What is a credit card? A credit card is a payment card issued by a financial institution—typically a bank—that allows the cardholder to borrow funds to make purchases. The cardholder agrees to repay the borrowed amount, usually with interest, over time.

Unlike debit cards, which draw funds directly from a linked bank account, credit cards provide access to a line of credit that can be used for purchases up to a predetermined limit. In essence, credit cards are short-term loans, offering consumers the flexibility to pay for goods and services now and repay later.

How Do Credit Cards Work?

When a cardholder makes a purchase using a credit card, the transaction initiates a multistep process. The merchant submits the transaction details to their acquiring bank, which then forwards the information to the credit card network. The network validates the transaction and routes it to the cardholder's issuing bank for authorization. If approved, the issuing bank pays the merchant, and the cardholder becomes responsible for repaying the transaction amount to the bank.

Key Understanding #1: Credit Cards Are Lines of Credit.

Credit cards provide a line of credit, meaning that cardholders can borrow up to a certain credit limit set by the issuing bank. The credit limit is determined based on factors like the cardholder’s creditworthiness, which is assessed using their credit score, income, and other financial factors. Once the credit limit is reached, the cardholder cannot make additional purchases without repaying part of the balance.

Key Understanding #2: Credit Cards Are Revolving Lines of Credit.

Unlike traditional loans where borrowers make fixed monthly payments over a set period, credit cards offer a revolving line of credit. This means cardholders can carry a balance from month to month, as long as they make the minimum payment by the due date. If the cardholder chooses to carry a balance, they will incur interest charges on the amount owed, which can accumulate over time. However, if the cardholder pays off the balance in full each month, they can avoid paying interest altogether.

Key Understanding #3: Credit Cards Typically Charge High Interest Rates.

Credit cards generally come with higher interest rates compared to other forms of borrowing. The interest rate on a credit card is referred to as the Annual Percentage Rate (APR). The APR can vary depending on the cardholder's credit score, the specific credit card, and whether the cardholder has a promotional interest rate. Those who carry a balance from month to month will face interest charges, and if the balance remains unpaid for an extended period, the accumulated interest can quickly become overwhelming.

Key Understanding #4: Credit Cards Offer Cash Advances (But They Are Expensive).

Credit cards often allow cardholders to access cash through a cash advance feature. However, cash advances come with high fees and interest rates that start accruing immediately, without any grace period. In addition to the interest charges, cardholders may be subject to a cash advance fee, which can make this option very costly. As a result, cash advances should be used sparingly and only in emergencies.

Key Understanding #5: Some Credit Cards Offer a Rewards Program.

Many credit cards offer rewards programs that allow cardholders to earn points, cashback, or miles for each purchase they make. These rewards can then be redeemed for travel, merchandise, or statement credits. While rewards programs can be a great way to earn something back from everyday spending, cardholders should carefully evaluate the associated fees, interest rates, and annual charges to determine if the rewards are worth it. In some cases, the cost of maintaining a rewards credit card may outweigh the benefits.

Key Understanding #6: Credit Cards Can Cause You to Spend More.

Studies have shown that using credit cards can result in spending more. This occurs because the pain associated with paying for an item is delayed. The delay makes it easier to swipe the card more frequently and less thoughtfully. Because of this, credit cards are probably best avoided for those who struggle to stay within their budget, are living paycheck-to-paycheck, or already carry credit card balances.  

Key Understanding #7: Credit Cards Pose Significant Risks.

While credit cards offer convenience and flexibility, they come with significant risks if not used responsibly. The most prominent risks include:

• Accumulating debt: Carrying a high balance on your credit card can quickly lead to unmanageable debt, especially if only the minimum payment is made each month. The high-interest rates on outstanding balances can make it difficult to pay off the debt over time.
• Damaging your credit score: Failing to make timely payments or maxing out your credit limit can hurt your credit score, which can affect your ability to borrow money in the future and even increase the interest rates on any future loans.
• Penalty fees: Late payments can result in penalty fees, and repeated late payments can lead to higher interest rates and even damage to your credit report. Additionally, many credit cards charge fees for exceeding your credit limit or for foreign transactions.
• Legal consequences: In extreme cases, failure to repay credit card debt may lead to legal action, further damaging your financial standing.

To avoid these risks, it is essential for cardholders to use credit cards responsibly and understand the financial implications. This means:

• Monitoring spending habits and avoiding unnecessary purchases.
• Creating and sticking to a budget.
• Paying bills on time to avoid late fees and interest charges.
• Avoiding carrying a high balance or maxing out the credit limit.

Credit cards offer convenience and flexibility to make purchases. However, they also come with significant risks, particularly if not managed carefully. If you are currently struggling to stay within your budget or already have credit card debt, it is probably best to avoid them.