How Do Credit Cards Work?

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Credit cards are a great tool to help you make the most of your finances. But if you think of them as magical pieces of plastic that let you buy whatever you want, you could be in for a rude awakening down the line. Understanding the basics of credit cards will allow you to take advantage of the numerous benefits they provide while avoiding the pitfalls.

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Credit account basics

A credit card is tied to a credit account, which is just a loan account. Unlike a car loan or a mortgage, however, credit accounts offer a revolving line of credit. Users can take money out (by purchasing goods and services or taking out a cash advance) and pay it back at their convenience.

Each account will have its own credit limit. That's the maximum balance a user can carry on their account. Separately, the account might have a cash advance limit, which is the maximum amount the bank is willing to extend as a cash withdrawal from the account.

The bank will provide an interest rate for both the regular balance as well as cash advances. If a user doesn't pay off his balance in full every month, or takes out a cash advance at any time, the bank will start compounding interest daily. That means interest will start piling up quickly.

If you don't want to pay off the entire balance, the bank will issue a minimum payment. This is usually a percentage of the balance or the bank may set floor price if the percentage falls below it. This is the amount you must pay every month to keep the account in good standing.

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How credit card companies make money

There are a lot of different ways for banks to make money from credit cards. It's important to understand, banks don't always make money off of cardholders, and you can be a great customer for a bank even if you don't pay them any fees directly.

Credit card companies earn revenue every time you use your credit card at a merchant. They take a few pennies plus a percentage of every sale. That's why credit card companies offer massive sign-up bonuses if customers show they can regularly spend a lot of money on their credit cards. Those fees also go toward providing cash-back and travel point rewards, as well as additional perks like price protection and extended insurance.

That said, credit card companies can still make a lot of money off their cardholders. The main ways cardholders end up paying for their credit cards are:

  • Annual fees -- high-end credit cards often charge annual fees. The fees help cover the costs of the added benefits and rewards compared to no-fee credit cards.
  • Other fees like late fees, balance transfer fees, foreign transaction fees, and cash advance fees. Your credit card will come with a whole fee schedule detailing all the fees associated with your account.
  • Interest. Credit cards typically charge some of the highest interest rates in commercial lending. While cardholders get a grace period of about 25 days after their statement closes to pay off their balance interest-free, be aware that cash advances start accumulating interest immediately.

Credit card rewards

One of the big draws of credit cards is the rewards. Rewards come in two forms.

Sign-up bonuses reward new members for signing up for a new credit card and meeting a certain spending threshold within a specific time frame. These bonuses are viewed as a marketing expense by the credit card companies to bring in new applicants. They usually act as a loss leader, as the banks are hoping to establish long-term relationships with customers after they sign up.

Rewards on everyday spending like cash back or travel points are paid for through the interchange fees mentioned above. Credit card companies are able to buy points from travel partners at a discount since they buy in bulk, spending much less per dollar of spend on the credit card than they take in. Cash-back credit cards usually put a cap on bonus spending, so the economics still work out in their favor.

Rewards on everyday spending are a win-win for consumers and the credit card companies.

Other credit card perks

Often overlooked are the additional benefits of using a credit card for your purchases. Many credit cards offer additional benefits like price protection and extended warranties. You can also get free rental car insurance if you use the right credit card to pay for the rental.

These perks are relatively easy to use, but many cardholders forget about them or don't even know they exist. You can look up how to use services like price protection online at your credit card issuer's website. A full list of benefits should be available in the literature sent with your card or online.

How credit cards impact your credit score

Credit cards can actually be great for building your credit score. If you use a credit card responsibly, stay below the credit limit, and pay off the balance in full and on time every month, you could see your credit score improve with the addition of a credit card. Lenders like to see that you can responsibly use all kinds of debt, including revolving lines of credit. Adding diversity in loan types to your credit report improves your score.

You'll also see a bump from decreasing your credit utilization. That's the ratio of debt to available credit. People with the best credit scores keep their credit utilization below 20%.

Now that you know how credit cards work, how credit card companies make money, how to earn rewards and use credit card perks, and how they impact your credit score, you can make the most of them. Here are some of The Motley Fool's top credit card picks.

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