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What Is a Credit Card and How Do Interest Rates (APR) Work?

Credit cards and debit cards might look the same, but they come with different risks and rewards.

On the plus side, they offer a flexible credit line with the potential for free travel, cash back, and other rewards. But with interest rates often exceeding 20%, and the average cardholder owing over $5,500 as of 2022, they come with plenty of risk for undisciplined consumers.

Before swiping plastic, make sure you understand the pros and cons of credit cards — and the risks if you misuse them. 

What Is a Credit Card?

A credit card gives you access to a rotating line of credit. You can charge purchases up to the specified credit limit, and pay back the debt at your own pace. 

For a price, of course. If you fail to pay off your balance in full each month, expect to pay steep interest on it. 

To a lesser extent, you can pull cash from your credit card account, although most cards come with lower cash advance limits than their purchase credit limits. Credit cards also hit you with a cash advance fee for the privilege, typically in the 3 to 5% range.

Your balance accrues as you draw on your account. You make monthly — or more frequent — payments to pay down that balance. 

A few major credit card networks dominate the market, including Visa, Mastercard, American Express, and Discover. Banks and other financial institutions work with these companies to issue credit cards to you, the consumer. 

How Credit Cards Work

You can use your credit card to buy almost any good or service available on the market. Millions of retailers, online and off, accept credit cards. 

Each month, your credit card issuer sends you a statement, listing all your purchases and repayments. The statement includes both a minimum balance due and your total current balance. 

If you pay the total balance in full, you avoid paying interest charges on it. If you pay the minimum balance due, the card company reports your monthly payment to the credit bureaus as on-time, but your unpaid balance carries forward to the next month and accrues interest. 

If you fail to make any payment by the due date or you pay less than the minimum payment, the card company reports the payment as late.

This gets at an important difference between credit cards and debit cards. Credit card accounts appear on your credit report. Debit cards don’t. 

Debit cards are merely a way to access your checking account. They aren’t credit accounts and thus don’t build credit

Every credit card has an expiration date, but the credit card issuer usually sends you a new card automatically if your account is in good standing when that date comes. In practice, you can keep using your credit card indefinitely as long as you keep paying down your balance. 

Types of Credit Cards

Credit cards come in many varieties. It’s especially important to understand the distinction between secured and unsecured cards, personal and business cards, and the different types of rewards credit cards.

Secured vs. Unsecured Credit Cards

To begin with, you have secured versus unsecured credit cards. Unsecured credit cards, which don’t require any collateral, are the norm. But borrowers with no credit history, or those emerging from bankruptcy or foreclosure, often don’t get approved for unsecured cards. 

Some card companies offer secured credit cards designed to build credit and raise your credit score. You deposit cash with the issuer — your collateral — and get a credit limit that’s usually equal to the deposit. If you stop making payments and eventually default on the account, the card issuer uses your deposit to make itself whole. 

Business vs. Personal Credit Cards

You can also distinguish between personal and business credit cards

Bear in mind that you may not need a legal entity in order to open a business credit card. Often sole proprietors and self-employed workers don’t bother filing to open an LLC or other legal entity, but they may still qualify for a business card.

Note that credit card companies still review your personal credit history when you apply for a business card.

Type of Card Rewards

The main differentiator between credit card types is the type of reward they offer. For example, cash-back credit cards earn — you guessed it — cash-back rewards. If you prefer travel rewards, you can earn a higher percentage of your spending with travel credit cards

Some people prefer low-APR credit cards, which have lower interest rates but also lower rewards (or none at all). In fact, many cards offer an introductory period with 0% APR, whether for purchases, balance transfers from other cards, or both. 

And so it goes, with hotel reward cards, restaurant reward cards, gas reward cards, ad infinitum. Look hard enough and you can find really quirky, niche cards like the Star Trek rewards card from NASA Federal Credit Union. 

Common Credit Card Terms

Like everything else in the world of finance, credit cards come with their own esoteric language. 

Here are a few common credit card terms to know, as you hunt for the perfect card — assuming you didn’t already strike gold with that Star Trek card.

  • Annual Fee: All right, this one isn’t so esoteric or opaque. As the name suggests, it’s a fee charged every year by the card company. 
  • APR: The annual percentage rate is the annual cost of both your interest rate and any fees charged by the card. 
  • Balance Transfer: Some cards let you transfer your balance from another credit card, to take advantage of lower interest rates or other perks. 
  • Cash Advance Fee: Most credit cards let you borrow cash from them — for a hefty fee. Options include withdrawing cash from an ATM or transferring money online from your credit card account to your bank account. 
  • Credit Limit: The maximum balance allowed by your credit card. Try to spend more than that balance, and your card will decline when you try to pay with it. 
  • Cash Advance Limit: Cards that allow cash advances typically set a lower cash advance limit than your total credit limit. 
  • Foreign Transaction Fee: Some cards charge a fee when you use your card internationally. 
  • Rewards Multiplier: Some cards offer greater rewards for specific types of spending. For example, a card might offer triple reward points for every dollar spent on travel purchases, or at a specific retailer. 

Pros & Cons of Credit Cards

Credit cards are a more versatile and powerful financial tool than most people credit them for (pun intended). 

But like all tools, they’re dangerous when used recklessly. 

Pros of Credit Cards

As much as personal finance experts love to malign credit cards, they come with many uses and advantages — if used responsibly. 

  • Interest-Free Borrowing. As long as you pay off your balance in full each month, you pay no interest on the borrowed money. You may also be able to take advantage of introductory 0% APR offers to transfer balances to new cards and pay no interest on them, often for a year or more. 
  • Fraud Protection. If someone steals your card information and makes purchases with it, the card company typically covers any costs, not you. 
  • Purchase Protection. Some cards offer warranties or price protections, for defective goods or items that you find cheaper elsewhere. 
  • Build Credit. Card companies report to the credit bureaus, which makes credit cards a great way to build or rebuild your credit history. 
  • Rewards. From free flights to hotel stays to high-end meals, credit card rewards are tangible and real. I know people who fly internationally for free several times each year using credit card rewards.
  • Perks. Some cards offer other perks beyond rewards, such as rental car insurance or free airport lounge access. 

Cons of Credit Cards

For all those upsides, credit cards also come with hefty risks. Misuse credit cards at your own peril.

  • High Interest Rates. Credit cards routinely come with interest rates over 20%. That puts them up there with mob lenders. 
  • Risk of Compounding Debt. Too many cardholders fail to pay their balance in full every month. That means that they end up paying interest on their interest — and potentially in a downward spiral of compounding debt. This can quickly dig a hole so deep that it takes years to escape. 
  • Fees. Some cards charge hundreds of dollars each year in annual fees. While these premium cards tend to come with premium perks, many cardholders either don’t know about them or don’t take advantage of them. 
  • Other Fees. Cardholders also face late payment fees if they fail to make the minimum payment within the grace period. Some cards also charge foreign transaction fees for overseas purchases as well.
  • Credit Score Risk. Fail to make the minimum payment each month and it appears on your credit report. But the credit bureaus also look at your credit utilization ratio, or the percentage of available credit that you use. If your balance exceeds 30% of a credit card limit, it can hurt your credit score.

Credit Card FAQs

Credit cards may be easy to swipe, but that doesn’t always make the rules easy to understand. 

Make sure you understand these common points of confusion about credit cards.

What’s the Difference Between a Credit Card vs. a Debit Card?

Debit cards are not a form of credit at all. They simply let you access cash held in your checking account. When you pay with a debit card, it deducts the payment from your checking account balance. Your debit card is just an extension of your checking account. 

A credit card is not a bank account. Rather, it’s a rotating line of credit. Your balance represents your debt to the credit card company. You can pay it down at your own speed. 

Debit cards don’t typically offer rewards or perks and sometimes don’t offer the same purchase protections. Read up on the other differences between credit cards and debit cards for more detail.

Do I Need a Credit Card?

Technically, no one “needs” a credit card. But credit cards can be useful. 

They help you build your credit history, and offer another way to pay if the merchant declines your debit card for some reason. Used correctly, credit cards come with enormous benefits, from rewards to perks to interest-free credit. 

Of course, if you don’t use them responsibly, credit cards can leave you buried in debt for years to come. 

How Do I Choose the Right Credit Card for Me?

There’s a credit card for every need. So what are your needs?

If you have limited or weak credit, you might need a secured credit card because you may not qualify for a standard unsecured card. 

Think through what kinds of rewards you’d prefer. Avid traveler? Get a travel rewards card. Prefer straight cash? A basic cash-back credit card will do. 

Also look at where you spend your money. Often cards offer better reward multipliers on specific types of purchases, so you can rack up rewards faster by choosing the best card for your spending patterns. If you have lots of mouths to feed at home, look to a credit card that earns extra rewards at the grocery store.

Can I Get a Credit Card if I Have a Bad Credit Score?

Yes, with caveats. 

First, you may need to put down collateral in the form of a cash deposit, for a secured credit card. Even if you qualify for an unsecured credit card, expect lower credit limits, higher interest rates, and fewer rewards and perks.  

Start by researching these credit cards for people with bad credit

Can I Get a Credit Card if I Don’t Have a Credit History?

Yes, although you should expect the same limitations as someone with bad credit. If you can’t find an unsecured credit card, open a secured card.

What Is APR?

Annual percentage rate or APR includes both the interest rate on your balance and any fees charged by card.

For more detail, read up how to calculate credit card interest based on APR, and the difference between APR and APY

What Is a Credit Limit?

Nearly all credit cards come with a limit that’s unique to you as the borrower. Credit card companies based your limit on factors like your income, credit history, and net worth

A few ultra-exclusive credit cards have no preset limit, although even these come with limitations. Good luck trying to charge a $50 million yacht on your credit card.

Final Word

No one likes to hear it, but if you can’t pay off your credit card balance each month, you shouldn’t be using credit cards. Lock them away in a drawer until you’ve paid off your balance in full. 

The one exception is financial emergencies. I keep a credit card in reserve, unused, as an extra fallback measure in the event of an emergency. I consider it another layer in my emergency fund

Get in the habit of only spending what you have in your checking account each month, and when you master that skill, consider dabbling with credit cards. As with everything else in personal finance, start low and go slow. No one becomes a rewards travel hacker overnight, and the risks of credit card debt far outweigh the benefits for undisciplined consumers. 

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.
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