How do credit cards work?
Credit cards explained. The guide is a rundown on how credit cards work for dummies. No question has been left unanswered – everything you need to know is covered! If you are unsure about whether a credit card is for you, understanding the ins and outs can really help.
What is a credit card?
You can use a credit card to make purchases, pay bills and withdraw cash. You are using borrowed money to make purchases. You need to pay back this borrowed money every month. If you don’t pay back your balance in full each month you will be charged interest on whatever debt remains on your card.
To summarise credit cards:
- Using a credit card creates debt.
- You must pay back this debt in full every month to avoid interest.
- If you pay back nothing each month you’ll be charged a fee and your credit score will be damaged.
How do credit cards work?
Credit cards are used to borrow money. You’ll need to pay this money back to your lender, the credit card company, along with a fee called interest. If you pay back your credit card debt in full every single month, you can avoid paying interest.
It can be easy to build up debt on credit cards, especially when interest gets added on top. Don’t spend more than you can afford!
You should only use credit cards to borrow reasonably small amounts of money, anything from £100 up to £5,000.
Try to pay off whatever you borrow each month in full. Otherwise, interest will start to accumulate on the remaining balance. This can result in a vicious cycle where you are only managing to pay interest each month and none of your balance. This is where credit card debt becomes dangerous.
Credit cards require a minimum payment every month if you have borrowed money. But where possible, try and pay more to clear your debt.
To summarise how credit cards work:
- You borrow money using your credit card.
- You spend that money (your credit limit) on purchases, bills etc.
- You then need to pay that money back.
- If you don’t pay that money back monthly, your debt will increase as interest gets added.
- You will now owe more money to your bank than you spent originally.
How do credit cards work: Minimum payments
Minimum payments are the amount you must pay back each month on your credit card. Failure to pay at least the minimum amount and you’ll be charged a penalty and it’ll be marked on your credit report.
This is worked out as a percentage of what you currently owe on your card (your balance). This percentage can be as low as 1%. Your minimum payment will depend on your credit card provider. You should pay more than the minimum amount. Otherwise, you are unlikely to clear your balance without paying a great deal of interest on top.
Minimum credit card payments are designed to keep you in debt for as long as possible. You won’t pay off your balance quickly and interest will be added each month, making the credit card company more money. Aim to pay off your balance in full, not just the minimum, and then you’ll only be paying back what you spent, no extra interest!
How do credit cards work: Interest
Interest is a fee you are charged for borrowing money from your credit card company. Interest is calculated as a percentage of your credit card balance. If you have cleared your balance entirely, your interest will be zero.
The average credit card interest rate in the UK is 20.77% per year. Your interest rate is determined by your credit history and type of card.
How do credit cards work: APR
APR is the annual percentage rate of a credit card. This is essentially the annual interest rate of your credit card. For example, if a credit card has an APR of 24%, that’s the total amount of interest charged over a year. Therefore, your interest rate will be 2% per month.
For example, if you spend £500 on your credit card one month and don’t pay it back, you’ll be charged interest. If you have 24% APR, you’ll be charged 2% which will be £10. You’ll now owe £510. Every month that passes another 2% will be added, depending on what your actual APR is.
To put in perspective how expensive credit cards can get, let’s take a look at the APR of £500 over a year. If your credit card comes with an APR of 24% and you spend £500 that you don’t pay off for a whole year, you’ll be paying back £500 plus £120 interest. So, you’ll have to pay £620 in total.
Debt mounts up so make sure you pay it back!
You will often see credit cards advertise the ‘representative APR’ which is the rate that at least 51% of applicants will be given. This does mean that potentially 49% of applicants might receive a higher, more expensive APR.
How do credit cards work: Credit limits
Credit limits are the maximum amount a lender will allow you to borrow on your credit card. Your credit limit is largely based on your credit score and history. The better your credit score, the more credit you’ll be able to borrow.
The average credit limit in the UK is between £3,000 and £4,000. However, if you have a poor credit history, the average maximum you’ll be allowed to borrow is £1,500.
If you exceed your credit limit you’ll be charged a penalty fee and it’ll be marked on your credit history, lowering your overall score. Stay well below your limit and pay back what you borrow every month.
How do credit cards work: Credit score
Your credit score is what lenders use to decide whether to accept your credit card application. Some credit cards will require higher credit scores than others. Generally, the more rewarding the credit card, the higher your credit score needs to be.
The main reasons for a bad credit score include the following:
- Breaking a credit agreement - if you miss monthly payments or exceed your credit limit, your score will be damaged.
- Financial difficulties - having a County Court Judgement (CCJ), being declared bankrupt or getting an Individual Voluntary Arrangement (IVA).
- Having no credit history - if you’ve never taken out credit or a loan before you could have a bad score. This is because card issuers will have no idea about your financial history and how you handle paying back money.
- Too many credit searches - multiple applications for credit cards will leave hard searches on your credit file. This can damage your credit score.
For more information credit scores, check out our guide on credit cards for bad credit.
How do credit cards work in foreign countries
You can use credit cards in foreign countries but not without plenty of fees. When you make a purchase abroad, you are charged a foreign transaction fee. Foreign transaction fees on most credit cards are 2-3%. If you are charged 3% every time you make a purchase, this can get very expensive.
For example, if you spend £500, you’ll have to pay 3% on top straight away, meaning you’ll pay £515.
Most credit cards do charge for cash withdrawals abroad too which can be anything from 2.5% to 3%.
Travel credit cards don’t tend to charge these fees abroad, making them a good option if you travel a lot.
How much do credit cards cost?
Credit cards can have a lot of hidden fees that add up if you don’t watch out for them. Take into account the following charges when deciding how much a credit card will cost you:
- Monthly/Annual fee - some credit cards will charge a monthly or annual fee simply for owning the card, even if you don’t spend on it. Always check whether a card charges a fee before you apply.
- Interest/APR - if you don’t pay back your balance by the end of the month, you’ll be charged interest.
- Balance transfers - if you transfer a balance from one card to another, you are usually charged a 3% balance transfer fee.
- Cash withdrawals - fees can be as much as £5 every time you make a cash withdrawal. Credit cards also charge interest instantly on cash withdrawals.
- Late payments - miss your monthly payment and you’ll be charged a penalty fee.
- Exceeding credit limit - if you overspend your credit limit, you will likely be charged a penalty.
How do balance transfer credit cards work?
Balance transfer credit cards are for paying off high-interest credit card debt. This works by moving the balance from your old card to a new balance transfer card with 0% interest. This 0% interest rate lasts for an introductory period, sometimes up to 36 months.
Your monthly payments will repay the original debt each month, rather than just chip away at the interest. Balance transfers are the answer to paying off debt quickly.
Find out more about balance transfer cards in our guide.
How do 0% purchase credit cards work?
0% purchase credit cards give you a set period where no interest is charged on money you borrow for purchases. The 0% period can last as long as 20 months.
Once this 0% period ends, your credit card will switch over to its standard interest rate. Therefore, to make the most out of a 0% purchase card, you’ll want to pay off your balance in full before the interest kicks in.
Find out more about 0% purchase credit cards in our guide.
How do travel credit cards work?
Travel credit cards make it cheaper to use your card abroad by not charging foreign transaction fees. Whenever you make a purchase in a foreign currency, abroad or online, you are charged a transaction fee, usually around 3%.
Travel credit cards don’t charge this fee, saving you a lot of money on holiday. Find out more in our travel credit cards guide.
How do 'bad credit' credit cards work?
Credit cards for bad credit are for those with bad or no credit history. They accept more applications and can help you rebuild your credit history.
They work just like normal credit cards but they are more likely to accept those with poor or very poor credit scores. These cards have lower credit limits and higher interest.
Find out more about credit cards for bad credit in our guide.
How do cashback or reward credit cards work?
There are many different types of rewards credit cards.
- Points rewards cards for things like vouchers tend to give you a certain number of points for every pound you spend.
- Airline credit cards give you airmiles for every pound you spend.
- Cashback credit cards will give you a percentage of cash back for every pound you spend.
The rate at which you earn rewards will vary depending on the card.
How do student credit cards work?
Student credit cards are aimed at college or university students who don’t have regular income or a credit history. Student credit cards work like regular credit cards but they have higher interest rates, lower credit limits and fewer rewards.
How to compare credit cards
Remember to use an eligibility checker before applying to any credit cards!
Here’s how to compare credit cards:
- Representative APR - When comparing credit cards, look at the ‘representative APR’. This is the interest rate that card offers to at least 51% of applicants. It’s a good way to compare cards, the lower the APR, the less interest you’ll be charged.
- Introductory APR - Some credit cards might come with 0% interest rates for the first few months of use. After this period, the interest will return to normal. This can be useful if you need to spread the cost of an expensive purchase and avoid interest.
- Credit limit - Different cards will offer different credit limits. You can shop around and ask providers what their average first credit limit is. Don’t always go for the highest credit limit, pick a limit that suits your needs so you won’t be tempted to overspend.
- Fees - Shop around to see which credit cards charge monthly or annual fees and which don’t. Bear in mind that there are other fees to take into account such as for cash withdrawals or using abroad.
- Rewards and perks - Compare the different perks on offer and try to choose a credit card that will reward your everyday spending and behaviour.
Take a look at our guide on the best credit cards for more information on choosing the right card.
Do I need a credit card?
Deciding whether a credit card is worth it is a very personal decision. It depends on what you need a credit card for and your financial situation. If you won’t be tempted to overspend and can afford to pay back your credit card balance in full each month, there can be a lot of benefits for you to enjoy.
Take a look at the pros and cons of credit cards to help you with your decision.
Pros of credit cards
- Ease of use - most places are going to accept credit cards, with the addition of contactless it’s even easier to make purchases in-store.
- Improve your credit score - regularly repay what you borrow on your credit card in full each month to build a strong credit score. A strong credit score is great if you need a loan or mortgage in the future.
- Payment protection - Under Section 75 of the Consumer Credit Act, when you make a purchase between £100 and £30,000, the credit card company and retailer are jointly liable to provide a refund.
- Rewards and perks - many credit cards can offer great benefits such as cashback, points, vouchers, airmiles, 0% interest periods and more.
- Safer than cash - if your card is stolen or you notice fraudulent charges, you can simply contact your credit card company to cancel the card or remove charges.
- Borrow money quickly and sometimes cheaply - if you urgently need money for an unexpected purchase, credit cards can be handy. If you get a card with a long 0% interest on purchases period, you can save loads of money on interest.
Cons of credit cards
- Credit card debt - it can be easy to overspend on your credit card. If you can’t afford to borrow what you pay back then you could end up paying high-interest and significant credit card debt.
- High-interest rates - you’ll be charged interest if a balance remains at the end of the month. These interest rates tend to be fairly high which means you can end up paying back a lot more than you originally borrowed.
- Hidden fees - interest isn’t the only fee you could be paying with a credit card. Other fees include annual fees, late payment penalties, charges for exceeding your credit limit, cash withdrawal fees and fees for using your credit card abroad.
- Credit score at risk - whenever you borrow any form of credit, your score and history are at risk if you don’t pay back what you borrow or exceed your credit limit. If you are unable to afford the minimum payments then your credit score will be damaged and you’ll find it harder to get accepted for credit in the future.
Credit cards vs debit cards vs prepaid cards
If you are unsure about getting a credit card, there are a few different options available including debit cards and prepaid cards.
Debit cards are tied to your bank account. When you make a purchase with a debit card, the money is taken from your account as soon as the transaction goes through. This means there’s no money to pay back as it’s your funds.
Debit cards won’t improve your credit score as your bank account activity isn’t reported to the credit bureaus.
Prepaid cards are sometimes known as prepaid credit cards. However, they are entirely different from credit cards. You have to preload money onto your prepaid card until you can spend on it. This means you can easily set a budget and it’s impossible to go overdrawn as you cannot spend more than you have loaded on.
Some prepaid cards do also offer credit-building programmes. This means that you can improve your credit score by using a prepaid card. You can find out more about this in our prepaid cards guide.
If you are looking to improve your credit history, a credit card or prepaid card could be a good option. If you are just looking for the ease of spending with plastic, then a debit card might be your best bet. This is because debit cards don’t come with the additional fees that prepaid and credit cards do.
Having said this, if you want the extra perks that credit cards offer, that could still be your best choice.
Consider your options carefully before making a decision.
How to use a credit card
There are different golden rules to follow for different credit cards. However, in general, if you want to make the most out of your credit card, make sure that you do the following:
1. NEVER miss a monthly payment
If you don’t make at least the minimum payment each month, you will be charged a penalty for late payment. On top of this, you’ll lose any benefits that might have come with the credit card, such as 0% interest on purchases introductory period.
Late payments are also marked on your credit history, damaging your credit score. Set up a direct debit to pay your credit card bill monthly to make sure you never forget.
2. Pay more than the minimum amount
Aim to pay off your credit card balance in full every month to avoid interest. The minimum payment set by your credit card company can be as little as 1% of your balance each month. This will only keep you in debt for longer as interest will be piled on top each month.
Pay off as much as you can afford each month, ideally the full amount. This is why you should never borrow more than you can afford to pay back!
3. Watch out for 0% credit cards
Getting a credit card with a 0% interest introductory period on either purchases or balance transfers can be useful. This 0% period won’t last forever though so make sure you can clear your balance before the interest-free offer expires.
The interest rate you’ll eventually get will end up far higher than other cards so clear your balance to avoid wasting your money.
4. Be careful with rewards cards
Rewards credit cards can be expensive to use with high-interest rates and annual fees. If you want a rewards card, pick one that rewards your normal spending habits. For example, if you shop regularly at the same store, pick a card that rewards you with points for that store. If you fly regularly, pick a rewards card that will give you airmiles.
Pay back your balance each month. Otherwise, the high-interest could outweigh any gains you got from the rewards.
5. Don’t apply for too many credit cards
If you apply for credit cards too often, you can harm your credit score. This ‘hard search’ will be reported on your credit history. Too many of these and it’s seen as a sign of poor finances and that you are in desperate need of money. This means future applications could be rejected.
If you get rejected from your first application, don’t rush into applying for another card right away. Find out why you were rejected and how to improve your chances.
I can’t meet my minimum credit card payments due to coronavirus. What should I do?
Coronavirus has put a financial strain on many. If you have a credit card and are struggling to meet your minimum repayments, you may be eligible for help.
The Financial Conduct Authority (FCA) has introduced measures that allow you to request a freeze on credit card repayments for 6 months. However, you may still be charged interest in this period.
You have until the 31st March 2021 to request a freeze but make sure you agree with your lender before stopping repayments. This won’t leave a bad mark on your credit history either due to the exceptional circumstances.
If you can afford to keep paying, it’s best to do so as you will still be charged interest during this holiday period.
All payment holidays must end by 31st July 2021.