Ever wondered how credit cards work? It may seem like a fairly simple transaction when you purchase something using your credit card, but there is more to it than meets the eye.
Whether you’re shopping for your weekly groceries or finally buying that 50” smart TV you wanted, swiping a credit card can be extremely convenient and beneficial.
Credit card companies offer rewards on money spent, including cash backs and credit points. In addition, if correctly used, credit cards can help you achieve an excellent credit score that can improve your financial standing and increase your creditworthiness.
However, before you apply for a new credit card to reap these benefits, it can help to understand how credit cards work.
How do credit cards work?
This is how credit cards work: once you apply for a credit card, your application is screened based on your current credit standing, aka credit score.
Once your application for a credit card is approved, the card company grants you a set credit limit. Your credit limit — the amount of money you can spend on the card- is determined by your credit history and current credit score. If this is the first card you’re applying for and don’t have any credit history or credit score, you may be offered a predetermined credit limit.
This credit amount is the short-term loan you get, and you can swipe your card to make purchases using this credit anywhere, be it online, at the movies, or the local drugstore.
When you swipe your credit card, the card details are sent to the merchant bank for authorization, and the transaction is processed. Your card issuer verifies your information and can approve or decline your transaction.
How credit limits work
Money is deducted from your credit limit for every approved transaction, and your available credit is reduced.
The amount of money you spend from your allowed credit is presented to you at the end of the billing cycle in the form of a statement balance. This statement balance must be paid in full before the due date to avoid interest charges.
Card companies allow a grace period, which is the time between the end of a billing cycle and the due date for repayment of the borrowed money, and as far as possible, you may want to attempt paying off the balance within this period.
If you delay your payments, the balance is carried forward from month to month, and your card issuer charges you interest on this amount. The interest rate can be fixed or variable, depending on the company.
So it can be wise to read up on how credit card interest works to make sure you are staying clear of any additional interest charges.
Credit cards vs. debit cards
Credit cards and debit cards are similar-looking rectangular plastic cards that help you pay for things. It seems fairly similar, right? Yet here are some differences between credit cards and debit cards.
1. The fundamental difference
A debit card is directly linked to your bank account, and every time you swipe it to make a purchase, money is deducted from that account. So the money you spend is removed from your bank account the moment you swipe it, and you have nothing pending to pay later.
When you use a credit card, you are using the credit card company’s money, an amount that you may or may not have in your bank account at the time of spending.
This borrowed amount is presented to you in the form of a statement balance at the end of the month, which you must repay with or without interest, depending on when you choose to pay it back.
2. Card rewards and benefits
Credit cards offer various rewards, depending on which card company you choose. Perks like cash backs on purchases, discounts, special insurance premium rates, and access to airport lounges are some examples of credit card reward programs.
Most debit cards don’t offer rewards.
While shopping for a new credit card, take some time to notice what your spending habits are and which rewards would benefit you most. For example, if you are a frequent flyer, card companies that offer travel discounts and airport lounge access might be more suited for you than companies that offer cash back perks.
If you are looking to own more than one credit card, you can split your cards across companies that offer varied benefits, so you have a diverse set of rewards.
3. Scoring systems
Credit card reports are sent to a credit bureau, and they study your financial habits to assign you a three-digit credit score. This scoring system reflects how responsible you are at paying back the credit. A good score can bring you perks like a smaller deposit while apartment shopping, a lesser interest rate on loans, and a more seamless loaning process.
Similarly, delaying your credit payments could hurt your score. When you have a low credit score, you may have fewer banks wanting to loan you money, and you may be charged a higher interest rate on loans.
If you are financially responsible, your credit score speaks of your creditworthiness. However, there’s no number or scoring system with debit cards, and you have nothing to show for your financial habits.
4. Fraud protection
Credit cards are more protected by federal law than debit cards.
If a person reports their credit card as missing or stolen, they face no liability charges. Credit card users are protected by the Fair Credit Billing Act, which states that the consumer’s liability cannot exceed $50 for any fraudulent transaction.
Furthermore, credit card users are typically protected in cases like if you ordered an item online, but the delivery never arrived, if a faulty/different item was delivered.
If a debit card is lost or stolen reported to the financial institution before any fraudulent purchase is made, the owner faces no liability charges.
However, according to the Electronic Funds Transfer Act, if the missing card is reported within 48 hours of being lost or stolen, the consumer is liable to pay $50 for the fraudulent transaction.
If the lost card is not reported within the first 48 hours, the consumer is responsible for paying $500 for fraudulent transactions. If the debit card owner takes more than 60 days to report the missing card, he is liable to pay all fraudulent charges.
- If you report a missing card in the first 48 hours, you may be liable for up to $50
- If you report a missing card between 48 hours and 60 days after the card goes missing, you may be liable for up to $500
- If you report a missing card more than 60 days after the card goes missing, you may be liable for all fraudulent charges
So, if you’re someone who tends to misplace their card often, a credit card can offer you more fraud protection than a debit card.
Getting a credit card?
Choosing your credit card can help you upgrade to a better lifestyle without splurging much more.
It’s smart to choose a card that caters to your unique spending needs so that you can maximize your benefits and save more money. Here are some things to look out for before getting a new card:
- Every person is not eligible for every credit card. Many companies have a screening process that requires the potential customer to have a specific credit score to qualify for a particular card. Ensuring that you are eligible for the card you are applying for can help minimize the chances of your application being rejected and an unnecessary drop in your credit score.
- Closely read the fine print on credit card promotional offers, and ensure that the card benefits align with your spending habits.
- Compare APR rates, initial bonus offer terms, and annual fees of different cards before selecting one.
How to use your credit card wisely
Once you find the perfect card for you, it’s essential to use it smartly. You may want to take calculated measures to keep your credit score high and avoid any chances of falling into debt.
Here are some things you can do to help keep your credit score high:
- Know your credit limit, and don’t exceed it
- Use only a portion of your available credit, ideally below 10%
- Always pay your statement balance on time
- Restrict the number of times you apply for a new card to minimize hard inquiries
- Find out your debt ratio, which shows you how much you owe compared to how much you earn. - Always spend less than you earn
- According to your debt ratio, set a monthly limit for how much you want to spend on credit, and stick to it
Ensure you get the right credit card for you
With credit cards, any purchase you make is just a swipe away. This convenience can easily lead you to overuse the credit facility without having the funds to repay the credit. It can be wise to be as careful spending on credit as you would with cash, and set reminders to pay off your balances every single time to stay clear of any additional interest charges.
Credit cards are great financial tools if used responsibly. The benefits and rewards can help you upgrade your lifestyle while giving you points and cash backs on your purchases.
Remember to plan out your finances each month, not spend more than you earn, and pay your balance in full before the due date. Having good financial habits can save you from spending your hard-earned money paying interest and may help you enjoy the benefits of having a good credit score.
Vital is the credit card that pays you to share and spend responsibly, with world-class customer service and three kinds of cash rewards. Join the waitlist for Vital Card now.
Sources
Fair Credit Billing Act | Ftc.gov
Electronic Fund Transfer Act | Ftc.gov
Why Do You Want a Good Credit Score? | Experian
Finding the Right Personal Loans for Borrowers with Good Credit | Equifax
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.