Credit cards offer convenience, consumer protections and a quick way to build good credit, assuming you use them responsibly. Use them unwisely, and your credit can suffer, which affects your ability to borrow money in the future. Understanding how credit cards work will help you choose the right cards for you, manage them well and save money.
Credit Card Basics
WHAT IS A CREDIT CARD?
A credit card is a plastic or metal card that allows you to access a line of credit offered by the bank that issued the card. Every time you pay for something with a credit card, you’re borrowing money from the card issuer to cover the purchase. You then have to pay that money back, either in full at the end of the month or over time.
HOW DO CREDIT CARDS WORK?
When you’re approved for a credit card, the bank authorizes a credit limit — the maximum amount you can borrow — to be used at your discretion. Your credit limit will depend on such factors as your income, your other debts and how much available credit you have on other cards.
Payment networks — Visa, Mastercard, Discover and American Express — process credit card transactions. They make sure that the money for the purchase gets to the merchant and that the correct cardholder gets billed.
When your bill comes, you have the option of paying a certain minimum amount, paying the whole balance in full, or paying some amount in between. Paying just the minimum every month is ultimately the most expensive option, since it will cost you the most in interest. Paying in full is the best option; when you pay in full each month, you get a grace period that allows you to avoid paying any interest on purchases at all.
Your credit card issuer reports your payments to the credit bureaus, the companies that prepare credit reports. Your payment history counts for 35% of your credit score — a three-digit number that indicates how risky it would be to lend you money. You must pay at least the minimum by the due date every month to avoid late fees and potential damage to your credit score.
HOW DO CREDIT CARDS DIFFER FROM OTHER CARDS?
A debit card is linked to your checking account; debit card purchases automatically pull money out of your account. You’re using your own money to pay for things rather than borrowing it. Some debit cards earn rewards, but they generally pale in comparison to credit card rewards. Debit cards also have weaker fraud protections.
A prepaid debit card isn’t linked to a checking account; instead, you “load” money onto the card, and you can only spend as much as you’ve loaded. These cards often charge many fees you wouldn’t pay with a regular debit card. Prepaid debit cards offer some protections, and they come with limitations. For example, some prepaid debit cards don’t offer ATM access or mobile banking. Also, not all merchants accept them.
Neither debit cards nor prepaid cards will affect your credit scores, because using them does not involve borrowing money. Only a credit card will affect your credit score.