A credit card is a small plastic or metal card issued by a financial company. It allows you to make purchases by borrowing money up to an established limit.
A credit card allows you to access a credit limit that’s provided by your credit card issuer. Your credit limit is the maximum amount you can borrow.
Instead of giving you the full loan in cash, the card issuer lets you take as much of the credit limit as you want at a given time. As you pay off what you’ve borrowed, you can borrow again.
How Do Credit Cards Work?
To make a purchase at a brick-and-mortar retailer, you typically insert the credit card into a card reader so it can read the security chip on the card. You may also be asked to enter your billing ZIP code. At an online retailer, you’ll be asked to enter the card number, expiration date, security code (typically found on the back of the card), and your name and billing address.
When you swipe your credit card to make a purchase, the merchant’s credit card terminal asks your credit card issuer whether the card is valid and has enough available credit.
Your credit card issuer then sends back a message stating whether the transaction is approved or declined. If it’s approved, you’re good to go. If not, you may have hit your credit card limit or your card may have been deactivated due to suspected fraudulent activity.
This doesn’t necessarily mean your identity has been stolen; card issuers may deactivate your card and get in touch if you’ve made unusual purchases.
For example, if you travel abroad, your card issuer may deactivate your card until it confirms that you’re the one who made the purchases.
How Your Credit Line Works
Each time you make a purchase, your available credit goes down by that amount. If you have a $300 credit limit and you make a $25 purchase, you’ll have $275 in available credit. You’ll owe $25 to the credit card company. If you borrow another $50 before paying back the $25 you borrowed, you would owe the bank a total of $75 and have $225 in available credit.
What makes a credit card different from a regular loan is that your credit limit is available after paying down the balance. Assuming you started with a zero balance, if you paid back the $75 that you owed by your credit card due date, in most cases, you’d have $300 of available credit again.
You can repeat the process of spending up to your credit limit and repaying the balance as often as you like, provided you abide by the terms of the credit card.
You can continue borrowing against your credit limit over time, which is why credit cards are referred to as revolving accounts or open-ended accounts.
How Credit Card Interest Works
The credit card issuer gives you a certain amount of time to pay back the entire amount that you’ve borrowed before you’re charged interest. The period of time before the interest is charged is called the grace period, which is typically between 21 and 25 days.
If you don’t pay off your full balance before the end of the grace period, a fee or finance charge is added to your balance. The finance charge is based on your interest rate and outstanding balance.
interest rate is the annual rate you pay for borrowing money on your credit card. Interest rates are generally based on market interest rates, your credit history, and the type of credit card you own.