How Do Credit Cards Work?

How credit cards work

Credit cards are a type of revolving credit. That means you may borrow up to your credit limit, repay what you borrowed, and then borrow again. You might compare this to a personal loan, which allows you to borrow a lump sum one time and repay it in fixed installments.

How does a credit card transaction work?

Credit card payments take seconds, but behind the scenes, transactions are complex. Each credit card transaction involves several parties and multiple steps.

The University of California explains what happens in the moments after you pay with a credit card:

1. The merchant’s point of sale device sends the transaction information to the acquirer (also called the payment processor), which transfers it to the credit card network (or payment network).
2. The payment network asks the card issuer to authorize the transaction.
3. The card issuer verifies the cardmember’s identity and the card’s available credit to approve or deny the transaction.
4. The card issuer notifies the payment network of the decision, which notifies the acquirer. Meanwhile, your transaction is approved or declined.

After a transaction, the merchant receives funds from the card issuer. Your balance increases as your available credit decreases. Each transaction appears on your credit card statement.

How does credit card interest work?

While credit cards give you the flexibility to take your time paying back what you owe, you might pay for the privilege of doing so. If you don’t repay your statement balance in full each month, your card issuer may charge you interest fees on purchases. A credit card’s annual percentage rate (APR) is the rate at which your balance accrues interest.

If you always pay your credit card balance in full and on time, you won’t pay interest on regular purchases (as long as your credit card issuer offers a grace period).

Different types of transactions may have different APRs. If you take a cash advance or make a balance transfer, you may be charged interest from the date the transaction posts to your account. Interest rates for cash advance transactions may be higher than interest rates for standard purchases.

Be sure to check the terms of your cardmember agreement to learn about the interest rates that apply to various transaction types on your account. You may use the Discover^®  Credit Card Interest Calculator to find out how long it might take you to pay off a credit card based on your interest rate and balance.

How do credit card rewards work?

With the right credit card, you might earn rewards as you use your credit card. 

A rewards credit card offers a percentage of each eligible purchase back as cash back or miles. Some rewards cards earn at a flat rate across all eligible transactions, while other rewards cards may have specific categories—like gas or restaurants—that earn at a higher rate.

Keep in mind that interest charges and fees may offset your rewards earnings.

How do credit card fees work

Even if you don’t accrue credit card interest, credit card membership still comes with some costs. Credit card issuers may charge several fees. Typically, credit card fees appear as a charge on your credit card statement. Check the terms and conditions on your credit card account for specific information about fees. Look out for some common fees:

• Balance transfer fee: If you move your debt from one credit card to another with a lower interest rate, you may owe a balance transfer fee. The fee may range from about 3% to 5% of the total amount you transfer.
• Cash advance fee: Borrowing cash against your credit limit may be a quick way to access funds, but it comes at a high cost. Cash advance fees may be a set amount per transaction or a percentage of the amount withdrawn.
• Late fee: When you fail to pay your credit card bill by the due date, the card issuer may charge you a late fee. Late fees may add up quickly and increase your debt.

Credit cards vs. debit cards

Many people have a debit card before they get their first credit card. Although they may look the same, credit cards and debit cards work in fundamentally different ways.

A credit card lets you borrow money, but a debit card is connected to the checking or savings account where you have cash. Your debit card allows you to access the money you have in your bank account, so you can buy things without physically carrying cash around. The bank withdraws funds from your account as soon as you complete a debit card transaction.

Additionally, credit cards may come with benefits and features that some debit cards may not offer, like rewards.

How do credit cards affect your credit score?

The way you manage a credit card account usually has a big impact on your credit score.

Making timely payments is one of the first good credit card habits you may want to adopt because your payment history makes up the largest percentage of your three-digit credit score. If you carry a balance, you have to make at least the minimum payment to your credit card issuer each month. Late or missed payments may seriously damage your credit score.

What is the minimum payment on a credit card?

The minimum payment on a credit card is the lowest amount your credit card issuer allows you to pay each month to keep your account current.

As you become more comfortable using a credit card, you should also try to keep your overall credit utilization low. Your credit utilization rate is the amount of credit you’re using across all of your credit cards compared to your total available credit. If the ratio becomes too high, your score may suffer. Whenever possible, try to pay your balance in full. That way, you may avoid interest charges and keep your credit utilization to a minimum.

Your credit card also affects other areas of your credit score, including your credit mix, new credit, and the age of your accounts.

Finding a credit card that works for you

The best credit card for you depends on your priorities and financial situation. If you’re just beginning your credit journey, you may want a good starter credit card. On the other hand, if you’ve practiced good credit habits for years, you may want a card with more extensive rewards. To find the right pick, you should understand your options.

Unsecured credit cards

Virtually all credit cards are either secured or unsecured. An unsecured credit card is any credit card that doesn’t require collateral to secure the credit limit. Unsecured cards are riskier for credit card issuers than secured cards, so applicants may need a higher credit score or more income to qualify. Most credit cards are unsecured.

Secured credit cards

A secured credit card requires a refundable deposit that’s used as collateral at account opening. Usually, your credit limit equals that deposit amount. If you don’t repay your secured credit card balance, the card issuer may keep your deposit and close your account. A secured card may help you build—or rebuild—credit history as long as you maintain good credit habits.

If you have limited credit history or you’re working to rebuild your credit, you may qualify for a secured card.

Rewards credit cards

Maybe you already have strong habits, and you’re looking for a card with more benefits. Rewards credit cards may allow you to earn rewards like cash back on eligible purchases. A rewards credit card may even offer additional rewards rates in certain categories. To earn the most rewards, you may want to choose a card with categories that align with your spending habits.

Rewards cards sometimes come with high annual fees. Before you apply, make sure the value of potential rewards offsets the additional cost.

Student credit cards

Student credit cards are cards specifically for people enrolled in college. Many college students have recently taken the first steps toward financial independence and may not have a credit history. Fortunately, you usually don’t need a credit score to apply for a student card. Credit limits often start small on student cards, as cardmembers are still learning good credit habits. The cards may also feature tools like payment alerts and expense trackers to help you build financial literacy. Plus, some student cards earn rewards.

Business credit cards

While personal credit cards help individuals shop, build credit history, and earn rewards, business credit cards are designed for business owners to cover business expenses and earn rewards that bolster the company. Credit limits on business cards may be higher than on personal cards, as they’re designed to finance larger expenses, like equipment. You typically have to own a business to open a business credit card account.

Travel credit cards

Travel credit cards are rewards cards with exclusive travel-related redemption options or benefits. You may earn miles, points, or cash back on a travel card.

Some credit card issuers offer co-branded travel cards in partnership with a hotel chain or an airline. You may be able to redeem the rewards you earn on a co-branded card for travel expenses like free nights or airfare with the partner company.

General travel cards may have lower rewards rates, but they often have more flexible redemption options. You may be able to use your miles on flights at various airlines, for example. With Discover, you can turn Miles into cash. Or redeem as a statement credit for your travel purchases like airfare, hotels, rideshares, gas stations, restaurants, and more.¹

The bottom line

A credit card can be a useful financial tool for managing expenses, building credit history, and earning rewards. The best way to reap the benefits of a credit card without taking on too much credit card debt is by using your card responsibly.