What Is a Credit Card

What Is a Credit Card and How Does It Work?

Credit cards are not a vital part of our lifestyle, and they are last-minute saviours as well as daily support systems. Whether it is about spending for an emergency situation or the daily small expenses, credit cards are always in use.

However, as you know, they come with some risks as well. The high compound interest rate of a credit card accumulates faster than you can imagine, making the repayment hefty. If you delay even a single instalment, it gets bigger in size so easily.

By knowing about credit cards and how they work, you may start using them smartly.

What is a credit card?

A credit card is a metal or plastic card issued to you by a bank to borrow money to purchase goods and services. Later, you need to pay back the used money along with the applicable interest rate.

You get a pre-approved limit to spend on a credit card, and you are spending money as credit. It means it is a kind of loan that you will have to pay back in monthly instalments. Either repay the pending amount in full or in instalments with the interest rate added to the payments. 

                                                 Credit Card Vs Debit Card                
Credit CardDebit Card
A credit card is a type of short-term loan that allows you to borrow and use funds for any of your expenses. It will have to be paid back.A debit card is linked to your bank account. Every time you use it, money is deducted from your bank account. It is not a loan, as the funds you use are earned by you only and debited from your bank account.

Components of a credit card

If you want to know how a credit card works, you should first know its key components that shape it as a financial product.

  • Credit limit – Every card has a maximum credit limit up to which you can use the money. This limit is decided as on your creditworthiness. Credit score, income, and employment stability are decisive factors. If you have a good credit score, getting a higher limit becomes easier.
  • Minimum payment – It is the smallest amount of instalment that you have to pay monthly after using the credit card. Also, the due date for that payment matters. Paying this minimum amount keeps you away from the tag of default, but the interest rate keeps adding on to the remaining balance.
  • Billing cycle – This is the duration during which all your transactions made through the credit card are recorded. The duration is usually 30 days. After that, a bill is generated showing all your transactions and the amount owed by you.
  • Rate of interest (APR) – The Annual Percentage Rate is charged on the outstanding or pending amount yet to be paid on the credit card. The APR varies as per the credit card provider’s policies and your creditworthiness.
  • Fees – Credit cards may include various types of fees such as annual fee, foreign transaction fee, late payment fee, and cash advance fee.
  • Grace period – It is usually a duration of 20 to 25 days after your credit card bill is generated. You can make a full payment without adding interest, which makes your instalments hefty and out of budget.

How do credit cards work?

It is now time to understand how a credit card works. That will help you get an insight into the smart use without getting into a trap of pending payments.

1)) Apply for a credit card – To use a credit card, you need to first apply for it from a financial institution or a bank. Approval decision depends on the following factors.

  • Credit score
  • Employment status
  • Income level
  • Existing debts

2)) Make a purchase – Once the card is approved, you can use it for any purpose. Online purchase, in-store, for urgent or daily expenses, whatever it is, you can use the money as per the assigned limit. Every time you tap or enter your card details or swap, it reduces your available credit limit.

3)) Billing statement – When the billing cycle ends, the credit card issuer company sends you a bill describing the transactions and the due payment amount.

The bill statement has the following –

  • All transactions
  • Minimum payment due
  • Total amount owed
  • Due date of payment

Now, make the payment by the due date, and you can avoid the incurred interest rate. This is where you can use a grace period to arrange the instalment amount.

4)) Pay the instalment – You can make the payment using the three options as mentioned below –

  • Make the payment of the full balance. In this case, no interest is charged.
  • Make the minimum due payment. It helps you to avoid late fees and a default tag. However, the interest rate keeps accumulating on the pending amount.
  • Make a partial payment that is more than the minimum payment. It incurs lower interest rate charges, but over time may cost you big if you keep avoiding making full payment.

5)) Interest accrual – If you make the timely payment within the grace period, no interest rate is charged. In case the payment is delayed, the interest rate keeps adding, and it is a compound interest rate type. Hence, technically, you pay interest on interest. Now, that is easy to understand how huge that can make your repayments.

6)) Revolving credit – Once you pay back the amount you have used; the same amount is available to be used again. For instance, you had £50,000 as an available credit limit. You spent £30,000 but repaid £20,000, so you can use £40,000. That is why it is called revolving credit.

Advantages and disadvantages of using a credit card

Now, it is better to know the pros and cons of using a credit card. That will definitely help you make wise use without getting into a debt trap.

AdvantagesDisadvantaged
Manage emergency expenses. Credit cards offer you revolving credit. Hence, if you are repaying on time, you are never out for funds during an urgent need.High rate of interest rates are the biggest drawback of a credit card. Once you fail to make a timely payment, the interest keeps adding, making the repayment difficult to repay.
You can improve your credit score while making timely payments on a credit card. In fact, not maxing out your card shows a good impact on your credit score.The debt trap threat is another disadvantage. The hefty instalments easily go out of budget, disturbing your other expenses and debt payments.
Cashback and reward deals on cards are great opportunities to get discounts on varied product purchases. Also, you qualify for amazing gift offers.The impact on your credit score is long-term if you default or delay on a credit card. Recovery from that bad impact takes a lot of time.
Fraud protection is another benefit as most of the finance companies offer have strong and safe transaction network. You are always safe against unauthorised use of the card.Credit cards are expensive credit types due to high interest rates. Other short-term loan options are more affordable, even if it is bad credit loans with no guarantor. The instalments are pocket-friendly.
Credit cards can be used for any financial purpose. From a medical emergency to daily expenses, you can use them anywhere for any purpose.Using credit cards is addictive, and it does not let you realise how much you are spending. Cash transactions inspire thoughtful spending habits. But credit cards make people do mindless spending.

Conclusion

Credit cards are unavoidable, but you need to use them wisely, considering all the facts above. Use smartly, don’t max out credit limit and make timely payments. These three practices ensure that you use the credit cards only when actually needed. Hence, if you are struggling even a little in handling your card payments, it is time to be cautious. After all, you pay back using your hard-earned money. Therefore, it is better to use credit cards with patience and a rational approach.

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