Credit cards are a handy tool, but not everyone fully understands how they work. Learn how credit cards work and how to make sure you stay in control, with Cashfloat.
Article highlights
- Find out how credit card contracts work
- Read ten tips for safe credit card usage
- Learn about six different types of credit cards, and the purpose of each.
With such a wide variety of credit cards on offer, it is often difficult to navigate all the information. While there are many different types of credit cards available, such as interest-free credit cards or cashback credit cards, most credit cards basically work in the same way.
In this article from Cashfloat, we will have a look at how credit cards work, whether or not it is wise to take one out, some tips on how to use them safely and how to work out which credit card is best for you.
Understanding Credit Cards
Credit cards all work on the same basic premise. The easiest way to look at credit cards is as ‘borrowing’ or ‘loan’ cards. Every time you make a payment with a credit card, you are borrowing money from your credit card provider and you have to pay this back. If you pay the money back before a certain date (usually by the end of each month) you won’t have to pay any interest on it. If you pay after the set date, then you have to pay interest. Credit card providers make money from the interest that they charge their customers and, sometimes, they also make extra charges to their customers as well. Customers get to benefit from being able to borrow money quickly and conveniently and, if they are sensible, they should not encounter too much of a cost (or any cost at all) for borrowing.
Credit cards can be used to buy goods and services, or to make cash withdrawals. Anyone who has a system in place to accept payment from your credit card will be able to accept payment with it. Your credit card provider will set a limit to the amount that you can spend on your card. In the UK, most credit card limits are between £3,000 and £4,000. This is the maximum amount that you can borrow with your credit card. Usually at the end of each month, your credit card provider will issue you with a statement. If you pay any money that you have spent back, in full, before the end of the month, you will not have to pay any interest. However, any money that you do not pay back will remain in your outstanding balance and interest will begin to be applied.
While most credit cards need to be paid off by the end of each month, some providers have different payment periods. Many offer an introductory interest free period, for say 12 months. During this time, you will not have to pay interest on any outstanding balance that you have. The key thing with all credit cards, is that if you do not pay off what you owe by a certain date, then interest will be applied to what you owe and this will cost you money.
Revolving Credit
Each month you will be presented with a statement of what you owe and a minimum payment that is due by a certain date. This is known as revolving credit. For as long as you have a credit card, you will have an amount that you owe (if you owe anything) and an amount that you are able to borrow. Used carefully, credit cards can be very useful things and risks can be kept to a minimum. However, if they are used unwisely, interest can accrue and debts can become quite large. While credit cards are popular things and while they can be useful, it is important to understand that each time you use a card you are effectively taking out a small loan that MUST be paid back.
Interest Rates (APR)
The interest rates which are applied to credit cards are calculated as APR (Annual Percentage Rate). APRs advertised with credit cards allow you to make a quick basic comparison of how much different credit cards will cost. Beware though, as APR is not always the only amount that you will be charged. Many credit cards come with added fees and additional interest, known as compound interest.
An APR shows how much it will cost you to borrow money for one year. For example, if you borrow £100 for one year with an APR of 20%, it will cost you £20 to borrow that money. If you pay the money back before the end of the year it will cost you less than that. For an in-depth explanation of APR, have a look at this article by MoneySavingExpert.
Different Types of Credit Card
While all credit cards operate according to the same basic premise, there are often differences between them in terms of how you can use them. For example, many credit card providers will apply interest to cash withdrawals as soon as you make the withdrawal. You do not have any interest free period and this will cost you money. Other cards charge an annual membership fee and there are often differences in the rules about minimum payments, interest free periods, balance transfer fees, fees charged for withdrawals made in foreign countries and the rewards that card providers give to their customers.
These differences in the rules about how credit cards can be used have given rise to there being different types of credit card. Look at the table below for an explanation of what some of the common types of credit card are best used for:
| Type of Credit Card | Use for the Card |
|---|---|
| Purchase Cards | Purchase credit cards is what we are most familiar with. These are designed for shopping and general purchases that people make in their everyday lives. |
| Balance Transfer Cards | Balance transfer cards allow people to move debts they have from another card or several other cards onto one card with a lower rate of interest. The credit provided by the new card is used to pay the debts of any old cards. |
| Rewards Cards | Rewards cards give people rewards when they spend using their credit card. Rewards can come in various forms, such as cashback, air miles, retail scheme points or even football merchandise. |
| Credit Builder Cards |
These are designed to help build up a credit rating from scratch or to repair a damaged credit rating. These usually come with a high APR and a low credit limit to reduce the risk to the card provider. People with a poor credit rating will usually need to take one of these cards. Beware of subprime credit cards, which are advertised as credit builder credit cards. These cards offer irresponsible ways to borrow money and can be dangerous. Go to Chapter 17 for more information about this. |
| Travel Credit Cards | These are designed to make it cheaper for users to spend money overseas and some even provide rewards for doing so. |
| Money Transfer Credit Cards | These are similar to balance transfer cards, except that you can use them to borrow cash rather than to move money between credit card accounts. These are commonly used to pay off bank account overdrafts. When interest rates may be high with an overdraft, it may be cheaper to borrow money on a credit card instead. |
Where Can I Use a Credit Card?
These days most businesses in the UK will accept payment by credit card. The exceptions are often just self-employed traders who need to be paid by cheque or bank transfer, small shops and market traders. Even taxi drivers now often have card machines installed in their cabs and there are few limits to where you can use a card.
On top of this, around the world, credit cards are globally accepted. It doesn’t matter whether you are in the middle of New York or a remote location in China, If you have a Visa or a Mastercard credit card, you will probably be welcome in local restaurants, hotels and shops.
In most countries, you can also make cash withdrawals with a credit card. However, as we mentioned earlier, this can incur extra charges from your credit card provider on top of your normal currency conversion fee. Most countries have ATMs that accept both Visa and Mastercard. However, in some places, machines only accept one or the other and so some people take both when they are travelling.
The Benefits Of Using a Card Abroad
Both debit and credit cards are useful ways of obtaining money when you are abroad. The main benefit to using cards abroad is that you will not be carrying lots of cash around. With a credit card, you also have the benefit of having protection for purchases you make while you are abroad. Although you may incur a fee for withdrawing cash from an ATM, you can often help yourself by choosing the currency exchange rate of your own bank and not the local rate.
When you take out a credit card, it is always wise to check with your card issuer what fees will be levied on foreign transactions. As always, keep a note of emergency phone numbers and all card numbers. In the event of a problem you can call your card company and get help.
Payment Systems
All credit cards run under a payment system, such as Visa, Mastercard or American Express. In the UK, most credit cards use either Visa or Mastercard. When you make a purchase using your credit card, these companies facilitate the payment process and allow it to happen. It does not matter whether you use a card from a bank like Lloyds or Barclays, a card issued by a US bank like MBNA or a multinational like HSBC, they will operate under a payment system. There are no major differences in the service that payment systems provide.
The main consideration that most people make, when choosing a payment system provider, is how likely their card is to be accepted. In the UK, most businesses will accept Visa and Mastercard and some will accept American Express. Other businesses may accept lesser known payment systems, such as Discover.
Should You Take Out a Credit Card?
Before dashing off to open a credit card account, it is always useful to sit back and think about whether you really need one. For an in-depth look at the advantages and disadvantages of having a credit card, go to Chapter 5 of this guide.
If you have never had credit before, then a credit card can be useful in building up your credit history. This can come in handy later when you may want to take out a personal loan or mortgage and many people are unaware of this fact. On the other hand, if you miss any payments they can harm your credit score for a number of years.
Using a card means you can spread the cost of expensive items that might otherwise be out of your financial reach at the time. They provide security benefits, compared to other methods of payment, they often come with rewards, such as free air miles and another big advantage to them is that purchases you make with them are guaranteed by your credit card provider.
Despite the advantages that they have, credit cards can cause financial nightmares, particularly when debts rack up to unpayable amounts. Sometimes a personal loan is actually a better option. Always make a balanced decision before you take out a credit card and remember the main risk, as we’ll explain below.
Interest Rates and Other Costs
Before opening a credit card account, you should always look at the cost. If you can pay off your credit card each month (or before interest is applied) then you won’t have a problem. However, if you are ever unable to pay off the full amount, you will have to pay interest. If you think that you will be unable to cover the cost of interest payments, you should not take out a credit card. If you are a responsible spender and can either cover payments before interest is applied or keep up with interest payments, finding a card with a low APR (and other costs) is still the best option.
Another thing to consider is that if your payment is late, even if it is because you had to make an emergency payment for something else or had money stolen, on top of interest being charged it will damage your credit rating. Credit cards come with a minimum monthly payment. This is usually 3% of the balance or £5, whichever is the higher amount. Failure to make the minimum payment damages your credit score. If you take out a credit card make sure that at least the minimum payments reach your credit card provider on time. For more information about credit scores go to Chapter 12 of this guide.
If you decide that you do want to take out a credit card, it is worth understanding how to compare credit cards and make the right choice about which one to get. Go to the next chapter of this guide for more on this.
Applying for a Credit Card
If you want to take out a credit card you will have to apply for it. Applying for a card is simple enough, but you are not guaranteed acceptance. The card issuer will look at your credit history, credit score and other factors, and will then decide whether you can have a card and what your credit limit and interest rate will be.
Providers offer the best credit card deals to those applicants with good credit scores. A failed application does not only mean that you won’t get a credit card, but it will also damage your credit score. Typical credit limits in the UK are between £3,000 and £4,000. For people on a low income or with a poor credit score, limits can be as low as £200 and for people on a high income, with a good credit score, they can be over £10,000. Typical APR rates in the UK are around 22.5%. For people with a good credit score who are on high income, they can be as low as 10%. For people on a low income with a poor credit score, they can be around 40% or higher.
Ten Tips For Safe Credit Card Use
Following these simple tips will help you to get the best out of your credit card.
- Only use your card for essentials and not for everyday items
- Try to pay off the balance in full and on time each month
- Never miss a payment and at least make the minimum
- Keep your balance to within an amount that you will be able to pay off
- Take advantage of a 0% interest rate card if it is offered
- Never make multiple applications for cards
- Set up a direct debit to make your payments
- Only opt for a reward card with points or cashback after you have checked whether there any hidden fees
- Never use a credit card to take out cash
- Never exceed your credit limit
Following these simple tips will help you to use the money available on a credit card to your advantage.
How to Compare Credit Cards
There are so many credit cards to choose from that it can be difficult to get the right one. However, there are ways to simplify the choice. Go to the next chapter of this guide for in depth advice on this.
Many people look at the reward schemes, cashback offers or other benefits that card issuers advertise to tempt people into opening an account. However, the most important things to look at are the interest rate, the credit limit and any additional fees that they come with.
Obviously, card companies make money when people spend and then don’t pay off all of the balance, and they do make huge profits. It is important to be realistic and to accept that you may well end up paying interest on money that you borrow. The wisest thing to do is to choose the card with the lowest interest rate. Many people use credit cards without it costing them a penny and they can be useful, however, interest rates are the main thing to be aware of. Alongside interest rates, it is a good idea to look at any additional or hidden fees that a credit card may come with, such as an annual membership fee.
While it may be advantageous to have a high credit limit, it is also wise to not take on a credit limit that you cannot keep up with. For people who are after a high credit limit, it is worth noting that most companies will impose a smaller credit limit to start with and if you are a good payer, you may find that your limit is increased automatically.
Surcharges for Paying by Credit Card
Before early 2018, paying for some goods or services using a credit card instead of a debit card would mean paying an extra fee. Commonly when booking flights online, you would see the choice of payment by debit card or credit card with credit cards involving a higher fee than debit cards.
In early 2018, this practice was made illegal and companies can no longer charge you extra for using a credit card to make a payment. We have mentioned this here because previously this was an aspect of credit card usage, which some people found discouraged them from taking out a credit card in the first place. It is now no longer a consideration that people have to make.
How Credit Cards Work – SummaryThere is a lot of information available on credit cards. Our guide to credit cards in the UK will help you to understand the implications of using a credit card as a form of payment. In the next chapter, we’ll discuss what to look at when comparing credit cards and how to make the right choice.
