one, to how to find the right one for you and the best alternatives.
What is a credit card?
When you pay for something with a credit card, you borrow money from your credit card provider rather than using your own cash.
Each month your credit card provider will send you a bill. If you pay the balance in full before the specified date, you won’t need to pay any interest. However, if you don’t pay back all of the money that you have borrowed, interest will start to be charged.
If you miss payments, or you’re late with them, you could be hit with extra fees, or a higher interest rate, as well as a mark on your credit score.
You can also use a credit card to withdraw cash, however, because interest starts being charged straight away this can work out very expensive and should only be used in emergencies.
When your provider approves you for a credit card, it will set you a credit limit. This is the maximum amount you can borrow and will depend on factors including your income and your credit history.
How to use a credit card
Credit cards can be used as a way of paying for something you don’t currently have the money for.
But they can also be used for other things including building up your credit score, making spending abroad cheaper, for consumer protection, and for lowering the cost of existing debts.
There is no limit to the number of credit cards you can have and it's often helpful to have different types for different uses. However, there’s no point in having one if you’re not using it and you need to make sure you’re able to manage them by paying the balances on time where possible.
» MORE: How to Close a Credit Card
The main types of credit card
0% balance transfer cards
If you have an expensive existing debt, you can lower the cost of that borrowing and pay it off sooner by moving it onto a 0% balance transfer card.
With one of these cards you’re given a period, which can be as much as two years or more, where you won’t be charged interest on the debt you’re paying.
When money is transferred to a balance transfer card there is usually a fee to pay, which can be a flat-rate fee or a percentage of the debt being transferred. The fee is usually around 3% of the debt you’re moving.
0% new purchase cards
These cards give you a period in which you can spend on the card without paying any interest.
For example, if you paid £1,000 towards a family holiday on a card with a 12-month 0% period and you paid it off before the year was up you wouldn't be charged any interest.
» MORE: Learn About 0% Credit Cards
Reward credit cards
From vouchers to use for your next hotel stay to money-off your weekly shop, you earn rewards – which are usually points you can redeem – whenever you use one of these cards.
They work best if you know you’re going to use the rewards and you pay your bill in full every month. If you don't, interest charges can quickly undo any savings you’ve made.
» MORE: Reward Credit Cards
In a similar way to reward cards, cashback cards pay out cash every time you use them. The rates depend on the card but you’ll usually earn back a fixed percentage of the amount you have spent on the card. This is likely to be in the region of 1% but you may be able to get as much as 5% for a short-term introductory period.
» MORE: Cashback Credit Cards 101
Credit builder cards
If you have a poor or non-existent credit history, a credit card can help you.
With credit builder cards, you’ll usually be given a small amount to spend and if you pay it back every month your credit score will improve. The interest rates are higher on these than they are on other credit cards so it’s important to pay them back on time to stop charges spiralling.
» MORE: Credit Card Builders
Cheaper foreign spending cards
Usually, when you're on holiday, you’ll be charged every time you use your credit or debit card.
But some credit cards don’t have any fees on cash withdrawals or spending when you are overseas.
» MORE: How to Use a Credit Card Abroad
How much a credit card could cost you
There are several ways in which you’ll pay for using a credit card. These include the annual interest rate, which is set when you take out the card but could change, and fees if you miss or are late with a payment or go over your card limit. Interest rates and charges vary between providers so it’s vital to shop around to make sure your borrowing does not cost you any more than is necessary.
Every time you apply for a credit card, or any kind of debt, a check will be made on your credit score. If you’re applying for lots of cards in a short period this will negatively affect your credit history.
To combat this, there are a number of free eligibility checking tools. These will show you which credit cards you may be accepted for before you apply.
How credit cards can provide consumer protection
When you use a credit card, you are protected under what’s called ‘Section 75’ of the Consumer Credit Act. This means anything you buy that costs more than £100 (but not more than £30,000) is protected. So, if what you have bought doesn’t turn up, is damaged, or if you’ve booked something such as a holiday which is then cancelled you will be able to claim the costs back from your credit card company. It doesn’t matter if you only paid for part of the item or service with your credit – the whole cost will still be protected.
The alternatives to credit cards
There are some alternatives to credit cards that, depending upon your circumstances, might suit you better. These include paying in cash or with your debit card or even using a prepaid card, where you load money onto a card before you use it. If you are borrowing money you may find a cheaper rate with a personal loan, depending on the amount of money you need and when you can pay it back.
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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