How Exactly Do Credit Cards Work?
If you're new to credit cards, you may be wondering exactly how they work. Sure, you know that you can swipe a piece of plastic at a store to make a purchase, but what's really going on? Additionally, you've probably heard your friends boasting about buying flights with credit card travel rewards points, or even getting cash back for purchases they make with their credit cards. How can you get in on these deals? Are they even worth it? This guide will provide you with all of the information you need to know about credit cards and how exactly they work.
What is a credit card?
Credit cards have been around in the United States since the 1920s. At first, they were for particular stores or companies. Later, in 1950, the first universal credit card was developed by Diners Club, Inc. Other companies such as American Express, Mastercard, and Visa soon followed suit.
How does a credit card work?
A credit card essentially provides users with a short-term loan from the credit card issuer, which must be paid once a month. Each plastic credit card has your account information encoded in it so that when a store swipes the card with its magnetic strip, your purchase is processed against your line of credit. Similarly, you can enter the unique numbers on your credit card into the payment system of an online store with the same result.
You will have a set amount of credit available to you on any given credit card. Your credit limit is often based on things like the type of credit card, your income, credit history, and debt-to-income ratio. Once you've hit your credit limit on your card, you won't be able to use it to make any more purchases until you've paid some off it back.
Just like any loan, you have to pay back what you owe. Once a month, your credit card company will send you a bill showing the total amount that you've spent each month, as well as a minimum payment amount and a due date for paying. It is best to pay the total amount due each month rather than just the minimum payment. Otherwise you will accrue interest. In other words, you could end up paying back more than what you initially spent on your purchases. You should make sure that you pay your credit card bill on time every month, or else you could be hit with costly late fees as well. Other fees to be aware of include annual fees, cash advance fees, foreign transaction fees, and balance transfer fees.
What about rewards?
Some credit cards offer rewards points or cash back incentives for making purchases. Some of these credit cards use a point system where you receive a certain number of points on every dollar you spend. You may receive more points for certain purchases (such as food or gas) than for other purchases (such as entertainment). These points can then be redeemed in the credit card company's virtual shop. Typically, you can buy any number of things with your points: books, appliances, clothes, gift cards, travel, or even cash back.
Other credit cards offer miles in exchange for credit card purchases. These miles act similarly as rewards points, except you can redeem them for airline tickets. You may need to use a particular airline to redeem your miles, or you may be able to convert your miles between different frequent flier programs for a fee.
Finally, cash rewards credit cards automatically provide you with cash back for your credit card purchase. You receive a specific cash amount back for different purchases you make. You can usually either apply this cash back directly to your credit card's monthly bill, or you can have it deposited directly into your bank account.
How can you get a credit card?
If you want to get a credit card, you need to first fill out an application. The easiest way is to go to the credit card issuer's website. You'll need to fill out some basic information such as your name, address, date of birth, annual income, and Social Security number. The credit card company will check your credit report and if you appear to be credit-worthy and a good match for that particular card, it will approve you and send you the card by mail. If you are denied for the credit card, you may have better luck with another card, or you may need to improve your credit score first.
A credit card can help you build your credit, which can later help you in life when it comes to things like renting an apartment, applying for auto loans, or applying for a mortgage. You can also earn travel miles, rewards points, and cash back. You should be careful to remember that a credit card is not free money and you will be hit with fees and interest if you don't pay off your credit card promptly. Not paying your credit card bill on time can result in lowering your credit card. Stick to one or two credit cards and be sure to pay them off each month, and you can feel secure about that new payment method that you've added to your wallet.