What are credit cards and how do they work?
May 2, 2023 1 min video
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.
- 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 also help you build credit when you use them responsibly.
- After you make a purchase, your account details are sent to the merchant’s bank and are then authorized by the card’s network, and funds are sent to the merchant.
- There are different types of credit cards, like cash back credit cards, travel rewards credit cards, secured credit cards and more.
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 keep using it. That means 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 and is the maximum amount you can charge to your account.
So how does this differ from a debit card? The biggest difference is where the money comes from when you make a purchase. With a credit card, you’re borrowing money from a card issuer. It’s the lender in this case. With a debit card, you’re pulling funds directly from your linked bank account.
Key players involved with credit card transactions
To understand 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.
- The payment network—think of Visa® or Mastercard®—connects your card with millions of 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?
Now you know the main players. But how does using a credit card actually work behind the scenes?
Say you’re checking out at the grocery store, and you decide to pay with your credit card. Here’s how the credit transaction works, step by step:
- You swipe, insert or tap your credit card—or mobile device if you’ve added your card to a digital wallet.
- The card reader sends your account information to the acquiring bank.
- The acquiring bank uses a payment network to get authorization from your card issuer.
- If your card issuer authorizes the transaction, it sends the money through the payment network to the grocery store’s bank.
That might sound like a lot of steps, but the entire process typically only takes a few seconds.
You can also use a credit card online to make purchases. After checking out online, your payment is processed generally 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.
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.
What’s on your credit card statement?
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.
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 score.
Another term you’ll see on your statement is 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. And when you make a payment, your available credit goes back up.
A statement balance is the balance once a billing cycle ends—usually 28-31 days. If you pay your statement balance in full each month, you typically won’t have to pay interest later on any new purchases made during this time. If not, the remaining balance rolls over to the next month and can then accrue interest, depending on the terms of your cardholder agreement.
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.
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 history 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. Responsible credit card use includes always paying your bills on time and keeping your credit utilization ratio low.
- Budgeting: Your credit card comes with a useful budgeting tool—the monthly statement. Your monthly statement is like a diary that shows your spending habits. It can help you figure out where your money goes so you can create a realistic budget based on that and your income. You can also typically access your monthly statement and manage your account online to make things even easier.
- Convenience: Credit cards give you a fast, convenient way to pay. And now, many cards even feature contactless technology. That means all you have to do is tap your card on a contactless-enabled reader to make a purchase. 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 specific needs. For example, a travel rewards card can offer rewards for travel-related purchases.
- Fraud protection: Unfortunately, credit card fraud can happen to anyone. But the good news is that many credit cards offer fraud protection and security features to help you keep your credit card more secure. While these protections vary by issuer, they might include things like $0 fraud liability on unauthorized charges if your card is ever lost or stolen, security alerts, card lock and virtual card numbers.
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 some of them:
- Opening a credit card: Applying for credit cards can trigger hard inquiries into your credit. And too many hard inquiries in a short period of time can hurt your credit score. If you don’t have many revolving accounts on your credit report, adding a credit card could improve your credit mix. This can be positive, as it can indicate that you’re responsible when managing different types of credit.
- Closing a credit card: Closing a credit card—even one you may not actively be using—can sometimes have an impact on your credit score. This is because it lowers your available credit, which can then increase your credit utilization ratio. Closing your card could also affect the length of your credit history, another important credit-scoring factor.
- Using a credit card: 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. Credit utilization also comes into play. That’s why the CFPB recommends keeping the ratio below 30%.
Monitor your credit
As a cardholder, regularly monitoring your credit can be an important step in understanding your financial health. One way to monitor your credit is with CreditWise from Capital One. CreditWise gives you access to your free TransUnion® credit report and VantageScore® 3.0 credit score any time.
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. Call 877-322-8228 or visit AnnualCreditReport.com to learn more.
Choosing the right credit card for you
Now that you know more about the potential benefits of credit cards, you might be wondering which is the best option. Here are some things to keep in mind:
- Consider the APR, fees and the type of credit card you’re looking for.
- Make sure you understand the terms of any credit card you’re thinking of applying for, and read the fine print.
- Check your credit score to see which specific cards you may qualify for.
- Keep your financial goals in mind and how your credit card selection may play into accomplishing these goals.
There are different types of credit cards, ranging from cash back credit cards to travel rewards cards to student credit cards. And whether you have excellent credit or you’re still working to improve your credit score, you can find a card that’s right for you.
How credit cards work in a nutshell
Picking a credit card to apply for can take some time and careful consideration. But understanding how credit cards work could help in your decision-making process.
Luckily, Capital One has a credit card comparison tool that helps you search by credit requirements, rewards type and other factors to find the right credit card for you. And with pre-approval from Capital One, you can find out if you’re eligible for a credit card before you even apply. It’s quick and won’t hurt your credit score.