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how credit cards work
how credit cards work

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How Do Credit Cards Work? Credit Cards Explained

Managing your finances isn't always easy, so being able to use a credit card to borrow money can be very helpful. However, credit cards aren't right for everyone. Therefore, finding out more about how credit cards work is advisable.
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Managing your finances isn't always easy, so being able to use a credit card to borrow money can be very helpful. However, credit cards aren't right for everyone. Therefore, finding out more about how credit cards work is advisable.

It's fair to say that having a credit card can give you more flexibility when it comes to your finances. From being able to spread the cost of buying to helping pay off your debts and building a better credit score, to earning rewards and cashback, they can be a beneficial option.

But, despite the advantages that having a credit card can offer, it can cause costly mistakes when used incorrectly. This includes deciding on how many credit cards you need, which can prove to be a detriment when used irresponsibly. Credit cards offer a range of features, and some charge an annual fee.

With this in mind, here we look at what a credit card is and answer the question, "how do credit cards work?" We also look at some things to think about before making your application.

The credit card - the basics

In their most basic sense, if you get a credit card, you'll be able to borrow money that you don't already have and spend it on anything of your choice. Your credit card issuer will trust that you'll pay the money back that you owe over a certain period of time.

Credit card providers will set your card's credit limit as well as your interest rate. If you pay off the balance in full each month, you'll pay no interest. That doesn't mean that you have to pay off the balance in full every month! Paying the full balance every month will offer you great financial benefits though!

  • You won't be charged interest on your borrowing.

  • You'll make fewer payments overall and will pay back less money over time.

Nevertheless, if you can't pay in full every month, so long as you pay at least the minimum amount on your monthly statement by the stated payment due date, you won't incur any late payment fees, and you won't end up with a bad credit score.

It's important to be aware, though, that if you don't pay your bill in full each month and make only the minimum payment, you'll be charged interest. This will be at the APR interest rates you agreed to when you applied for your credit card. In some cases, this rate of interest can be quite high, meaning you'll be paying back for longer and making higher payments.

Missing a payment or failing to make minimum payments on time will result in you being charged late payment fees. Every fee you're charged could result in financial repercussions, and costs can quickly add up.

What benefits do credit cards offer?

Using a credit card can offer many benefits. These include:

  • Credit cards allow you to spread the costs of an emergency or large one-off purchase.

  • You can carry out balance transfers to move your existing debt during an interest free period, so you'll have longer to pay off your credit card balance without having to pay interest.

  • You'll have extra financial protection if you're spending on expensive purchases - something you can't get from using debit cards.

  • Having a credit card could help you repair or build your credit rating and improve your credit score.

  • You could earn financial benefits such as rewards and cashback on your spending and borrowing.

  • You may be able to enjoy spending without any additional fee and at a lower exchange rate when making purchases overseas - a much better option than using debit cards.

These are just some of the advantages that credit cards have, so it isn't surprising that so many people want to get a credit card to reap the benefits. There are also several different types of credit card supplied by different types of credit card provider.

What are the advantages for the card provider?

No card provider will hand out credit cards for the fun of it! Credit cards are only ever provided with the expectation of earning a profit.

Credit card lending is all about banks, building societies and other providers making money from customers' inability or unwillingness to make their credit card payment in full every month. A significant percentage of credit card users won't pay their entire credit card balance in full every month. Instead, they will pay a lower amount and often only the minimum payment. They will therefore be required to pay interest at the interest rate stated by the card provider.

This overall revenue is large enough to outweigh any rewards or cashback given to customers, or even any fraudulent payments that they end up covering, for example, if your credit card details have been stolen.

Different styles of credit card

There are several styles of credit card available, but how do you choose which one to make a credit card application for?

The answer lies in knowing what you're looking for from a credit card as well as your credit rating, credit history, and spending habits. So, which credit cards can you pick from?

0% purchase credit cards

These cards are used for attracting new customers and persuading them to apply for a credit card from their bank or building society. As an introductory offer, these cards have a zero interest purchase rate for a certain period of time. This makes borrowing affordable in the short-term. You can purchase an item today then pay for it later within the interest free period, spreading the cost if you wish without needing to pay more and simultaneously improve your credit.

0% balance transfer credit cards

Like a 0% on purchases card, these cards offer balance transfers from different credit cards or loans with high interest rates and no need to pay interest on your debt. Fees are charged for this, but it's often lower than the interest you're being charged on your other credit cards. This is a good way to pay off your debt more quickly and affordably, but don't use these cards for borrowing money, cash withdrawals, or spending on new purchases.

Also, using a credit card with an introductory 0% balance transfer offer comes with a caveat - you should always try your hardest to clear all your debt before the balance transfer introductory period expires. Otherwise, you'll likely end up paying a lot more in interest as the interest rate you'll be charged following that period will almost certainly be high.

0% money transfer credit cards

This card allows you to withdraw cash from your credit card into your own bank account. How does this type of credit card work? Essentially, these cards enable you to pay off debt like overdrafts by letting you give yourself a free of interest cash loan over a fixed period of time. Again, there's a fee for this, and you'll need to ensure you tell the lender at the time of application to transfer the amount of money directly to your bank. Cash withdrawals don't count for the interest free offer.

Rewards and cash back cards

These cards reward spending by giving you cash back on your purchases. Alternatively, they may offer you rewards like store credit or air miles whenever you use them. These cards are offered as a loyalty incentive with the expectation that fees and interest repayments will make the provider money. If you always make your full card payments on time, you can make these cards work for you with no penalties.

Credit score building cards

When you think of credit cards, credit building may not be your first thought. However, there is a type of card that can help you to boost your credit score.

If you're a new borrower or have a low credit score due to ongoing debt, you may find that your credit history gets in the way of securing borrowing. If you owe a lot of money or have missed repayments in the past, this will affect your credit score, and you'll find that most lenders will view you as a risk, refusing to lend you money.

A credit builder card can help in this situation. Usually, these cards will come with a low credit limit and a high representative APR. But if you handle your money wisely, you'll eventually build up your credit record by showing you're a responsible borrower. You can achieve this goal by only spending a little money of your available credit each month then paying the entire balance off as soon as the statement arrives. Once your credit rating has improved, you'll then be able to choose from a wider variety of cards.

Travel credit cards

Designed for overseas spending, these credit cards charge either low fees or no fees when they're used abroad. If you're a regular traveller, you'll find these fee-free cards very beneficial. The card’s credit limit you may be offered will vary, and the lender may charge an annual fee on top of your regular credit card payments for this kind of card. However, the fees will probably be offset by the money you could save overseas when compared with the fee another card issuer may charge on your foreign expenditure.

The features of credit cards

One major advantage offered by credit cards is the protection offered on any large purchase by the Consumer Credit Act's Section 75. Credit cards registered in England (i.e. with a registered office in England) are regulated by the Financial Conduct Authority, which affords you additional protection. If you purchase an item costing between £100 - £30,000 then discover the company from which you bought the item has gone out of business, or the item is faulty, you are able to get a refund from your card issuer. This is far better protection than that offered by the "chargeback" system on debit card expenditure.

Just like with a debit card, you'll also be reimbursed if any fraudulent activity takes place on your account due to your card being stolen so long as you've taken reasonable precautions and acted quickly as soon as you realised there was something wrong.

You can use a credit card all over the world, with most retailers now accepting them. They are, therefore, a convenient way of spending and can now often be linked to your smartphone or even smartwatch for extra convenience.

Thanks to modern technology, you can also keep a close eye on your account balance through the internet. You can set up automatic alerts to let you know when your bill needs to be paid or when you're reaching your cards credit limit. You can also set up a direct debit to cover your full or minimum balance to avoid being charged a late fee.

How do I get maximum benefit from a credit card?

Although credit cards bring many advantages, they must be used smartly. You need to always stay on top of your debts and ensure that your bills are paid on time.

Some other helpful advice includes:

  • Paying more than your minimum. This clears the balance more rapidly and reduces your interest over time.

  • Paying the entire balance off every month whenever possible.

  • Applying wisely for new cards. If your application is rejected, your credit score can be negatively impacted. If you make a lot of applications in a short period of time, this can also lead to a bad credit rating. Do your research first and compare credit cards so that you can determine which ones you are most likely to be accepted for before making an application.

  • If your credit rating is poor, use a credit building card to improve it.

  • Ensure bills are paid on time to avoid late charges and a mark against your credit score.

  • Set up a direct debit to avoid accidentally missing your bill's due date.

  • Get a reward or cashback card to maximise the value of your card.

  • Avoid paying overseas fees by using a travel credit card.

If you use your card wisely, you'll find that the advantages of having a credit card will outweigh the disadvantages.

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