How do credit cards work?

How do credit cards work? Most of us understand the concept of credit in the most simple form - "credit" is when we "buy now, pay later". In other words, it is a loan. In the case of credit cards it is a revolving loan. It "revolves" in the sense that when we pay some money off what we owe (our balance) that money becomes available to us again - it comes back around and is available again as credit.

There are some exceptions: so-called "credit cards" that are not credit cards at all, for example:

1. Gift Credit Cards

2. Prepaid Visa Credit Cards

3. Secured Business Credit Cards.

4. Fake Credit Cards.

But how do credit cards work? As the saying goes, "the devil is in the details"! Here are the 10 things you must know about how do credit cards work:

1. CREDIT IS NOT FREE: The credit card companies are profit driven organizations who must make money to survive. Their profits come from two sources: first, the fees and charges you pay in order to have a card, and second, from the interest they charge on the money you "borrow" whenever you use your credit card. This is the fundamental underpinning to how do credit cards work - the card issuer extends you credit so you can buy and pay in installments, but a price.

2. ALMOST ALL CREDIT CARDS HAVE A CREDIT LIMIT: For example, the credit limit may be $2,000. You as the card holder can make purchases or draw cash up to a limit of $2,000. If during a single month or billing cycle you spent $500, you would get a bill from the card issuer for $500 and still have $1,500 available credit. However, if during the month you spent over the $2,000 limit, you could damage your credit, incur penalties like extra charges, or have your card cancelled.

3. REPAYMENT IS FLEXIBLE - BUT THERE ARE RULES: The monthly balance on your card can be paid in full, or in installments. If you opt to pay by installments (that is, pay less than the total amount owing), you must pay at least the minimum payment, which is usually either $15 or 4% of the total outstanding, whichever is more. For example, if you have spent all of your $2,000 limit, 4% would be $80 so that would be your minimum payment. If, however, you only spent $100, then 4% would only be $4 so the minimum payment would be $15. Late payment, non-payment, or lesser than minimum payment can all result in adverse consequnces such as extra fees, damaged credit and a lowered credit score, or cancellation of the card.

4. INTEREST IS ONLY CHARGED ON THE OUTSTANDING BALANCE: If you pay the full amount you spend each month, you do not pay any interest. However, interest will be charged on the amount unpaid. The problem is that if each month you only pay the minimum (or any amount less than the total outstanding amount), interest is added to the outstanding balance. Even if you don't spend any more on your card, the outstanding balance will increase every month because interest is added. This is the big credit card trap - paying interest on interest. If you come away understanding only only one thing about how do credit cards work, it should be the danger of this kind of compound interest when you are paying it instead of earning it.

5. TIMING IS EVERYTHING: You can avoid interest charges completely by paying your full balance each month. In other words, smart credit card use can give you an interest free loan every month. For example, if you spent $500 on the 29th, and you didn't receive your next bill until the 15th of the following month, the interest charges would not be applied until the due date. As the due date will not be for another 10 to 20 days, you are effectively using your credit card company's money, interest free, for a month.

6. ANNUAL FEES: Most credit cards charge an annual fee of around $30 to $50. It is important to know exactly how much the annual fee is and to shop around for a good deal. Although you only pay interest on the unpaid balance, you will always have to pay the full annual fee, regardless of whether you pay off your card in full every month or not. You must even pay it if you never use your card. It pays read up on the best no fee credit cards.

7. TRANSACTION FEES: When folks throw up their hands in desperation and ask "How do credit cards work?", it is usually because they have been slammed with some unexpected fees. Most credit card companies charge you a fee for transactions such as cash advances or balance transfers. Often there will be a transaction fee for any transaction other than a straightforward use of the card to charge an item directly with a merchant. These transaction fees are usually a percentage of the amount of the transaction, although sometimes a minimum fee applies. One unpleasant trap is using your card for a cash advance. This can attract a higher interest rate which is applied to the total baance outstanding on your card - not just the amount of the cash advance.

8. PREPAID CREDIT CARDS: Sometimes it can be hard to get a conventional credit card, for example if you are just starting out building your credit. However, some things like renting a car are almost impossible without a credit card. A popular solution is to get a prepaid Visa credit card. These cards are actually more like like debit cards - you must first deposit the the money before you can use it. The card issuer does not really extend you any credit. Even so, prepaid cards offer a great alternative. They are easy to obtain and generally do not require a credit check. Also, it is impossible to get into trouble with them because you are never spending money you do not have. For a business, secured business credit cards are a good option for similar reasons.

9. ANNUAL PERCENTAGE RATE (APR) CAN VARY - A LOT!: The APR is the annual yearly rate of interest applied to your outstanding balance. This varies from introductory or honeymoon rates of 0% APR, to around 6.5% for the Pulaski Bank credit card at a fixed rate, to 15-22% for some of the others. Obviously the lower your APR the better. This is why credit card comparisons are vital. Understand what is going on with your APR and how it compares to the other deals out there and you have mastered the most important detail of How do credit cards work?

10. REWARD PROGRAMS: It is true that some people get into credit card debt and create terrible financial burdens for themselves. However, smart use of credit cards can actually MAKE YOU MONEY. Say you combine the technique of paying your monthly balance in full with a good rewards program such as one of the good gas card deals.

You could use a $200 limit credit card to pay at the pump all month, instead of using cash or your debit card. As long as you paid the full balance each month you would be getting an interest free loan of $200 per month - that is freeing up $200 to invest so you earn interest instead of pay it. PLUS, you would get a discount of 5% on all your gas!

So how do credit cards work? They work for you or against you, depending on well you understand the details.

Still asking "how do credit cards work?" See: 1. the FTC Consumer Guide on how do credit cards work? or the uber cool 2. HowStuffWorks site for how credit cards work.

CLICK HERE to discover Statistics on Credit Cards

CLICK HERE to read entertaining Credit Cards Quotes

Of course, to make all this information about how credit cards work REALLY work for you, you need to know your own credit score and the state of your latest credit report: The Average U.S. Credit Score: 692. The cost to see yours: $0.

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