You could win $5,000! Enter our giveaway.

Skip to Main Content

How Credit Cards Work

Maybe your parents gave you one when you turned 18. Or maybe you only got one for “emergencies.” Either way, someone convinced you that you needed a credit card to be successful in life. But we’re here to tell you that’s a straight-up lie!

If you haven’t already figured out, we’re anti-credit card around here. Why? Because credit cards are designed to build debt, not wealth. And the higher your credit card balance, the higher your stress level. Still, many people sign up for credit cards without reading the fine print first. And that’s just what those money-hungry credit card companies in their shiny towers want.

Time to pull back the curtain and find out exactly how credit cards work. Once you realize how dangerous this game really is, you’ll want to steer clear of credit cards and debt for good.

What Is a Credit Card?

A credit card is a piece of plastic that lets you pay for things even if you don’t have the money. Sound too good to be true? That’s because it is.

money icon

Take control of your money with a FREE Ramsey+ trial.

A credit card is tied to its own account instead of your bank account. So, when you use your card to make a purchase (anything from a pair of flip-flops to a pair of headphones), you’re actually borrowing money from a credit card company—kind of like a modern IOU.

But having a credit card doesn’t mean you can spend to your heart’s content. There are credit limits, which are basically like the allowance your parents gave you when you were a kid. You can only borrow up to a certain amount on a card for every billing cycle (the amount of time between payments—usually a month). And your credit limit depends on things like your income and credit score (aka your borrowing history).

Credit cards are a type of debt—revolving debt to be exact. The more you charge on the card, the more you owe. And the more you pay back, the more you can spend. That’s why it’s called a billing cycle—because it’s one big cycle of debt! And at the end of each billing cycle, you’ll get a credit card statement that lists your current balance (how much you owe).

If you want the credit card company to let you keep using your card, you have to at least make the minimum payment by a specific date each month. The minimum payment depends on your credit card balance and what kind of card you have. If you miss sending in the minimum payment by the due date, you’ll get hit with late fees. And if you don’t pay off all your card balance at the end of the billing cycle, you’ll get charged interest.

How Does Credit Card Interest Work?

Credit card interest is money charged just for the act of borrowing. Like we said, if you don’t pay off your entire balance on your credit card each month, you will be charged interest. In 2018, only 47% of Americans with credit cards actually paid them off every month.1 That means over half of people with credit cards carry a balance month to month and end up paying interest. That’s a lot of wasted money!

You may see interest show up on your credit card statement as a finance charge (it’s the same thing). Your finance charge depends on something called the annual percentage rate (APR). Credit card companies use APR to figure out how much to charge you for borrowing each month. And each kind of credit card (we’ll get into those in a moment) comes with its own APR.

The main thing to keep in mind is the difference between variable APR and fixed APR. With variable APR, your interest rate can change because it’s based on the national average. A fixed APR means your rate tends to stay the same. But depending on the kind of credit card you have, there are some reasons why your fixed rate could change (like if you’re more than 60 days late on a payment).

And you should also watch out for introductory rates. This is when credit card companies use low interest rates to hook you into signing up for a card—but it doesn’t take long before the trial period is over and your rate skyrockets.

Here’s the deal: Interest is how credit card companies make most of their money. That means they want you to only make minimum payments, so they can charge you more interest—and put more money in their pockets. The bigger your credit card balance, the more you’re going to be forking over in interest and the longer it could take to pay all of it off. Paying off your credit cards each month is one way to dodge interest, but if you really want to avoid debt, just stay away from credit cards altogether!

What Are the Different Types of Credit Cards?

There are a lot of credit cards out there, but before you can start using any of them, the first thing you have to do is get approved. Card companies will check your credit score and how much you’ve used credit cards in the past. Then they’ll offer you the credit cards they’ve approved for you. You may even get a letter in the mail from some of the bigger credit card companies saying you’ve been preapproved.

But don’t forget that a credit card company’s only priority is to make money. They may offer you all sorts of perks to sign up for one of their cards (they may even let you put your pet’s face on the front), but don’t fall for these gimmicks. Let’s look at some of the most common types of credit cards and what they mean for users:

  • Unsecured Credit Cards: These are your basic, run-of-the-mill credit cards made for people with decent credit. They don’t come with a lot of perks, so the interest rate is usually lower. But don’t be fooled—the average credit card still has the power to put you in some serious debt, one monthly balance at a time.
  • Rewards Credit Cards: Rewards cards (obviously) offer rewards like cash back, points or travel perks. These cards may seem like a sweet deal, but be careful—most of the time, credit cards with rewards also have higher interest rates. Stay tuned for our rant about why credit card rewards are never worth the trouble.
  • Student Credit Cards: Since most college students have little to no credit history, credit card companies created special cards just for them. These cards usually have low credit limits and don’t charge annual fees. But an 18-year-old with the ability to rack up debt is pretty dangerous. Thankfully, the Credit CARD Act of 2009 keeps credit card companies from going onto college campuses or bribing students with free T-shirts to sign up for a credit card. But that doesn’t mean students don’t still get targeted—so watch out!
  • Charge Credit Cards: These are cards without credit limits, so you can charge as much as you want. But here’s the catch: You have to pay off your entire balance in full at the end of the month. There’s no finance charge with this kind of card, but if you miss a payment, you can get hit with late fees and purchase limits—or you might even have your card canceled.
  • Retail Credit Cards: Retail credit cards can only be used at certain stores. These are super popular because the cashier will usually offer you a discount for signing up for the card. You think, Well, I already shop here anyway. I might as well get their credit card since I’m such a loyal customer. But pretty soon, you’re buying things you don’t need just because you want the discount. And before you know it, you’re in debt to your favorite clothing store. Awkward! Trust us: That 5% cash back isn’t worth all the money you’ll spend to get it.
  • Secured Credit Cards: If someone has no credit history or bad credit (like if they went through a bankruptcy), the bank or credit card company may recommend a secured credit card. With these, you first have to put down a security deposit, which acts as your credit limit. But listen, if you’ve already been burned by credit, the last thing you need is another credit card.
  • Subprime Credit Cards: Subprime cards are the worst of the worst! They’re usually marketed toward people with terrible credit history, so they have super high interest rates and crazy fees. If someone has already tried to play the credit game and lost, this is typically the only kind of credit card they would be approved for. But subprime credit cards only help these people dig themselves a deeper hole.

What Are Credit Card Fees?

Credit card companies love to nickel-and-dime people. What may seem like chump change to you can add up to some big bucks for them. And if you can think it, there’s probably a fee for it. Here are some of the most common fees credit card companies can add to your monthly balance:

  • Annual Fee: Did you know you can get charged just for the “privilege” of having a credit card? Yeah. Ridiculous, but true. Not all credit cards have an annual fee, and sometimes the credit card company will waive the fee for the first year. But once it kicks in, the annual fee can be anywhere from $5 to $500, depending on the card. Um, no thank you!
  • Late Fee: This is a charge you get for being (you guessed it) late. More specifically, it’s when you’re late sending your minimum monthly payment. But the Credit CARD Act says your first late fee can’t be more than $28, and any late fee after that can’t be more than $39.2
  • Balance Transfer Fee: Let’s say you have more than one credit card and you want to transfer a balance from one card to another. Well, that’s going to cost you—you’ll get charged a percent of the amount you’re moving over.
  • Cash Advance Fee: Because credit card companies don’t want you to discover the power of cold, hard cash, they charge you for cash advances. This is any time you use your credit card to take out cash from an ATM or from a bank teller. You get charged a percent of the amount you took out, and most credit cards have a super high APR for cash advances. But unlike other purchases, cash advances don’t have a monthly grace period. That means they’ll start tacking on interest the moment the cash is in your hand, not just when the billing cycle is up. Yikes! You’re better off cutting up that card and using cash you’ve saved instead.
  • Over-the-Limit Fee: Not every credit card user has to deal with this—you have to sign up for this option before purchases over your credit limit can be approved. But if you do agree to let those purchases go through, you’ll face a fee of up to $25 the first time you go over your limit, and up to $35 if you go over more than once in six months.3 But either way, you can’t be charged more than the amount you overspent.
  • Expedited Payment Fee: If you’re afraid you won’t get your minimum payment in before the due date, you can always pay an expedite fee to make sure your payment isn’t late. Yes, it’s less than a late fee, but do you really want to be charged extra just to pay a bill on time?
  • Foreign Transaction Fee: If you’re traveling or even if you’re just buying something online with anything other than U.S. dollars, you may have to pay extra for a foreign transaction fee.
  • Returned Payment Fee: You get charged this fee if the credit card company has to send your payment back to you because they can’t process it—like if it wasn’t the right amount or if you don’t have enough money in your bank account.
  • Card Replacement Fee: If you lose your credit card, you may be charged a fee to get a new one—more if you need it in a hurry.

Credit Cards vs. Debit Cards

They look the same. They feel the same. But they definitely don’t work the same. Time to settle the great credit vs. debit debate. Here’s how credit cards stack up against debit cards:

  • Spending: While there’s nothing as satisfying as paying with cash, debit cards are the next best option. Because debit cards take your own money directly out of your bank account, you have to actually keep up with how much you have. But with credit cards, it’s harder to keep track of how much you’re spending because it’s not your money. It might as well be Monopoly money.
  • Convenience: Debit cards offer the convenience of cash without having to carry around a bunch of Benjamins. Just about anywhere that takes a credit card (retail stores, gas pumps, online, etc.) will also take a debit card. Even buying airline tickets or renting a car is totally possible with a debit card. A debit card can get you anywhere a credit card can—except in debt.
  • Security: We hear this one all the time, but a debit card is just as safe as a credit card. If your debit card is backed by a company like Visa or Mastercard (and you run it as credit when you make a purchase), you have the exact same protections as a credit card. Just make sure you’re checking your bank account often (which you should be doing anyway), so you can catch any suspicious charges.
  • Rewards: But I get cash back! What about my precious points? Listen, credit card rewards are one of the biggest jokes out there. If you’ve got a card with 5% cash back, you’d have to spend $100 just to get $5. And did you know about 3 out of 10 credit card users don’t redeem their rewards?4 That’s because many of them expire before you can even use them!

Debit cards may not have rewards, but you know what else they don’t have? Interest. Yep. Like we said before, rewards cards usually have higher interest rates. The more you spend because you want that free flight, the harder it’ll be to pay off that entire balance at the end of the month. And the more likely you are to owe the credit card company a big cut. Plus, let’s not forget about those annual fees that could be just as much as a flight from New York to L.A. Still think those points are worth it?  

Are Credit Cards a Good Option?

That’s a good one! Oh wait, you were serious? The short answer: No, they’re never a good option. And here’s why: The national credit card debt is over $1 trillion—that’s millions of people who are drowning in debt.5 In fact, American households with credit card debt carry an average balance of $14,564!6,7,8 And credit card companies make over $100 billion a year from credit card interest.9 With numbers like these, clearly something’s wrong.

The credit card is the most aggressively marketed product in today’s culture. And at some point, people started believing that getting a credit card is just another rite of passage, like getting a driver’s license or graduating high school. But since when does borrowing money make you a responsible person?

Maybe you were told you need a credit card to build up your credit (aka FICO score). Credit card companies want you to bow down to the “great and powerful FICO” because it means you’ll keep using their products. The truth is, a FICO score is really just an “I love debt” score, and you can live your life without one. Really!

And if you think you’re avoiding debt because you pay off your credit card balance each month, think again. Credit cards are pretty much short-term loans, so carrying a balance means you have debt, even if it’s just for the month. And it only takes one missed payment to trip you up. It’s a game that’s been rigged from the start—but you don’t have to play anymore!

If you’re struggling to live in the present because you’re too busy paying for the past, it’s time for a plasectomy. Consider this your permission to cut up your credit cards and say goodbye to borrowing money for good. If that sounds scary, don’t worry. We have a free trial of Ramsey+ to help. Learn all you need to know about paying off your credit card debt, saving for emergencies, and building wealth. It is possible to live a life without credit and win with money!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.