What Is a Credit Card?

In today's world, it's hard to get by financially without knowing the basics of what credit cards are. Understanding the ins and outs of credit cards, from their benefits and drawbacks to important terminology, will help you use credit to your advantage while avoiding expensive debt.

What is a credit card?

A credit card is a form of payment that allows the cardholder to charge purchases to a card issuer and then pay off those purchases, plus other agreed-upon charges such as interest fees, at a later date. Credit is granted on a revolving basis, meaning the cardholder can charge the card continually up to a pre-specified credit limit, and each time payments are made toward the card's balance, those funds become available again.

How do credit cards work?

Credit cards are a payment method that allows you to make purchases on credit at any time, up to a pre-specified limit. The credit card issuer is charged for each purchase on the understanding that you'll then pay that money back according to the terms and conditions of your credit card.

At the end of each credit card billing cycle, which typically lasts 28 to 31 days, you're sent a credit card statement that details all the purchases you've made during that cycle that you now have to repay. You'll be asked to make a minimum monthly payment at the end of each billing cycle -- typically it's either 2% to 3% of your overall balance or $25, whichever is higher. This minimum payment is required, and missing it can result in a blow to your credit score. While you don't have to pay off your entire balance at the end of each billing cycle, doing so is ideal because you're charged interest (according to your credit card's APR) on the balance you carry over to your next billing cycle.

You must apply and be approved for a credit card. Approval is typically based on your credit report, which is pulled by credit card issuers when you submit your application, although some credit cards will consider other factors.

Credit card pros and cons

Like any other personal finance tool, using credit cards comes with benefits and drawbacks:

Credit cards are one of the most convenient payment methods around. You can pay back your balance over time, which can come in handy if you want to finance a big purchase or cover an unforeseen emergency. Credit cards also come with excellent fraud protection. Most offer zero-liability policies, meaning you won't be liable for any fraudulent charges you report. Credit cards can also be good for everyday purchases. Using them regularly and responsibly will help you build credit. Some cards offer rewards that become more lucrative the more you spend with them. And as long as you pay off your balance in full every month, you won't ever have to pay interest.

However, this temptation to spend can easily lead to overspending. That's why credit cards are notorious for landing people in unmanageable debt. Unfortunately, most credit cards come with relatively high interest rates, which may make it hard to pay down debt if you rack up a large balance. In addition to costing cardholders a lot of money in fees, high balances and missed payments can also wreck your credit.

Types of credit cards

Credit cards come with a variety of different features, and there's no such thing as a one-size-fits-all card. It's important to know what you're looking for and understand the different types of credit cards so you can choose one that best meets your needs. Note that some credit cards come with annual membership fees (typically the cards that offer more generous rewards and benefits), while others are no annual fee credit cards.

Travel credit cards: With a travel credit card, you'll typically earn bonus rewards on travel-related spending, and the rewards you earn can be redeemed for travel such as toward airline tickets or hotel stays. The best travel credit cards come with additional travel-related perks, such as trip insurance, airport lounge access, travel statement credits, and more.

Cash back credit cards: A cash back credit card will earn you money back on purchases. You'll earn it as a percentage of the total purchase price. Some cash back credit cards offer a flat rate on purchases, while others offer bonus cash back in certain categories.

Low-APR credit cards: These cards come in two forms: low-interest credit cards, which offer a relatively low ongoing APR, and 0% intro APR credit cards, which offer a 0% intro APR on new purchases, or sometimes on new purchases and balance transfers, for an introductory period -- often 12 to 20 billing cycles -- after which the higher standard APR is applied.

Balance transfer credit cards: Balance transfer credit cards come with a 0% intro APR on balance transfers for an introductory period of as much as 21 months. A balance transfer credit card can be used to avoid interest fees and so pay down debt more quickly. This is an effective way to get out of debt as long as you're able to pay off the card's balance before the introductory period ends.

Business credit cards: These credit cards are meant to be used for business-related expenses, and activity is sometimes recorded on your business credit report rather than your personal credit report. Business credit cards often come with relevant features like employee credit cards and bonus rewards on business purchases, and they're a great tool for small business owners to easily separate business and personal finances.

Credit cards for bad or no credit: There are a variety of credit cards for bad credit. Cards for rebuilding credit include secured credit cards, which require a security deposit that then acts as the card's credit limit. Other credit cards, like student credit cards, are designed for people with no credit or a thin credit file who want to start building credit from scratch.

Difference between credit and debit cards

Credit cards and debit cards are both card payment methods -- the key difference lies in the way your purchases are funded. When you pay with a debit card, the money comes from a linked checking account, so you can only spend money that you have in your bank account. When you pay with a credit card, the purchase is paid for by the credit card issuer, and you then pay it back.

There are some differences in features as well. Debit cards rarely come with a rewards system or extensive benefits like many credit cards do. Your debit card activity doesn't show up on your credit report or impact your credit score. Debit cards also offer less fraud protection than credit cards. Your liability for fraudulent purchases made on a debit card can range from $50 to $500 (depending on when it's reported), whereas most credit cards come with a $0-liability policy.

Credit card terminology

Here are terms you should understand before applying for or using a credit card.

Credit score: Your credit score is a number rating (between 300 and 850) that's calculated based on the way you've used credit in the past. Lenders and credit card companies use it to calculate the likelihood you will repay your debt. FICO® Scores are most commonly used by lenders to judge creditworthiness.

Credit limit: Your credit limit is the maximum amount of credit that your credit card issuer will extend to you. If you try to charge more than your credit limit to your credit card, the transaction either won't process or your credit card issuer will charge you an over-limit fee.

Available credit: Your available credit is your credit limit minus your current balance. It's the amount of credit you have left on your card that can be spent.

Annual percentage rate: Also known as your card's APR, the annual percentage rate is essentially the cost of carrying a balance on your credit card. A credit card's APR is simply its interest rate.

Annual fee: The annual fee on your credit card is a membership fee that's charged once each year. Cards that charge an annual fee usually do so because they offer additional rewards and benefits that save you money.

Authorized user: An authorized user is a secondary user you can add to your credit card that allows them to make purchases on your account. If you do so, any activity on that account impacts their credit score. But you'll still be on the hook for the entire balance, including any charges they've made.

Billing cycle: A credit card's billing cycle, usually 28 to 31 days, is the length of time between the closing dates on your monthly statements.

Statement balance: Your credit card statement will always include a statement balance, which is the amount you owed when your most recent billing cycle closed. This is the number you need to pay off if you want to avoid interest charges.

Current balance: Your credit card statement will also include a current balance. This number reflects all unpaid charges to the account, including those made after your most recent billing cycle closed.

Minimum payment: The minimum payment will also be displayed on your credit card statement, and it's the minimum amount you have to pay before your payment due date. If you fail to pay this amount, you'll likely be charged a late fee, which can drag down your credit score.

Grace period: The grace period is the number of days between the closing of your billing cycle and your payment due date. If your credit card company offers one, it has to be at least 21 days. This grace period only applies to new purchases, not to balance transfers or cash advances.

Cash advance: A cash advance is when you use your credit card to withdraw cash, usually from an ATM or at your bank. These transactions don't have a grace period and often have a higher APR applied to them, as well as cash advance fees.

Balance transfer: A balance transfer is when you transfer existing debt from one account to another. This is typically done to secure a lower interest rate or more favorable terms, like when a balance is transferred from a credit card with a high APR to a credit card with a low or 0% intro APR on balance transfers.

Secured credit card: A secured credit card is backed by a security deposit that's charged to the cardholder upon card opening and used to mitigate the risk of lending to someone with bad credit. Typically, that security deposit then acts as the card's credit limit.

History of credit

The concept of credit, in one form or another, has been around for thousands of years, but modern consumer credit only became widely available in the 20th century. By the 1950s, many Americans had access to revolving credit accounts with specific stores, and in 1958, Bank of America launched the BankAmericard (now Visa) -- the first general-purpose credit card. American Express and Mastercard soon followed.

Credit reporting and scoring evolved over the second half of the 20th century, making credit accessible nationwide. While there are still populations commonly left out of today's credit industry -- including young adults, immigrants, and the formerly incarcerated -- new credit scoring models and credit products are working to continue broadening access to credit.

Still have questions?

Here are some other questions we've answered:

• How Credit Cards Work: A Beginner's Guide
• How Does Credit Card Interest Work?
• Credit Card Types: Which Fits Your Needs?