What are credit cards and how do they work?

Credit cards can give you a fast, convenient way to pay. But after you swipe, insert or tap your card, what happens behind the scenes? How exactly does a credit card work? And why use a credit card, anyway? 

Keep reading to find out what a credit card is, how it works, the benefits of using it and more. 

Key takeaways

  • A credit card is a type of revolving credit account that involves borrowing money—generally up to a predetermined credit limit—and paying it back over and over again while the account is open.
  • Credit cards can be a convenient way to make purchases in stores or online, and they can help you build credit when you use them responsibly. 
  • After you make a purchase, your account details are sent to the merchant’s bank, are then authorized by the card’s network, and funds are sent to the merchant. 
  • There are different types of credit cards, including cash back credit cards, travel rewards credit cards and secured credit cards.

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What is a credit card?

A credit card is a type of revolving credit account. Revolving credit accounts don’t have a set end date. As long as the account stays open and in good standing, you can repeatedly spend and pay back the money you’re borrowing up to a certain credit limit. The limit is set by the credit card issuer.

Credit cards vs. debit cards: What’s the difference?

The biggest difference between credit cards and debit cards is where the money comes from when you make a purchase. With a credit card, you’re borrowing money from a card issuer. With a debit card, you’re pulling funds directly from your linked bank account.

Key players involved with credit card transactions

To get a better understanding of how credit cards work, it may help to understand who’s involved in the transactions you make. They often include the following:

  • Your credit card issuer provides you with a credit card, making you a cardholder. Capital One is an example of a credit card issuer.
  • Payment networks, such as Visa®, Mastercard® and Discover®, connect your card with businesses that accept credit card payments. That’s why you might see two logos on your card: one for your card issuer and the other for the payment network. 
  • The merchant is the business where you’re making a purchase. It could be a grocery store, a gas station, an online store or millions of other businesses. 
  • The acquiring bank handles the merchant’s transactions. Acquiring banks connect the dots of a credit card purchase between the cardholder, the card issuer, the payment network and the merchant. 

How does a credit card work?

Despite having so many different parties involved, credit card transactions typically only take a few seconds. It might take more time to pull a credit card from your wallet than it does for your credit card issuer and the merchant’s bank to exchange funds through a payment network.

Here’s a step-by-step look at how a credit card transaction might work when you check out at the grocery store:

  1. Using a point-of-sale system, or POS, you use your card or mobile device to make a purchase if you’ve added your card to a digital wallet.
  2. The POS sends your account information to the acquiring bank.
  3. The acquiring bank uses a payment network, such as Discover, to get authorization from your card issuer.
  4. If your card issuer authorizes the transaction, it sends the money through the payment network to the grocery store’s bank.

You can also use a credit card online to make purchases. After checking out online, your payment is generally processed the same way it would if you were shopping in person.

How do credit card payments work?

After using a credit card to make purchases, you’ll receive your credit card statement for each billing period either through the mail or electronically. Your statement will include any charges you made during the current billing cycle, plus any interest that might be charged, fees and previous unpaid balances

In most cases, the payment is due on 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 exactly how credit card payments work, and how much to pay, it can be helpful to get a better idea of the different amounts listed on a credit card statement, including:

  • Minimum payment: A minimum payment refers to the least amount of money you have to pay, typically 1%-3% of the card’s outstanding balance, to keep your credit card account in good standing. This can vary from month to month, depending on the balance. 
  • Available credit: Every time you make a purchase, the amount you charge is subtracted from your credit limit. The amount you’re left with is your available credit. When you make a payment, your available credit goes back up.
  • Statement balance: A statement balance is the card’s balance once a billing cycle ends, which is usually 28-31 days. If you pay your statement balance in full each month, you typically won’t have to pay interest on any new purchases made during this time. If not, the remaining balance rolls over to the next month and may then accrue interest, depending on the terms of your cardholder agreement.
  • Current balance: Your current balance is your most recent balance at a given moment. This amount may include any recent transactions made and any balance rolled over from the previous billing cycle.

Keep in mind that while you might only have to make a minimum payment, the Consumer Financial Protection Bureau (CFPB) recommends paying as much of your full balance as you can each month to keep a low credit utilization ratio and help your credit scores. 

Credit card fees

Here are some common credit card fees that may appear on a credit card statement, depending on your cardholder agreement and how you use the card: 

  • Annual fee: Some issuers charge an annual fee to keep certain credit cards open.
  • Late fee: If your credit card payment is late, the card issuer may charge a late fee. Missing two or more payments could also result in a penalty APR and higher fees. 
  • Balance transfer fee: You may have to pay a balance transfer fee when you move credit card debt to another issuer. 
  • Cash advance fee: You may be able to use your credit card to withdraw cash against the card’s line of credit. This is called a cash advance. Cash advances may come with fees and a higher interest rate than other purchases.

Potential benefits of credit cards

There can be many advantages to using credit cards, as long as they’re used responsibly. They include: 

  • Help building credit: By using a credit card responsibly, you might be able to build or rebuild your credit and improve your credit score. A good credit score can help you get better interest rates for things like car loans, personal loans and mortgages. 
  • Budgeting: Your credit card comes with a useful budgeting tool, your monthly statement. It can help you figure out where your money goes so you can create a realistic budget based on that and your income.
  • Convenience: Credit cards give you a fast, convenient way to pay. And many cards even feature contactless technology and virtual card options. You can also add your credit cards to your digital wallet to give you faster, more secure ways to pay online or in person.
  • Credit card rewards: Earning rewards can be an advantage of using a credit card. And you might be able to find a rewards card that fits your spending habits and needs. If you’re a frequent traveler, you might consider a travel rewards card that lets you earn rewards and redeem them for travel-related purchases. 
  • Protection from unauthorized charges: Unfortunately, credit card fraud can happen to anyone. But the good news is that many credit cards offer protection and security features to help you keep your credit card more secure. 

How do credit cards affect your credit score?

Credit cards can affect credit scores in different ways, depending on how they’re used. Here are a few of the ways a credit card may affect your credit scores:

  • Opening a credit card: Applying for credit cards can trigger hard inquiries into your credit. Hard inquiries can cause a temporary dip in your credit scores. And too many hard inquiries in a short period of time can hurt your credit score. But if you don’t have many revolving accounts on your credit report, adding a credit card could improve your credit mix
  • Closing a credit card: Closing a credit card typically lowers your available credit, which can then increase your credit utilization ratio. Closing a card could also affect the length of your credit history, another important credit-scoring factor.
  • Payment history: Credit scores can be affected positively when cardholders make on-time payments each month. That’s because payment history is a major factor in calculating credit scores.

Regularly monitoring your credit can help you understand how different factors affect your credit. One way to monitor your credit is with CreditWise from Capital One. CreditWise lets you access your free TransUnion® credit report and VantageScore® 3.0 credit score anytime. CreditWise is free and available to everyone, whether or not you’re a Capital One cardholder.

You can also get free copies of your credit reports from all of the credit bureaus. Visit AnnualCreditReport.com to learn more.

How credit cards work in a nutshell

Picking a credit card to apply for can take time and careful consideration. But understanding how credit cards work could help in your decision-making process.

Capital One has a credit card comparison tool that helps you search by credit requirements, rewards and other factors to find the right credit card for you. And with pre-approval from Capital One, you can check for potential card offers before you apply. It’s quick and won’t hurt your credit score.

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