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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, the costs you could face and which one may best suit your needs.
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A credit card might look just like a debit card, but it’s very different. There are several types available but they all have one thing in common: they offer a flexible way to borrow money. 

Credit cards can be useful if you’re planning a large purchase and want to spread the cost. Used responsibly, they can help you to build or repair your credit rating, with the bonus of providing free purchase protection

However, if you’re considering applying for your first credit card – or you’re wary after building up debt in the past – it’s worth taking time to understand exactly how they work and what costs are involved. 

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. Most providers issue contactless cards, so you can pay simply by tapping the card on a card reader. In most cases you can add credit cards to a digital wallet, which gives you the added convenience of paying using a device such as a phone or smart watch. 

Credit cards can also be used to withdraw cash from an ATM, but this can be expensive as you will be charged extra interest and fees, usually from the day you make the withdrawal. 

The difference between a debit and credit card

While you can generally use them in the same way, there is a key difference between debit and credit cards:

  • When you pay using a debit card, you are spending money that’s already in your account
  • When you use 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.

Each month, the credit card company will send you a statement 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 few ways: via the provider’s website or app, over the phone, using your banking app, or by setting up a direct debit.

Another key difference between credit cards and debit cards relates to payment protection. When you use your credit card to pay for something that costs between £100 and £30,000 you are protected under Section 75 of the Consumer Credit Act. This means, that if there is a problem with the goods or services you’ve purchased, you may have the right to claim the costs back from your card provider.

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 which offers a low or 0% interest rate for an introductory period. Before you apply, check exactly how to transfer credit card balances and take note of any transfer fees you will have to pay, which are usually around 2% to 4% of the balance you’re transferring.
  • Credit builder cards: These may be an option if you have a poor credit history, or no credit history at all, and struggle to get a standard credit card. They usually have low credit limits and high interest rates, but if you only use up to 25% of your credit limit and make payments on time you should see your credit score improve. 
  • Money transfer credit cards: You can use these cards to borrow cash from your credit card and transfer the money into your bank account, for a fee. Some providers offer a low or 0% introductory period, so it can be a cost-effective way to pay off an overdraft or access a low-interest loan. 
  • Travel credit cards: These are specifically designed for people travelling abroad, which makes them a good option for holidays. Unlike standard credit cards, you won’t be charged a fee when you spend overseas and you will usually benefit from good exchange rates. However, this type of card usually charges a higher rate of interest so it’s best to clear your balance as soon as possible after your trip. 
  • Rewards credit cards: Some cards offer cashback, reward points or air miles when you make a purchase. However, these often have a higher interest rate which could cancel out the benefit of the rewards unless you clear your balance in full each month. 

» MORE: How do balance transfer credit cards work?

How does credit card interest work?

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

Provided you pay off your credit card balance in full before the due date specified in your statement, you shouldn’t need to pay any interest. This interest-free period varies between different providers, but most cards give you up to 56 days from the date of purchase before interest is applied to the amount you borrowed. 

Interest is charged as a percentage of the amount you owe, and you can find the exact interest rate 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. The better your credit score, the lower the interest rates you will be offered. 

When you compare and apply for credit cards, you will see something called the APR, or annual percentage rate. This predicts the cost of using a credit card over one year, taking into account interest charges and standard fees. However, depending on how you use the card, you may end up paying more interest than the APR indicates, especially if you use your card to transfer money or withdraw cash. 

Many credit cards also have a variable APR, which means the interest rate could go up or down depending on changing market conditions, such as the Bank of England base rate, or how you use your card. 

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, your provider will start charging interest on any outstanding balance on the card.

What is a credit limit?

A credit limit is the maximum amount of money you can borrow on your credit card. 

The credit card company sets the limit when you apply for the card, based on several factors including your credit history and financial situation. Typically, the lower your credit score, the lower the credit limit you qualify for, if at all.

Your credit limit isn’t set in stone and can change over time. For example, you may be offered a higher credit limit if you manage your account well, or it can be limited or reduced if the provider is concerned that you may not repay what you owe. 

» MORE: What are credit card limits?

What are minimum payments?

A minimum payment is the lowest amount you need to pay back to your credit card each month to avoid late fees and extra charges. 

The minimum payment is set by your provider and calculated as a percentage of your outstanding balance plus interest and fees. The percentage you need to pay may vary depending on the provider, but it will usually be between 3% and 5% of your total balance – so your minimum payment will increase as you spend. However, if your balance is low, you may be charged a fixed minimum amount instead.

When you receive your credit card statement, you will see the minimum repayment due date. 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.

If you can, you should always try to pay more than the minimum as this will stop interest mounting up and mean you can clear your credit card balance more quickly. 

» MORE: Credit card minimum payments explained

Do credit cards charge fees?

Interest isn’t the only additional cost to be aware of 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 usually get a penalty fee if you miss the payment deadline on your credit card statement. 
  • Overlimit fees: You can expect to be charged if you exceed 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 may also be charged interest from the day you withdraw cash, so you won’t benefit from the standard interest-free period as you would if you made a purchase. 
  • Balance transfer fees: When you move existing credit card debt 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 bank account the provider will charge a fee.
  • Foreign transaction fees: Most providers 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 that may apply.

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

Applying for a credit card

Now you understand how credit cards work, you are in a better position to decide if you should apply – and which credit card to choose.

When you apply for a credit card, the provider will ask for details about your finances. It will then run a credit check to see how you have managed credit in the past. This check will be visible on your credit history, and it can damage your credit score if you apply for several credit cards in a short period of time. 

For this reason, it’s a good idea to see which cards you are eligible for before you make a formal application. In order to do this the provider will run a soft credit check – which won’t affect your credit score – to see what deals they can offer you. You can then find out the credit cards you are most likely to qualify for, reducing the chances of having your application rejected.

» COMPARE: Check your eligibility for credit card deals

Image source: Getty Images

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