What Is a Credit Card, and How Do the Charges Work?

Credit cards in the form of a question mark
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Most of us are introduced to credit cards long before we ever use them. But, watching someone else use a credit card is deceiving. It seems like magic when someone swipes their credit card and walks away with their purchase without ever paying any cash. The technology that makes credit cards work is impressive, but cards aren’t magic; you still have to pay for what you purchase, you just pay for it later.

What Is a Credit Card?

A credit card is a plastic card that lets you access the credit limit your credit card issuer gives you. A credit limit is like a loan. However, instead of giving you the full loan in cash, the bank lets you take as much of the credit as you want at a given time and then allows you to reuse the loan over and over as long as you pay back what you've borrowed.

How Credit Cards Work

A lot goes on behind the scenes of a credit card transaction. When you swipe your credit card to make a purchase, the merchant's credit card terminal asks your credit card issuer whether the card is valid and if you have enough available credit. Your credit card issuer sends back a message that the transaction is approved or declined. If it's approved, you can take your goods and services and go on your way.

Each time you make a purchase, your available credit goes down by that same amount. If you have a $100 credit limit and you make a $25 purchase, you’ll have $75 available credit remaining. You'll owe $25 to the bank. If you borrow another $50 before paying back the $25 you borrowed, you would owe the bank a total of $75 and have $25 in available credit.

What makes a credit card different from a regular loan is that your credit limit is available after paying down the balance on the card. In the earlier example, if you paid back the $75 that you owed, you'd have $100 of available credit again.

You can repeat the process of spending up to your credit limit and repaying the balance as many times as you like provided you abide by the terms of the credit card. The terms would include making your payments on time and not charging more than your credit limit.

You can continue borrowing against your credit limit over time, which is why credit cards are referred to as revolving accounts or open-ended accounts.

The Cost of Charging a Credit Card Balance

The credit card issuer gives you a certain amount of time to pay back the entire amount that you’ve borrowed before you're charged interest. The period of time before the interest is charged is called the grace period, which is typically between 20 and 25 days. If you don’t pay off your full balance before the end of the grace period, a fee or finance charge is added to your balance. The finance charge is based on the interest rate and your outstanding balance.

The interest rate is the annual rate you pay for borrowing money on your credit card. Interest rates are generally based on market interest rates, your credit history, and the type of credit card you own. If you have a good history of paying back your credit card bills, you’ll usually qualify for lower interest rates than what's typically charged.

You have to pay your balance in full before the end of the grace period if you want to avoid paying interest. However, the credit card issuer usually doesn’t require you to pay back all of what you owe at once, but you must pay at least the minimum payment by the due date to avoid a late penalty. Paying only the minimum is the slowest and most expensive way to pay off your credit card balance.

It's important to always pay at least the minimum amount on time each month to maintain a good credit history and to avoid late fees. As you build a stable credit history, you may qualify for a lower interest rate on the card.

Reviewing Your Credit Card Activity

Each month, the credit card issuer will send you a billing statement that includes your minimum payment, the due date, and a list of the transactions that have been posted to your account since your last billing statement. It’s a good idea to review these transactions to make sure that all of the transactions were made by you and that there are no discrepancies. You also want to make sure your last payment was correctly applied to your account. If any fees have been added to your balance, make sure they are legitimate.

Other Types of Plastic

Physically, a credit card is a piece of plastic measuring 3-1/8 inches by 2-1/8 inches. Typically, there are 16 digits embossed on the front (15 digits for an American Express card). Note that there are other types of cards that fit this description that aren't credit cards, but mimic a credit card in that you swipe to make a purchase. For example, a check card or debit card will also have 16 digits imprinted on the front. However, purchases on a debit card are taken from your checking account. Also, a prepaid card looks and works very much like a credit card, but purchases are deducted from the prepaid account balance.

The same is true for gift cards.