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How Do Credit Cards Work?

6 min read

Last Updated: November 14, 2024

Table of contents

Key Takeaways

A credit card gives you a line of credit you can use to make purchases up to the limit approved by your credit card company.
You should pay at least the minimum amount due each month on your credit card bill.
Some credit cards offer rewards for eligible purchases, such as cash back or Miles.

Even if you’ve had credit cards for years, you may not know exactly how credit cards work.

Put simply, a credit card is a type of loan. When a credit card issuer gives you a credit card, you receive a line of credit that you can access as needed to make purchases. In exchange, you pay at least the minimum monthly payment and interest charges on any balance you carry into the next month. If you always pay your credit card balance in full and on time, you won’t pay interest on regular purchases as long as your credit card issuer offers a grace period.

Did you know?

The bank, credit union, or credit card issuer approves you for a credit card based primarily on your credit history, credit report, and credit score, which can help determine how likely you are to repay the money you borrow.

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How credit cards work

Credit cards are a type of revolving credit. That means you can borrow up to your credit limit, repay what you borrowed, and then borrow again. You might compare this to a personal loan, which allows you to borrow a lump sum one time and repay it in fixed installments.

Understanding how a credit card functions may empower you to use the card responsibly, earn rewards, and avoid accumulating too much credit card debt.

How does a credit card transaction work?

Credit card payments take seconds, but behind the scenes, transactions are complex. Each credit card transaction involves several parties and multiple steps.

The University of California explains what happens in the moments after you pay with a credit card:

The merchant’s point of sale device sends the transaction information to the acquirer (also called the payment processor), which transfers it to the credit card network (or payment network).
The payment network asks the card issuer to authorize the transaction.
The card issuer verifies the cardmember’s identity and the card’s available credit to approve or deny the transaction.
The card issuer notifies the payment network of the decision, which notifies the acquirer. Meanwhile, your transaction is approved or declined.

After a transaction, the merchant receives funds from the card issuer. Your balance increases as your available credit decreases. Each transaction appears on your credit card statement.

How does credit card interest work?

While credit cards give you the flexibility to take your time paying back what you owe, you may pay for the privilege of doing so. If you don’t repay your statement balance in full each month, your card issuer may charge you interest fees on purchases.

If you take a cash advance or make a balance transfer, you may get an interest charge from the date the transaction posts to your account. Interest rates for these transactions may be higher than interest rates for standard purchases.

Be sure to check the terms of your cardmember agreement to learn about the interest rates that apply to various transaction types on your account. You can use the Discover^® Credit Card Interest Calculator to find out how long it might take you to pay off a credit card based on your interest rate and balance.

How do credit card rewards work?

Rewards credit cards offer rewards like cash back or Miles. Generally, you earn rewards as a percentage of your purchases, such as 1%, 2%, or 5% cash back.

You can usually redeem your rewards for a statement credit on your credit card account, gift cards, or merchandise, based on your cardmember agreement. Although Discover rewards never expire, ¹rewards from some credit card issuers may expire.

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Credit cards vs. debit cards

Many people have a debit card before they get their first credit card. Although they may look the same, credit cards and debit cards work in fundamentally different ways.

A credit card lets you borrow money, but a debit card is connected to the checking or savings account where you have cash. Your debit card allows you to access the money you have in your bank account so you can buy things without physically carrying cash around. The bank withdraws funds from your account as soon as you complete a debit card transaction.

Additionally, credit cards may come with benefits and features that debit cards don’t offer, like rewards.

How do credit cards affect your credit score?

Credit cards affect your credit score in many ways, most notably through your payment and spending habits.

If you carry a balance, your card issuer requires you to make at least a the minimum payment each month. You can also choose to pay more than the minimum credit card payment or pay the balance in full. Making timely payments is one of the first good credit card habits you may want to adopt because your payment history makes up the largest percentage of your three-digit credit score.

As you become more comfortable using a credit card, you should also try to keep your overall credit utilization low. Your credit utilization rate is the amount of credit you’re using across all of your credit cards compared to your total available credit. If the ratio becomes too high, your score may suffer.

Finding a credit card that works for you

The best credit card for you depends on your priorities and financial situation. If you’re just beginning your credit journey, you may want a good starter credit card. On the other hand, if you’ve practiced strong credit habits for years, you may want a card with more extensive rewards.

Student credit cards and secured credit cards are often good first credit card options, as they may not require credit history. If you’re enrolled in school and have some income, you may qualify for a student card. A secured card requires that you make a security deposit upfront equal to your credit limit. Both cards may have smaller credit limits than standard cards, but otherwise, they work the same way. Learning how to use a student credit card or a secured credit card responsibly can help you establish good habits that can build your credit history over time.

Maybe you already have strong habits, and you’re looking for a card with more benefits. Rewards credit cards may allow you to earn cash back or Miles on eligible purchases. Some cards offer bonus reward rates in certain categories. To earn the most rewards, you may want to choose a card whose bonus categories align with your spending habits.

A credit card can be a useful financial tool for managing expenses, building credit history, and earning rewards. The best way to reap the benefits of a credit card without taking on too much credit card debt is by using your card responsibly.

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