How do credit cards work? A guide to credit, interest, and APR
6 min read
Credit cards can be a useful spending tool. They allow you to make purchases without carrying a lot of cash around every day and using a credit card can help with the big purchases that you aren’t able to pay for all at once.
That said, it’s important to understand how credit cards work and how they can work for you. Fees and interest rates, such as the annual percentage rate (APR), can cost you big, especially if you don’t pay off your credit card balance each month or make your monthly payments on time.
Whether you’re already a credit card user or applying for a card for the first time, Spruce is here to help with what you need to know about how credit cards work. Plus, find out how you get free access to your credit score with Spruce.
How does a credit card work?
Simply put, when you make a purchase with your credit card, the lender/credit card issuer approves the purchase up front (as long as it is within your credit limit), and then you pay them back in accordance with your Cardholder Agreement. They send you a credit card bill each month (also known as a monthly statement), and you have to pay it off in full by the due date they’ve set in order to avoid interest and late fees.
It’s important to know that credit cards are a form of revolving credit. While it’s best to pay them off each month, they allow you to carry a balance from month to month. And if you do, you’ll owe interest on that amount, and your balance will increase. Each month, you’ll be responsible for a minimum monthly payment against the balance owed.
But heads up! If you miss your minimum payment, additional penalty fees and interest will be added to your balance, and your credit score can be negatively affected.
What else should you know? Your credit card will allow you to charge up to a pre-determined credit limit. If you try to make a purchase that goes over your limit, your card will be declined the next time you try to make a purchase. But as you pay off what you owe, the available amount will increase. And when you keep your account in good standing — keep paying those bills on time! — your credit limit may increase over time.
When shopping for credit cards, pay close attention to the fine print and understand what fees you could owe and what triggers them. For example, some cards charge an annual fee simply to maintain an account. Be sure to review the terms and conditions of your credit card to understand your credit limit, interest rate and fees.
How does interest work on a credit card?
Interest is the amount the credit card issuer charges you to borrow money, and it’s shown as a percentage. Your interest rate is specified at the time you sign up for a card. Familiarizing yourself with the terms of your agreement is a crucial part of understanding how credit cards work and the interest rate and potential fees you will be charged.
Your rate can be a “fixed” interest rate that always stays the same, or it can be a variable interest rate that changes over time based on various factors, such as ups and downs in the larger economy. In fact, your credit card interest rate can change every month based on the index your bank or lender is using. Credit cards are considered high-interest debt since rates are often as high as 20% or more.
The interest rate you’re offered will typically depend on your credit score. Generally, the better your credit score, the lower your rate will be.
How does APR work on a credit card?
Annual Percentage Rate, or APR, refers to the yearly interest rate you’ll pay if you carry a balance on a credit card. For other types of loans, like auto loans or mortgages, APR refers to interest and fees that you’ll owe over the life of the loan. But for credit cards, it only refers to the balance you owe on your monthly statement.
Credit card interest is based on your average daily balance. But here’s the rub: Interest also compounds. In other words, if you carry a balance for months on end, you’ll owe interest on the interest you’ve already been assessed. As a result, the amount you owe can increase quickly. Each month, your billing statement will indicate the interest added to your balance.
Using your credit card to build your credit score
Your credit score largely determines your credit card’s APR. It’s a three-digit number, usually from 300 to 850, that’s calculated based upon several factors, such as your history of paying bills, credit utilization, and length of credit history. For that reason, it can have a big impact on what your credit card might cost you.
When you apply for a credit card, most creditors will do a credit check to determine how creditworthy you are. The card issuer wants to know how likely you are to pay your outstanding balance back on time. The higher your score, the more responsible you’ve likely been when paying your bills in the past. This could translate to a lower APR.
But if you’re new to credit, or have experienced financial challenges in the past, your credit score may be lower than you’d like it to be. For many, the first step to building credit is opening a credit card account.
If you have trouble opening a traditional credit card at first, you may be able to open a secured credit card to start. Doing so requires putting down an initial deposit, which is kept on hold. Then,
- The amount of that deposit is usually the limit you can charge on the secured card.
- If you were to default on your payments, the creditor will use those funds to pay off your remaining balance.
From there, the most effective way to build your credit history and your credit score — which makes it cheaper and easier to secure future credit — is to pay your bills on time, including your credit card bills. Fail to do so, and your score will take a hit.
How Spruce can help you keep tabs on your credit
With Spruce, you get free access to your credit score, empowering you to check your credit score at any time. What’s more, you can get insights to help improve your score over time.
Not sure a credit card is the best bet for you? Learn how to build credit without a credit card.
Build a stronger financial foundation with Spruce
Spruce provides a suite of convenient and secure tools that can help you monitor your credit score, pay your bills, and connect with resources to make sure that your financial future is healthy. What’s more, when you shop with Spruce at select retailers, you can earn cash-back rewards.
Sign up for the Spruce mobile banking app and start your journey toward a healthy financial future.
This information provided for general educational purposes only. It is not intended as specific financial planning advice as everyone’s financial situation is different.
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