What is a Credit Card and How Does It Work?

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Are you interested in getting a credit card but want to know more about what one is and how it works before you do? Then you have come to the right place.

If used correctly, a credit card can be a useful financial tool that allows you to borrow money, reduce debt or earn rewards. But in order to do any of those things, you first need to know what a credit card is, what types of credit cards are out there and how they work. So let us break it down for you.

What is a credit card?

A credit card is a payment card that allows you to borrow money from a bank, building society or another credit lender to make purchases. By signing up for and using a credit card, you agree to repay the money you borrow, plus any interest or charges that accrue on the amount you owe, until you have paid it off completely.

There is usually a limit to the amount of money you can borrow. This is determined by the credit card company and may differ depending on the lender and your financial situation.

There are also different rules for paying off what you owe, including the minimum amount that you must repay each month to avoid penalties. If you pay off your entire balance each month, you will not have to pay extra in the form of interest.

How do credit cards work in the UK?

Most merchants in the UK accept credit cards, so you can use them to pay for almost anything, including food, clothing, household goods and medicine. Credit cards can also be used in ATMs to advance you money from your account.

Every month, your credit card company sends you a billing statement that details all of your transactions and charges. Two options are available: you can pay the full amount that you have accrued (and thus avoid interest) or pay a fixed minimum amount and then repay the rest over time. The latter is usually a fraction of the total owed for that billing cycle (about 1% to 3%). This option includes interest charges on the balance, which compound as long as you owe the debt.

What are credit charges and fees?

To understand the main charges that come with a credit card, let’s break them down into two sections: interest rates and general fees.

Interest rates

One of the most important things to note is that every credit card has an interest rate. This is presented as a percentage and it’s what you will be charged on your borrowing. However, there are different interest rates attached to different functions on the card:

  • Purchase rate – This is the interest you will be charged on purchases you make using your card if you do not pay them off fully each month.
  • Balance transfer rate – If the card offers balance transfers (not all cards do), then this is the rate of interest attached to any balances you transfer over to your new card from previous cards.
  • Money transfer rate – As with balance transfers, not all cards offer a money transfer feature. If they do, the money transfer will have a separate interest rate that may differ from the purchase rate.
  • Cash withdrawal rate – This is the rate of interest that you will be charged for any cash withdrawals made with your card. It is very important to note that with cash withdrawals interest is charged from day one, so it is advisable to avoid using this function if possible.

You will be able to find details of these rates in your credit card’s summary box online. However, when comparing credit cards, what you are more likely to see is a card’s APR or annual percentage rate. This includes the interest rate on the card, as well as any other charges, such as an annual fee. As the APR represents the annual cost of borrowing, it is a good figure to use when comparing the costs of different cards.

General fees

Something else you can expect from any credit card is that there will be some fees involved. If you use your card wisely, the likelihood is that you won’t encounter any of these – but it is a good idea to know what they are, just in case.

  • Late payment fee – This fee is charged if you miss a monthly payment.
  • Overlimit fee – This fee is applied if you exceed your credit limit.
  • Cash transaction fee – This is a fee applied to any cash withdrawals you make using your credit card. This is on top of any interest charges.
  • Non-sterling transaction fee – This is a fee for any transactions you make abroad or in a different currency.
  • Annual fee – This is a yearly fee for simply having the card and accessing its perks.

Some cards have other fees attached, such as balance transfer fees or money transfer fees, but that depends on what type of card you have. 

What types of credit cards are there?

As you may have already gathered, there are many different types of credit cards. What type of card that’s right for you will depend on your financial needs. Credit cards aren’t a one-size-fits-all financial product, but the advantage is that there are a number of options to cover most financial situations.

0% purchase cards

A 0% purchases credit card offers you an interest-free period on your purchases. With this type of card, you can make a large purchase and pay it off over a period of time without incurring any interest charges.

0% balance transfer cards

A 0% balance transfer card lets you transfer existing debt to your new credit card, typically interest free. You then have a set period of time in which to pay off the balance before incurring interest charges. Balance transfer cards typically carry a fee that is taken as a percentage of the amount of debt you have transferred.

0% money transfer cards

A 0% money transfer card is similar to a balance transfer card. It enables you to transfer money from your credit card to your current account, essentially providing you with an interest-free loan. Once again, transfers usually have fees attached.

Reward cards

Reward credit cards reward you for spending on your card. Rewards can vary but usually come in the form of points, vouchers or air miles.

Cashback cards

Cashback credit cards are a type of reward card, but instead of points, you receive cashback on your spending. Typically, you automatically earn a percentage of whatever you have spent on the card in cashback.

Travel cards

Travel credit cards are designed with features that make using your card abroad easier. These include no fees for foreign transactions and often no fees for cash withdrawals made while overseas.

Credit cards for bad credit

Not everybody has a squeaky clean credit score, and there are cards that are more likely to accept applicants with a poor credit history. Credit cards for those with bad credit often include features to help manage credit accounts better, such as a lower credit limit and a credit rebuilder feature. However, they typically have higher interest rates.

What are the advantages and disadvantages of credit cards?

While a credit card can be a helpful financial tool, it’s helpful to look at both the advantages and disadvantages to fully understand whether a credit card is right for you.

Advantages of having a credit card

  • Good for emergencies – Credit cards can act as a source of funds in times of emergency.
  • Safer than cash – Using a credit card is safer than carrying a large amount of cash with you.
  • Good for big purchases – Credit cards can enable you to buy expensive products immediately and spread your payments over time.
  • Purchase protection – Cardholders have additional protection if goods bought are faulty or if there is any other kind of problem with a purchase. This is covered under Section 75 of the Consumer Credit Act.
  • Can boost your credit score – Credit cards when used correctly (i.e. staying within your credit limit and making at least the minimum payment amount) can boost your credit score and therefore improve your ability to qualify for other loans or credit.
  • Extra perks – Some credit cards let you earn great perks and bonuses, including cashback, air miles and discounts.

Disadvantages of having a credit card

  • It’s easy to overspend – It is easy to overextend yourself and spend more than you can afford when using a credit card. This could land you in debt.
  • Interest can add up – Interest charges can quickly rack up if the total monthly balance is not repaid in full.
  • Can damage your credit score – If you miss a payment, you can hurt your credit score, which can then affect your ability to borrow in the future.
  • Additional fees – While it’s possible to find cards that don’t have too many fees, you could find yourself paying extra fees or penalties for missing a payment or withdrawing cash. 

Who is eligible for a credit card?

To be eligible for a credit card in the UK, you typically need to: 

  • Be 18 and over 
  • Live in the UK permanently

You can apply for a credit card online, either through the provider’s own site or through a comparison site. Alternatively, some providers allow you to apply in branch or over the phone. You usually need to provide your personal details and information regarding your income and outgoings. Sometimes you’ll need to share details about your UK bank or building society account.

If the option is available, it could be a good idea to use an eligibility checker before applying. This is a ‘soft search’ to see how likely you are to be accepted for the card. This search doesn’t leave a trace on your credit report.

Even if you don’t use an eligibility checker, you should always check the eligibility criteria before applying for a card. Some card providers have a minimum income requirement or prefer applicants to meet a certain credit score threshold. If your application is rejected, this can negatively impact your credit score, so it is worth checking you are eligible before applying for a card.

Finally, not all applicants are guaranteed the promotional offer. Lenders are required to give the headline rate to 51% of applicants, but the remaining 49% may be offered a different rate or interest-free period. This will depend on factors such as your credit history and personal financial circumstances.

How can you choose the best credit card for you?

There are so many credit cards available that it can be difficult to know which one is best for you. Ultimately, the right card for you is the one that most closely matches your needs, habits and patterns of use. These three steps can help you identify the best card for you.

1. Determine how you’ll use the card

For example, are you planning to make a large purchase and need several months to pay it off? In this case, you could go for a card with a 0% introductory rate. Perhaps you’d like to transfer a balance from a card with a higher interest rate. In this case, a 0% balance transfer card would be the best option.

2. Make a plan for how you’ll repay what you owe

If you plan to pay your balance in full each month, then a card’s interest rate is of less concern. In this case, you’ll want a card with a longer grace period and no annual fee. If you don’t intend to pay off the balance each month, look for a card with a low interest rate.

3. List the benefits that are important to you

Common rewards and perks offered by credit cards include cashback, air miles and discounts on products. Decide which of these perks are most important to you and look for a card that offers the best mix. Keep in mind, however, that some of these perks might come at a cost. This is usually in the form of a high annual fee, so make sure the benefits outweighs the cost.

The Motley Fool’s top credit cards

Once you know what type of card you want, you can start shopping around and comparing cards. Here at The Motley Fool, we have compared credit cards across many different areas and focused on the key features and benefits that are likely to matter the most when you’re choosing a new card.

You can explore our top picks in each category, taking into account the length of any interest-free periods, the regular APR, cashback offers, loyalty points and much more!

To see our top picks for rewards and cashback credit cards, check out our featured rewards credit cards in the UK.