What is a credit card and how do they work?
A credit card is a financial product that lets you borrow money from a bank or credit card provider to make purchases, withdraw cash, or pay bills. Instead of using your own funds, you use the bank’s money (up to a predetermined limit) and repay later, either in full or in instalments.
How do credit cards work? Â
These are the key components of a credit card:
Credit limit: This is the maximum amount you can borrow on your credit card. For example, if your limit is £2,000, you can spend up to that amount. If you try to exceed it, your transaction may be declined, or you might even face an over-limit fee.
Billing cycle: This is the period of time during which your purchases are tracked (usually 30 days).
Grace period: This is the time you have to pay your balance in full without incurring interest.
Interest rate:Â This is the cost, expressed as a percentage, you pay for borrowing money when you do not pay your full balance by the due date.
APR: This is the total cost of borrowing on a credit card, including interest and fees, expressed as a yearly percentage.
Minimum payment: This is the smallest amount you must pay each month to avoid further penalties.Â
When you use a credit card, you are essentially borrowing money from the credit card provider, up to your established credit limit. Each time you make a purchase, the amount is added to your balance. At the end of the billing cycle, you will receive a statement showing how much you owe. You can either:
Pay the total amount due within the grace period to avoid interest charges. In this scenario, you borrowed money for free - nice!
Pay the minimum payment (usually a percentage of your balance) to keep your account in good standing. However, you will be charged the interest rate on the remaining balance.
Pay more than the minimum payment but less than the total balance. This reduces the amount of interest you owe, but you will still be charged interest on the remaining balance.
How do credit card interest rates work​?
Let's say you have a balance of £200 on your credit card, with an APR of 20%.
If you pay the full £200 by the due date, you pay £0 interest.
If you only make a minimum payment of £10, the remaining balance of £190 will incur interest.
At a 20% APR, this means you would pay approximately £3.17 in interest for the month (£190 x 20% ÷ 12 months). It's a little more complicated than this because interest compounds monthly, but we'll keep the maths simple here.
If you continue to carry a balance, the interest continues to accumulate, making it harder to pay off.
Tip: Don’t forget, if you don’t make your full repayment at the end of the month, you will have accrued interest from the date of each purchase, not your statement date.
How do monthly statements work?
At the end of each billing cycle (usually 30 days), you’ll receive a credit card statement showing:
The amount you’ve spent
The minimum repayment required
The due date for repayment
You can either pay the full amount (recommended to avoid interest) or pay the minimum amount (but the remaining balance will accrue interest).Â
You have the flexibility to choose whether or not to pay off your balance in full, or to make use of your line of credit and pay off your balances in installments. Â
Different types of credit cards
There are various types of credit cards available across the market, each designed for different financial needs:
Standard credit cards: Basic cards for everyday use.
Rewards credit cards: Earn cashback, points, or air miles for spending.
Balance transfer cards: Transfer an existing balance from another card at a lower interest rate.
0% purchase cards: Get interest-free periods for purchases for a set time.
Credit builder cards: For those with a poor or limited credit history.
How does a credit card impact your credit score?
A credit card can improve your credit score if you make on-time payments and keep your credit utilisation low.Â
Making on time payments is an incredibly important factor. This is because a perfect payment history proves you are reliable.
Credit utilisation is how much of your available credit you're actually using. To maintain a good credit score, aim to use less than 30% of your limit.
However, missed payments or maxing out your limit can harm your credit score as you may not be seen as financially responsible.
Credit card benefits
Build your credit history: Regular, on-time payments can improve your credit score.
Interest-free period: If you pay in full every month, you can borrow at no cost.
Protection on purchases: Section 75 of the Consumer Credit Act covers purchases over £100, which means you’ll get your money back in the case of fraud.Â
Are there any risks?
There are some risks associated with using credit, however, if you keep your expenses low and always make your repayments on time - these risks may not apply to you.
High-interest charges: Carrying a balance month-to-month can lead to expensive interest fees.
Temptation to overspend: Easy access to credit can lead to unmanageable debt.
Late payment fees: Missing payments can result in penalties and a lower credit score.
How do you use credit cards responsibly?
Credit cards are a powerful financial tool when used responsibly. They can provide convenience, help you build credit, and even offer rewards. However, it is essential to understand how they work and to use them wisely.
Pay your balance in full: To avoid interest charges you should clear your statement balance each month, if you can afford to.
Keep credit utilisation low: Try to use less than 30% of your credit limit.
Monitor your spending: You need to be extra careful when borrowing to spend - make sure you stay within your means.Â
Set up direct debits: Ensure you never miss a payment.
Stay within your credit limit: Avoid over-limit fees.
Avoid cash withdrawals with your credit card: These often come with high fees and interest.
This blog is for informational purposes only and does not constitute financial advice. Please speak to a qualified financial adviser before making financial decisions.