How do credit cards work?
Credit cards are a convenient financial tool, but they can be confusing for many people. Understanding how credit cards work is essential for using them responsibly and maximising their benefits. In this guide, we will explain what a credit card is, how it works, and how you can use it wisely.
What is a credit card?
A credit card is a financial product that allows you to flexibly borrow money from a bank or credit card provider up to a predetermined limit. You can use it for everyday purchases, online shopping, travel expenses, and much more. Unlike a debit card, which uses your own money, a credit card provides you with a line of credit.
Key components of a credit card
Credit Limit: This is the maximum amount you can borrow on your credit card.
Interest Rate (APR): This is the annual percentage rate charged on any unpaid balances.
Minimum Payment: This is the smallest amount you must pay each month to avoid further penalties.Â
Billing Cycle: This is the period of time during which your purchases are tracked (usually 30 days).
Grace Period: This is the time you have to pay your balance in full without incurring interest.
What even is the interest rate? (APR)
The Annual Percentage Rate (APR) represents the yearly cost of borrowing on your credit card, including interest and fees. It’s expressed as a percentage and helps you understand how much extra you will pay if you carry a balance on your card rather than paying it off in full each month.
Make sure to always read the terms and conditions carefully before initiating a balance transfer to ensure you fully understand the costs involved and how the APR may impact your repayment plan.
So, how do credit cards work?
When you use a credit card, you are essentially borrowing money from the credit card provider. Each time you make a purchase, the amount is added to your balance. At the end of the billing cycle, you will receive a statement showing how much you owe.
Pay the total amount due to avoid interest charges. In this scenario, you borrowed money for free - nice!
Pay a small, required amount (usually a percentage of your balance) to keep your account in good standing. However, you will be charged interest on the remaining balance.
Pay more than the minimum payment but less than the total balance. This reduces the amount of interest you owe, but you will still be charged interest on the remaining balance.
Example: How interest is calculated
Let's say you have a balance of £200 on your credit card, with an APR of 20%.
-> If you pay the full £200 by the due date, you pay £0 interest.
-> If you only make a minimum payment of £10, the remaining balance of £190 will incur interest.
-> At a 20% APR, this means you would pay approximately £3.17 in interest for the month (£190 x 20% ÷ 12 months). It's a little more complicated than this because interest compounds monthly, but we'll keep the maths simple here.
If you continue to carry a balance, the interest continues to accumulate, making it harder to pay off.
The different types of credit cards
There are various types of credit cards available across the market, each designed for different financial needs:
Standard Credit Cards - the basic cards for everyday use.
Rewards Credit Cards - with these you can earn cashback, points, or air miles for spending.
Balance Transfer Cards - transfer an existing balance from another card at a lower interest rate.
0% Purchase Cards - interest-free periods for purchases for a set time.
Credit Builder Cards - for those with a poor or limited credit history.
Understanding credit card interest
Interest is charged on any outstanding balance that you do not pay in full by the due date. The interest rate is expressed as an Annual Percentage Rate (APR). Here’s how it works:
If you pay your balance in full each month, you won’t pay any interest.
If you only make the minimum payment, interest will be applied to the remaining balance.
Different types of transactions (purchases, cash withdrawals, balance transfers) may have different interest rates.
And what are the benefits of using credit cards?
Convenience: Use them for online shopping, travel, and everyday purchases.
Credit Building: Responsible use can help you build a strong credit score.
Purchase Protection: Section 75 of the Consumer Credit Act protects purchases over £100.
Rewards and Cashback: Some credit cards let you earn points, cashback, or other benefits.
How do you use credit cards responsibly?
Pay your balance in full - to avoid interest charges you should clear your statement balance each month, if you can afford to.
Keep credit utilisation low: try to use less than 30% of your credit limit.
Monitor your spending: you need to be extra careful when borrowing to spend - make sure you stay within your means.Â
Set up direct debits: Ensure you never miss a payment.
Avoid cash withdrawals: These often come with high fees and interest.
Here are the common mistakes you should avoid when dealing with a credit card…
Only making minimum payments This can lead to debt accumulation due to interest.
Missing payments This can negatively impact your credit score as you might not be seen as financially responsible.
Exceeding your credit limit This can result in over-limit fees.
Ignoring your credit report Regularly check your report for errors, and don’t forget to do this. You can do this for free with Zable.
Credit cards are a powerful financial tool when used responsibly. They can provide convenience, help you build credit, and even offer rewards. However, it is essential to understand how they work and to use them wisely.
This blog is for informational purposes only and does not constitute financial advice. Please speak to a qualified financial adviser before making financial decisions.