How Does A Credit Card Work?

Are there advantages of credit cards that make them a friend or foe? Credit cards are surrounded by myths, facts and a whole lot of controversy. Let’s clear the air. How does a credit card work? And most importantly, will it work for you?

Ask around and you'll see that credit cards are the most universal financial tool products available. Some people pay all their expenses using them, while others swear that the credit cards are the embodiment of pure evil.

There are those who love it for the financial freedom it gives, and others who live in fear of its destructive powers.

What Is A Credit Card?

What Is A Credit Card

There are different types of credit cards, but it is basically a piece of plastic, rectangular metallic alloy or graphite, which represents a financial account. That magnetic strip that you see is what enables customers to make payments.

Some cards come with an RFID Chip (the chip in credit card) for extended security measures. The account number and your name or that of your business may be imprinted at its front.

Think of it like a Digital Video Recorder for money. Let's say your favorite show airs at 7.30p.m and for some reason, you won't be around to watch the next episode. DVRs allow you to "time shift". Your DVR enables you to watch the entire episode later at your own convenience.

You don't have to miss out on what you love because you're not in a position to watch it. The same philosophy applies to the credit card. You don't have to suffer financial hurdles because you currently don't have funds to pay for your needs.​

Where Does Credit Card Money Come From?

A credit card is a type of financial account. When you use a credit card to pay for a product or service, you're offering to use the bank's money instead of your own. But at the end of the day, it's not your money. You'll have to repay the bank over time. It's like a personal loan, or cash advance, without all the bureaucracy and explanations on why, how and when you need it.

SEE ALSO: How To Get Cash From A Credit Card​

The funds are transferred instantly. And like any other loan, when you use someone else's money, you'll need to pay credit card interest. This is where some people get problems.

Using other people's money instead of your own is all fine and dandy. It gives you financial freedom and lets you keep your money for the other purposes you may have.

However, if you purchase something with another person's money and you’re unable to repay it, the consequences on your financial future can be dire.

This brings us to the raging debates on whether the credit card can give you wings to fly or cripple and root you to the ground. Is it a force for good or evil? It's neither.

It's nothing but a tool. Whether it helps or harms you depends on your skills and knowledge on how to use it. The same way a car can drive you to work or off a bridge. It all depends on how you drive it.

Follow one simple rule: "If you can't pay for something outright, don't charge it". A credit card should correlate to your budget, not expand it.

How Do Credit Cards Work?

Here is the basics of how credit cards work!

  • When you swipe your cards, or enter its account number online, you transfer purchase charges to the bank. The bank then credits the merchant's account as soon as the sale slips are received. You then get the products/services that have been paid for.
  • The bank then assembles and bills all the charges to you at the end of each billing period, say a month. You, as the card holder, can choose to either pay the entire balance of your statement, or make payments in monthly installments. You pay for this privilege through interest.
  • Banks usually determine the minimum amount of money that you must pay with each statement, or else you'll receive additional charges on top of the interest. It’s best to pay the bill in full by the due date.

Credit Card Credit Score

When you pay fully and on time, the bank considers you to be a well-behaved customer. In addition, it reports your behavior to the other companies that evaluate whether you’re a good borrower.

Basically, you want these companies to label you as a good borrower. Otherwise it will have financial consequences your future.

This brings us to the credit score. It is affected by factors like your credit card payment history, how long your accounts have been open and what you currently owe on those accounts. Even though you’ve just started using credit cards, do not take your credit score lightly.

Buying a home or a car may seem like a far-off fantasy for now, but how you treat your credit card today will impact your financial standing for years to come. For instance, if you have a good credit score you maybe be able to get a huge loan at a lower interest rate in future.

SEE ALSO: What Is A Good Credit Score To Buy A House?​

Do not let maxing out your credit card (or even coming close to doing so) to be an option.

It's advisable to try and limit your credit use to a third of your available credit. In case you're totally about your credit card debt, you can always go on an "All-cash diet".

SEE ALSO: Does Paying Off Credit Cards Increase Credit Score?

All you have to do is withdraw the amount of cash that you've budgeted for a week, and when it's gone, it's gone. Handing over physical money actually has a psychological impact-you literally feel yourself giving money. It goes a long way in ensuring you use your credit card responsibly.​

How To Apply For A Credit Card

Getting a credit card is fairly straight forward. All you need to do is fill out an application and wait for the card to appear in the mail. In order to complete your credit card application, you need to provide:

  • Your full legal name and date of birth
  • Home address, email address and phone number
  • Gross annual income
  • Current and previous employers
  • Optional - Social Security Number (USA) or Social Insurance Number (Canada)
  • Information on other credit cards you hold

The application process can be done online, over the phone, or in person by visiting a credit card issuer. Note that applying for the card doesn’t automatically mean you'll get it.

Obviously, you can lie on the application about things like income and house payments, but that would be considered fraud and can have serious consequences. If you want a credit card immediately, then you must apply for a card that matches your credit score.

Related Credit Card Reviews:​

My Credit Card Application Was Rejected

In case you're application is rejected, you should find out why. Usually it's because you made a mistake in your application or some information is missing.

If there's an issue with your work history, such as you recently changed jobs or became unemployed, you may have to wait for some time, about six months, depending on the issuer.​

See ALSO: Loans For Unemployed People​

You may also have a bad credit history or facing financial problems. Whichever the case, you should immediately order for copies of your credit reports. Under the Fair Credit Reporting Act, you’re entitled to a free one from each of the three credit bureaus (Experian, Equifax and TransUnion) once a year. Study your reports and work on improving your credit.

SEE ALSO: How To Build Credit Fast And Easy​

How Many Credit Cards Should You Get?

​Truth be told, there is really no perfect number of credit cards that you "should" hold. The average consumer has nine credit cards, according to myFICO.com. It's the consumer division of the company which invented the FICO credit risk score.

"A couple of general-purpose cards tend to suit most consumers' needs."

When getting a credit card, remember that you have rights. The "Truth in Lending Act" requires credit card issuers to explain all the terms of the contract in detail, and to do so in a language that the average adult can understand.

The bottom line is that you should make sure that you understand all aspects of your card before you get and start using it.