What is a credit card and how do they work?

Credit cards are a way of life in America. According to a May 2023 report from the Board of Governors of the Federal Reserve System, 82% of adults in the U.S. had a credit card in 2022. The popular financial tool allows you to borrow money to pay for almost anything, from your weekly groceries and morning coffee to home improvement projects and utility bills. 

Here’s a closer look at credit cards and how they work, types of credit cards and pros and cons to consider if you’re thinking of getting one. 

What is a credit card?

A credit card is a payment card issued by a financial company, bank or credit union that allows you to borrow money from the bank for purchases from companies that accept credit card payments. Cardholders can borrow up to a total amount set by the card issuer, called a credit limit. 

This is different than a debit card which uses funds the cardholder has in an account, such as a checking account. 

Most credit cards are plastic or metal, with personal information displayed on the front or back, including the cardholder’s name, account number and expiration date. Credit cards usually contain added security features to protect cardholders, like Card Verification Value (CVV) codes and EMV chips for contactless payment.

How does a credit card work?

Credit cards are used to pay for goods and services. When you use a credit card, you borrow money from the credit card company to cover the charge with an agreement to pay back the borrowed amount later. 

Some credit cards allow you to receive cash advances or transfer over balances from other accounts. Typically, these transactions come with upfront fees and carry different interest rules than standard card purchases. 

Credit cards come with a credit limit set by the card issuer. Your limit is the maximum amount you can borrow at any given time. As you use your card, the available limit decreases accordingly, and when you make payments, the limit increases. 

For example, if your credit limit is $5,000 and you make a purchase of $2,000 you will have $3,000 left as available credit. If you make a $500 payment your balance will decrease to $1,500 and your available credit will increase to $3,500.

As you make purchases, the card issuer adds them to your monthly credit card statement. Once a billing cycle completes, the card issuer sends a statement containing a list of your transactions, a minimum payment amount due, and a due date, typically at least 21 days after the statement date. If you pay the full account balance by the due date, the card issuer won’t charge interest on the amount. If you carry a balance, the issuer charges interest on the average daily balance during that billing cycle. Card issuers may charge a late fee if you fail to make the minimum payment by the due date. 

Balances, credit limits and on-time or late payments are typically reported to the credit bureaus. Depending on usage, this can positively or negatively affect your credit score. 

You must apply and be approved to obtain a credit card. Consumers and businesses apply for credit cards through a bank or card issuer. For unsecured credit cards, card issuers perform a credit inquiry to determine eligibility for a card and set credit limits and interest rates. 

Secured credit cards are available for individuals who don’t meet credit and other requirements to get approved for an unsecured card. They are typically secured through a refundable security deposit. Eligibility requirements vary depending on the card issuer or specific credit card. 

Some credit card issuers offer instant access to a credit card upon approval, but generally, you will receive your card by mail within two weeks of approval.

What is a credit limit and how does it work? Here’s everything you need to know.

Types of credit cards

“Consumers now have hundreds of credit cards to choose from; while the options may seem overwhelming, you should do your research and be smart about the cards you choose to keep in your wallet. Credit cards have different perks and are designed for different purchases; as the cardholder, you want to make sure you are getting the best benefits and rewards for your individual needs and lifestyle – whether it’s cash back, points or miles,” said Krista Phillips, executive vice president and head of consumer credit cards and enterprise marketing at Wells Fargo.

Credit card issuers offer credit cards for almost every need or interest. Below is a list of the different types of credit cards and how they work. 

Rewards credit cards

Rewards credit cards offer a rewards system where you earn points based on purchases, either in specific categories or general spending. Typically, you can redeem points you’ve earned toward specific rewards. 

Travel rewards credit cards earn points or miles that can be redeemed for flights, hotels, or other rewards. Cash-back credit cards typically earn a percentage of your spending as a check or statement credit.

Travel credit cards

Travel credit cards are a type of rewards card specifically geared toward travel. As you earn points or miles, you can redeem them for travel-related redemptions or other offerings. Travel credit cards may come with additional travel benefits and perks.

Cash-back credit cards

Cash-back credit cards are another form of rewards credit card. With cash back cards, you receive a percentage of cash back on eligible purchases, usually in the form of a statement credit, direct deposit or check by mail. 

Considering a cash-back card? Here are the pros and cons to be aware of.

0% APR credit cards

0% APR credit cards feature 0% introductory APR offers for a predetermined period, either on purchases, balance transfers or both. They are typically used to finance larger purchases or pay off existing account balances and pay them off over time without interest. After the offer period ends, the card returns to the regular ongoing variable APR set by the issuer. 

Starter credit cards

Starter credit cards are geared toward individuals looking to build or improve their credit. Unsecured credit cards with lower credit requirements fall under this category. Other types of starter credit cards include: 

• Secured credit cards: These are credit cards secured by an upfront deposit equal to the credit line you receive. 
• Student credit cards: These are credit cards geared toward young adults and college students.

Starter credit cards generally have a lower barrier of approval to accommodate individuals with poor or limited credit history. 

Co-branded credit cards

Co-branded credit cards are collaborations between a card issuer and a brand, like a retailer, travel provider, gas station or other company. Typically, co-branded credit cards earn rewards redeemable within the brand’s loyalty program and feature brand-specific benefits. 

Store credit cards

Store credit cards are offered by a specific retailer or business. Generally, store cards are specifically for purchases with the store or its family of brands and are not accepted as payment elsewhere, but some allow general use outside of the store. 

Business credit cards

Business credit cards are credit cards for business owners. Some business cards are geared toward small business owners, while others are specific to corporations or larger businesses. 

Typically, you must provide proof that you operate a business, along with revenue and other business and personal information, to qualify for a business credit card. 

Charge cards

Charge cards work just like standard credit cards, except you’re required to pay your total balance in full every month. 

Important credit card terms

Understanding common credit-related jargon can help you better understand how credit cards work. Here are definitions for common credit card terms you may come across.

Annual percentage rate (APR)

The annual percentage rate (APR) is a credit card’s interest rate expressed as a yearly rate. It’s the cost of borrowing money. Typically, credit cards feature variable APR, which fluctuates as market rates change. Credit cards may have different APRs for purchases, balance transfers, cash advances, introductory offers and penalty APR for missed payments. APR is also referred to as the interest rate.

Balance transfer

A balance transfer allows you to move an existing balance from one credit card to another. Card issuers typically charge a fee for balance transfers, usually a flat rate or a percentage of the amount transferred, whichever is more. Balance transfer credit cards often feature 0% introductory APR offers for a limited period. After that, the card’s regular variable APR applies.

Credit balance

When you make a payment or return a purchase made with your card, credit card companies issue a credit to your account. A credit balance occurs when the total of those credits exceeds the amount you owe.

Daily periodic rate

Credit card companies sometimes calculate and apply interest using a daily periodic interest rate. In this case, the interest compounds on a daily basis. Issuers calculate the daily periodic rate by multiplying a card’s interest rate by the amount owed at the end of the day. 

How does credit card interest work? We explain it in simple terms.

Grace period

A grace period is the time between the end of a billing or statement cycle and a card’s payment due date. If the balance is paid in full by the due date any accrued interest is waived.

Minimum payment

The minimum payment is the amount that must be submitted by the due date to avoid a late charge. This is often calculated as a percentage of the total balance due. Each monthly credit card statement will state the minimum payment due and the due date. 

Pros and cons of credit cards

Pros

• More secure than cash: Credit cards come with better consumer protections than debit cards or cash. 
• Interest charges are avoidable: You can avoid interest by paying your card balance in full each month. 
• You can earn rewards: Many credit cards earn rewards on your spending. 
• Access to card benefits and perks: Some cards come with travel and consumer perks and protections, credit score access and other benefits. 
• A credit-building tool: Responsible use and on-time payments can help build your credit score and develop a positive payment history. 

Cons

• Interest charges: Card issuers charge interest if you carry a balance from month to month. 
• You may not qualify: Many of the best credit cards have eligibility requirements of good or better credit. There’s no guarantee that just because you want a particular card, you’ll be approved.
• Fees: Some credit cards come with annual fees. You may pay additional fees for late or returned payments or if you request a cash advance or balance transfer. 
• Can damage your credit: Card issuers report payments and balance to credit card bureaus. Missing payments or carrying large balances could hurt your credit profile. 
• Overspending: Credit cards are sometimes too convenient, which can lead to overspending and debt that can be difficult to pay off.

Should you get a credit card?

A credit card is a powerful financial tool that can help you finance purchases, gain access to exclusive benefits and rewards and build positive credit history. Having a credit card can also hurt your credit and lead to debt if not used responsibly. 

Check your credit score and reports to gauge your standing and determine whether you meet the basic credit card requirements for the card you’re considering. If approved, make a plan to use the credit card responsibly and make regular payments each month to avoid taking on debt.

Frequently asked questions (FAQs)

Are there any fees associated with credit cards?

Card issuers charge various fees with credit cards. Some credit cards charge an annual fee for access to the card and its benefits. Other fees charged by card issuers may include late, foreign transaction, balance transfer, cash advance and returned payment fees.

How can I apply for a credit card?

You can apply for a credit card online through a credit card issuer or bank. Some banks may allow or require you to apply for a credit card in person at a bank branch. When you apply, the card issuer performs a credit check to determine your eligibility based on your credit score, payment history and other factors.

When is getting a credit card a good idea?

A credit card is an excellent way to build credit. It can also be a useful tool to finance purchases, earn rewards or access exclusive benefits. Getting a credit card is a good idea if you can pay your bill each month and avoid falling into a cycle of debt.