What Is a Credit Card?

Credit Cards Explained

Definition

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.

Younger main sitting on a couch making a credit card purchase on his phone.
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Definition and Examples of a Credit Card

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 the minimum monthly payment required by the issuer, you can continue to borrow as long as you do not reach the credit limit.

One example of a credit card is the Chase Sapphire Preferred credit card. It offers cardholders rewards in the form of points that can be redeemed for things like airline miles and more.

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, and 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. That 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.

Note

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 would 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 you pay down the balance. Assuming you started with a zero balance, if you were to pay back the $75 that you owed by your credit card due date, 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'll be charged interest. The period of time before the interest is charged is called the "grace period," which is typically about 21 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.

The 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.

How Credit Card Minimum Payments Work

To avoid paying interest, you typically have to pay your statement balance in full on or before your due date. However, the credit card issuer usually doesn’t require you to pay back all of what you owe at once. You must pay at least the minimum payment by the due date to avoid a late penalty. Credit card issuers vary when it comes to how they determine your minimum balance, but you can find it in your credit card terms.

It's important to always pay at least the minimum amount on time each month to maintain a good credit history and avoid late fees.

Note

Paying only the minimum is the slowest and most expensive way to pay off your credit card balance. It's best to pay as much as you can and, ideally, pay the balance in full.

Credit Cards vs. Debit Cards

While credit cards and debit cards look identical, they function in very different ways. With a credit card, you're borrowing money from the credit card issuer. With a debit card, you're using money from your checking account to pay for purchases. To use a debit card, you also need to enter your PIN.

You can also use a debit card to take cash out of your checking account at an ATM or when you make a purchase. Some credit cards allow you to access cash by taking a cash advance, but these transactions tend to have higher interest rates than purchases do, and they may not have a grace period. In other words, you must pay interest on the advance.

Credit Card Debit Card
Allows you to borrow against a credit line. Allows you to deduct purchases from your checking account electronically.
You may have to enter your billing ZIP code to make a purchase. You may have to enter your PIN to make a purchase.
You may be able to withdraw cash by making a cash advance. You can use it to withdraw cash from your checking account.

Key Takeaways

  • A credit card is issued by a financial company and allows you to make purchases by borrowing money up to an established limit.
  • To make a purchase in person, you must insert the card into a card reader. To make an online purchase, you must provide all your card information and your billing address. 
  • Once you pay down what you've borrowed, you can borrow again up to your credit limit. 
  • You can often avoid interest charges by paying your statement balance by your due date. 
  • Though they look the same, debit cards function differently. They allow you to make purchases by electronically deducting money from your checking account. 
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