How do credit cards work?

Credit cards offer a fast, convenient way to pay in person or online. A transaction occurs when your credit card issuer and the merchant’s bank exchange funds through a payment network. But after you swipe, insert or tap your card, what happens behind the scenes? How do credit card payments and fees work? And how do credit cards affect your credit scores? 

What you’ll learn:

• Credit cards provide access to a revolving credit account, allowing cardholders to borrow up to a specified credit limit and repay the balance over time.

• For purchases, account details are routed through a network to the credit card issuer for approval, and the funds are then sent to the merchant.

• Monthly statements from the issuer detail purchase history.

• You can build credit by using a credit card responsibly, which means doing things like paying your monthly statements on time.

Credit cards allow you to use a line of credit to borrow money to make purchases. You can use them to make online or contactless payments. They can help cover large purchases. And depending on the card, you could earn rewards like cash back. 

And because credit cards are a form of revolving credit, funds can be borrowed and paid back repeatedly.

Most credit cards work the same way, allowing cardholders to spend up to a certain limit. Payments are typically required every month. Here are some examples of different types of credit cards: 

• Rewards credit cards: Offer rewards such as cash back and bonus miles on qualifying purchases

• Secured credit cards: Require a one-time refundable security deposit that can make them easier to qualify for than unsecured cards

• Student credit cards: Designed for students with little or no credit history

• Business credit cards: Designed for business owners and may offer benefits to match

When you make purchases with a credit card, transactions are generally processed the same way, whether you’re paying in person or online. Here’s how a credit card transaction might work when you check out at the grocery store:

1. You use your card to buy groceries at a point-of-sale (POS) system.

2. The POS system sends your account information to the acquiring bank.

3. The acquiring bank uses a payment network to get authorization from your credit card issuer.

4. If your card issuer approves the transaction, it sends the money through the payment network to the grocery store’s bank.

5. The total purchase amount is subtracted from your credit card’s available credit.

After making purchases with your card, your available credit is reduced by the purchase amount, and that amount is owed to your credit card issuer. Any amount not paid back by the due date could be subject to interest charges. The amount you can borrow is known as your credit limit, which is based on factors like your creditworthiness and payment history.

Card issuers send their customers a monthly credit card statement through the mail or electronically. Statements include purchases and other transactions made during the current billing cycle, plus any interest, fees and previous unpaid balances. 

In most cases, payment is due the same day each month. But if the due date is on a holiday or weekend, the payment may be due the following business day. Making a credit card payment on or before the due date is one way to keep your account in good standing.

To understand how credit card payments work and how much to pay, it can be helpful to know some of the terms you might see on a credit card statement:

• Minimum payment: A minimum payment refers to the least amount of money you have to pay each month to keep your credit card account in good standing.

• Available credit: Your available credit is the amount of credit you have left to spend on your credit account. You can calculate your available credit by subtracting your card’s current balance from its credit limit. 

• Statement balance: A statement balance is what you owe at the end of a billing cycle, which is usually every 28-31 days. If you pay your statement balance in full each month, you typically won’t have to pay interest on new purchases during this time. 

• Current balance: As you swipe your credit card, each purchase is added to a running total called the current balance. This is the most up-to-date amount owed on the credit card. As your current balance grows, your available credit shrinks.

Card issuers charge interest for carrying a balance past the due date and certain fees for using and maintaining the card.

Interest is the cost credit card issuers charge cardholders for borrowing money. It’s usually shown as the annual percentage rate (APR) in your card’s terms and conditions. You might see a few different types of APR, such as purchase APR, balance transfer APR or promotional APR. 

If you pay your bill in full each month before the due date, typically issuers won’t charge interest. But if you carry a balance, you may see interest charges on your next statement. Some cards also offer a grace period, which is the time between the end of your billing cycle and the payment due date during which you might not be charged interest. 

Card issuers commonly charge common credit card fees to process transactions and use the account. Depending on your card, the issuer and how you use the card, you might see these types of fees on your statement: 

• Annual fee: Some cards come with an annual fee. Think of it as a kind of membership fee you’re charged once a year to offset some of the benefits the card offers.

• Late fee: If your credit card payment is late, the card issuer may charge a late fee. Missing two or more payments could result in higher fees and a higher penalty APR. 

• Balance transfer fee: A credit card balance transfer allows you to move credit card debt from one card to another card issued by a different bank.

• Cash advance fee: Using your credit card to withdraw cash against the card’s line of credit is called a cash advance. Cash advances may come with additional fees or higher interest rates than other credit card purchases.

Credit cards can affect your credit scores positively or negatively, depending on how you use them. That’s because they can influence the factors that are used to calculate your scores:

• Payment history: Credit scores can be positively affected by making on-time payments each month. Missing payments, even one, could negatively impact your credit scores.

• Debt: Credit-scoring models analyze how much total debt you have, along with your credit utilization ratio, which is a measure of how much credit you’re using versus how much you have available.

• Credit age: Your credit age indicates how long you’ve had your credit accounts open. Typically, a longer positive credit history can have a positive impact on your credit scores.

• Credit mix: Credit mix describes the different types of credit accounts you have, and if you’re using them responsibly. It considers both revolving credit, like credit cards or personal lines of credit, and installment loans like mortgages, student loans and car loans. 

• New credit: This takes into account how many times you’ve recently applied for credit. The effect on your scores might be minor, but a lot of new hard credit inquiries could still give a negative impression to lenders.

Regularly monitoring your credit can help you understand how the different factors affect your credit. One way to monitor your credit is with CreditWise from Capital One. CreditWise lets you access your credit score and credit report anytime. It’s free to use, even if you’re not a Capital One cardholder.

You can also get free copies of your credit reports from all the credit bureaus by visiting AnnualCreditReport.com.

Here are some frequently asked questions about how a credit card works:

Understanding credit cards and how they work could help you decide whether one is right for you. They offer a convenient way to shop in stores and online. You can borrow money up to a set credit limit and pay it back over time. If you use the card responsibly, you can potentially build your credit, too.

If you’re thinking about applying for a credit card, you can compare Capital One cards and learn more about credit requirements, rewards and other factors to find the right credit card. And with pre-approval from Capital One, you can check for card offers before you apply. It’s quick and won’t hurt your credit scores.