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How Do Credit Cards Work?

It seems to be an unwritten rule in life that once you turn 18, you have to get a credit card. Maybe you’ve thought that having a credit card means you’re finally an adult. Maybe your parents told you that you need one for emergencies. Or maybe you’ve bought into the lie that you need one “to get ahead in life.”

Whatever you’ve heard about credit cards and how they work may not be the full truth. Why? Because credit cards are actually designed to build debt—not wealth. That’s right, credit card companies’ main goal is to let you borrow money until you can’t pay it back in full. Because that’s when they start charging you interest (and raking in the dough).

We’re pulling back the curtain to show you the bad, the worse, and the ugly parts of the credit card industry—and just how dangerous it can really be.

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What Is a Credit Card?
How Do Credit Cards Work?
How Does Credit Card Interest Work?
Credit Cards vs. Debit Cards: What’s the Difference?
What Are the Types of Credit Cards?
What’s the Cost of Using a Credit Card?
What’s the Best Kind of Credit Card?
Do I Need a Credit Card?

What Is a Credit Card?

A credit card is a payment option that allows you to buy what you want right now (with money you don’t have) and pay for it later. Sounds too good to be true, right? That’s because it is.

Using (and abusing) a credit card is a one-way ticket to debt island. And once you’re on the island, it’s even harder to get off. Don’t believe us? Listen to this: Right now, the current personal debt in America is at whopping $14.64 trillion.1 And credit card debt alone adds up to $770 billion.2 

So, how did we get here?

Here’s a quick history lesson: Before 1920, borrowing money (in the form of credit) wasn’t the norm. Installment credit (dishing out a down payment and promising to pay the rest month after month) popped up to “help” people “buy” things they couldn’t afford. Then more and more types of credit crept in, with Visa, Mastercard and American Express credit cards hitting the scene in 1958. People no longer had to wait and save up for something. Talk about instant gratification—on a whole new level.

Now, debt is seen as a normal part of our culture. But don’t let that fool you. Using credit cards won’t make you rich—it’ll just make you another statistic . . . swimming in debt and living paycheck to paycheck.

How Do Credit Cards Work?

A credit card is a modern IOU—with strings attached. (So. Many. Strings.) When you use a credit card to make a purchase, you’re borrowing from a credit card company, because the card isn’t attached to your bank account. It’s attached to their bottom line.

Credit cards are a type of revolving debt. That means the more you charge on the card, the more you owe. And the more you pay back, the more you can spend.

Here’s how credit cards work:

Get approved.

Wait . . . you’re telling us you have to prove that you can handle debt? Ridiculous, right? But it’s true: Credit card companies will check your credit score, your borrowing history and your income. They want to know how likely you are to pay them back. If you seem like a good candidate (the bar is very low), then they’ll issue you a shiny new card with a credit limit based off your credit score.

Activate your card and start swiping.

After you get your new plastic, call or text the number on the back of the card (or go to their website), give them your card details, and viola! You’re the “proud” owner of a new line of credit and whatever you just swiped your card for.

Pay your balance (plus interest).

At the end of each billing cycle, you’ll get a credit card statement that lists your current balance. You have to make at least the minimum payment by the due date each month. (The minimum payment depends on your credit card balance and what kind of card you have.)

If you miss paying by the due date, you’ll get hit with late fees. And if you don’t pay off all of your balance by the end of the billing cycle, you’ll get smacked with interest.

Say goodbye to your paycheck.

If you’re not careful, credit cards will lead you straight into a never-ending cycle of debt. Next thing you know, you’ll be spending your hard-earned paychecks on a steak dinner you ate . . . last month. That won’t pay the light bill.

How Does Credit Card Interest Work?

Credit card interest is money charged to you if you only make the minimum payment on your credit card balance.

Here’s the deal: Interest is how credit card companies make most of their money. That means they want you to make just the minimum payment, so they can charge you more interest—and make themselves more money. So, the bigger your credit card balance, the more you’ll fork over in interest each month.

This often shows up on your credit card statement as a finance charge (it’s the same thing). And that finance charge depends on something called the annual percentage rate (APR).

What is APR?

An APR (annual percentage rate) is the rate credit card companies charge you every single month for borrowing from them. And each kind of credit card (we’ll get into those in a moment) comes with its own APR.

The average APR on credit cards is at 16.3%.3 That’ll hurt.

There are two different kinds of APR: variable and fixed. 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).

Psst, watch out for introductory rates too. Credit card companies like to use low interest rates to hook you into signing up for their card—but it doesn’t take long before the trial period is over and your rate skyrockets.

What if I pay my balance every month?

According to our quarterly research, four in 10 Americans who have a credit card carry a balance and are racking up interest. And get this: One in five have maxed out a credit card before—meaning they hit that credit limit and have an embarrassing story to go with it. (“Sir, your card has been declined. Do you have another?”)

The truth about interest is that you end up paying more for things in the long run as you hand over your hard-earned money to a company that’s getting rich off of you falling behind on payments. Gross. Yuck. No.

Credit Cards vs. Debit Cards: What’s the Difference?

They look the same. They feel the same. But they definitely don’t work the same. It’s 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. Debit cards take your own money directly out of your bank account—so you actually own what you spend your money on. You’re also more accountable to yourself (and your income) when the money is physically leaving your bank account, rather than racking up on a credit card bill.
  • Convenience: Debit cards offer you 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. You can even buy airline tickets or rent a car with a debit card. A debit card can get you anywhere a credit card can—except into 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 do anyway), so you can catch any suspicious charges.
  • Rewards: This is one of the biggest arguments we hear: What about my cash back? I need my reward points! Okay, hear us out. First of all, debit cards are starting to get on the rewards train and offer perks—without the risk of interest and all those fees we unpacked earlier. And with a credit card, even if you say you’ll pay off your balance at the end of every month, you don’t have to—and don’t forget: Credit card companies don’t want you to. The risk is just too high for some measly credit card rewards.

Second, we conducted the largest survey of millionaires (10,000 to be exact), and do you know how many of them said credit card rewards were the key to their money success? Zero. Absolutely none of them. 

And finally, is it really about the reward points? Or is this a cash flow problem? Don’t let credit cards and their rewards slap a bandage on a deeper money issue. What you really need is a budget to put you in control of your money and an emergency fund to help you feel secure about facing whatever life throws at you. You work hard for your money. Make your money work for you—not the credit card companies. 

What Are the Types of Credit Cards?

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 (like putting your pet’s face or your favorite team’s logo on the front of your card), 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.
  • Rewards credit cards: As the name tips off, rewards cards offer rewards like cash back, points or travel perks. These cards may seem like a sweet deal, but that makes them even more dangerous—most of the time, credit cards with rewards also have higher interest rates.
  • 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 and suddenly inactivated while you’re trying to pay for your date’s crème brûlée.
  • Retail credit cards: Retail credit cards can only be used at certain stores. Cashiers often hit you with this temptation at the checkout with promises of a percentage off your purchase. You think, Well, I do shop here a lot. I mean, who doesn’t want a discount? But pretty soon, you’re buying useless stuff—just for the discount.
  • 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 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.

What’s the Cost of Using a Credit Card?

Credit card companies love to nickel-and-dime people. And think of this: According to our quarterly research report, they’ve got eight out of 10 Americans in their hands, so any tiny fee sprinkled here and there adds up to some big bucks for them.

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. The Credit CARD Act says your first late fee can’t be more than $28, and any late fee after that in the next six months can go up to $39 but never more than the minimum payment itself.4 Still, a fee is a fee.
  • 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 percentage 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 bank teller. You get charged a percentage 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. Talk about a punch in the gut!
  • 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.5 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 to cover it.
  • Card replacement fee: If you lose your credit card, you may be charged a fee to get a new one—and it’s even higher if you need it in a hurry.

What’s the Best Kind of Credit Card?

There isn’t one. Seriously—credit card companies say they have your best interest in mind. But they’re really just interested in that 16.3% average interest rate they’re looking to suck out of you. Multiply that by the amount of credit card debt in America (remember—it’s at a staggering $770 billion), and we’re talking about a $125 billion profit for credit card companies on interest alone. $125 billion!

That’s jacked up.

Did you read that number with clenched teeth? Did you get angry? It’s time to say no freaking more.

Do I Need a Credit Card?

Absolutely not. Let us repeat: You do not need a credit card. Nope, not one, not two, not three. And not even for emergencies.

You’ve probably been told that you need a credit card on repeat since you were old enough to know what a credit card even is. But since when is it a good idea to follow the crowd? (Hint: rarely ever.)

So, if you’ve got a credit card, it’s time to cut it to shreds. It’s time to tell those dumb credit card companies they can’t hold you back anymore. This is your income. This is your money. And you’re spending it on what you need today—not that steak dinner from last month or that leather jacket from last year. You’re saving it for your future. You’re. Moving. Forward.

Want to build real wealth—the kind without debt? With Ramsey+ you’ll learn how to save for emergencies, live without debt, and budget with confidence. It’s the proven way to get your finances (and your future) in tip-top shape. Want to take a peek? Sign up for your free trial right here.

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.

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