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

Credit cards
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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 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 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 a much of the credit as you want at a time and allows you to reuse the loan over and over as long as you pay what you've borrowed.

How Do Credit Cards Work

A lot goes on behind the scenes of a credit card transaction. Here's a simplified version. 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 on 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 left and you owe the bank $25. If you borrow another $50 before paying back the $25 you borrowed, you would owe the bank a total of $75 and have $25 available credit remaining.

What makes a credit card different from a regular loan is that your credit limit is available again when you pay back the balance. In the example before, when you pay back the $75 you owe, you’ll have $100 of available credit again. But if you only pay back $25 of the $75 owe, you’d only have $50 available credit.

You can spend and repay as much as you want as long as you abide by the credit card issuers terms, e.g. make your payments on time and don’t charge more than your credit limit. Because you can keep borrowing against your credit limit over time, credit cards are sometimes referred to as revolving accounts and 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 all of what you’ve borrowed before they charge interest. This period of time is called the grace period and is usually between 20 and 25 days. If you don’t pay off your full balance before the end of grace period, a fee called a finance charge is added to your balance. The finance charge is based on your interest rate and your balance.

Credit cards have an interest rate, which 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 have. If you have a good history of paying back your credit card bills, you’ll usually qualify for lower interest rates than other credit card users.

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 set minimum payment by the due date to avoid a late penalty. Paying just the minimum is the slowest and most expensive way to pay off your credit card balance.

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 they’re all transactions that you made. 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 a 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 from the major credit card networks.