How do credit cards work?

Credit cards give people a convenient way to make payments for a huge range of goods and services. It allows you to pay for the things you want to buy, but don’t have the money to pay for now. People often use credit cards to pay for weddings, holidays and so much more. But it’s essential to understand the features and charges that come with a card before deciding which one is right for you.

A credit card is a payment card that allows you to borrow money to pay for any goods or services and repay the amount later.

Depending on the specific features and benefits offered, there are several types of credit cards in the market, such as bad credit credit cards and balance transfer cards.

Understanding how does a credit card work is essential to appreciate the utility of your card.

A bank or financial institution issues a credit card. Every time you swipe your card for a transaction, your card details are sent to the merchant’s bank. After that, the bank seeks authorisation of payment from the card issuer. The issuer verifies your information and pays the amount on your behalf, making you a borrower of that amount. You must repay that amount in full at the end of your monthly billing cycle. If you don’t, the outstanding is carried forward to the next cycle and the card issuer charges you interest.

Here are some key features to help you better understand how credit cards work:

Credit limit

Credit limit refers to the maximum amount you can spend on your card. The card issuer determines it based on your credit history and income bracket. Usually, you can also increase the credit limit or decrease it.

Interest rates

The interest rate refers to the cost of borrowing money. It is a critical component of how credit cards work. As long as you pay off your dues on time, you can avoid paying interest. Most credit card issuers provide the interest rate for the entire year as opposed to on a monthly basis. The interest rate is also known as the Annual Percentage Rate or APR.

Interest-free periods

This refers to the maximum time period, usually 44 or 55 days, during which you are not charged any interest for any transactions on your card. But you can only take advantage of it if you have paid off your outstanding bill in full. In case you miss a bill or only pay a minimum amount, the credit card provider will start charging interest over the unpaid amount and future transactions. The interest-free period starts on the first date of your billing cycle and ends on the payment due date.

Repayments

The repayment amount is the sum total purchases made through the credit card during a billing cycle.

While it is ideal to repay the entire amount on the due date, you can also make a minimum repayment. The minimum repayment amount which is usually 2% of your outstanding, should be paid to avoid paying fees for delayed payment.

If you only pay the minimum amount, the card issuer will still charge you interest on the outstanding balance.

Balance transfer

Those who struggle to manage multiple credit card debts rely on balance transfer credit cards, which allow you to consolidate and transfer multiple high-interest debts to a single card.

You can use the card to repay the transferred debt and other bills and payments at a very low or even zero-interest rate during the introductory period, which is usually between six to 21 months. Once the introductory period expires, the regular interest rate kicks in.

Annual fees

An annual fee is charged on some credit cards for using those cards. The fee is used by banks and financial institutions for maintaining credit cards.

Monthly fees

Instead of charging a lump sum annual fee, some card issuers charge the total annual fee on a monthly basis.

Late payment fees

If you miss paying your credit card dues on time, you may need to pay late fees as penalty. This is in addition to the interest charged on the outstanding amount.

When you use a credit card, you borrow money to fund a purchase. Your card is not linked to your checking account and no money gets debited. The credit card company makes the payment on your behalf, and you must repay the amount by the payment date. If you don’t pay as per the terms of your agreement, you are charged interest.

Your debit card is linked to your checking account. Whenever you use your debit card, the amount gets deducted from your account in real-time. There are no repayments or interest fee involved since you do not borrow funds from anyone.

Help building credit

Credit card repayments can help you build your credit history. Paying off credit card bills on time increases your creditworthiness and boosts your credit score. A good credit score enables you to borrow from the market on more favourable terms.

Credit card rewards

Paying with a credit card can help you earn rewards such as cashbacks on your transactions, air miles that can be redeemed against air tickets, gift vouchers, and much more.

Fraud protection

Most credit card companies protect against fraudulent credit card payments. Usually, you can get reimbursed for the total amount once you notify the card company about the loss and also satisfy them that you didn’t mastermind or aid the commission of fraud in any manner.

Relaxed payment terms

You can make high-value purchases on credit and repay later, as long as your spending is within the credit card limit. Some card companies also allow you to convert the dues into EMIs that you can pay off over time.

To apply for credit cards in Australia, you must be:

• At least 18 years or above
• An Australian citizen, permanent resident, or a Temporary Residency visa holder
• Have a regular source of income, fulfil minimum income and any other criteria as may be specified by the issuer

If you have an existing credit history at the time of application, you can also check your credit score as card issuers use that to determine your eligibility.

Most card companies allow you to sign up for credit cards online. You need to upload relevant information regarding your employment and income status. You may also be required to furnish proof of your assets and details of debt that you may have incurred when applying for the credit card.

There is a number of different card types and the right card will depend on your circumstances.

Zero interest

This card does not accrue interest for a period of up to 12 months, after which point interest is charged on the card’s balance. People often use this type of card when they consolidating their credit card debts into one card, with a view to paying off as much of the card’s balance as possible during the interest-free period.

Check when the interest-free period ends and also the rate that will apply to all future transactions. This is because after the interest-free period finishes, some lenders charge a rate that’s above the market average to recoup the interest waived during the interest-free period. So check what the rate will shift to after the end of the interest-free period.

Low fee or low rate cards

Low fee cards tend to have a higher interest rate than the market average and are often used by people who intend to pay off the card’s balance in full before the end of the interest-free period. In contrast, low rate cards often suit people who don’t pay off the balance in full each month, to help them to reduce the interest they pay. They typically have a higher annual fee to make up for the lower rate charged. Check the fees and charges before you take out a card.

Awards points

Many cards come with an associated rewards program, through which consumers earn points for using the card to make purchases. For instance, many cards issued by airlines have an associated rewards program. Cardholders are rewarded when they use the card to buy airline or a range of other goods. Points accrued can go towards the price of future airline tickets. Rewards points can also be redeemed to buy products and services from businesses affiliated with the program.

Premium cards

Borrowers can apply for a premium account if they spend above a certain amount each year. These cards charge higher fees and interest rates and come with a substantial credit limit. Cardholders can access a range of benefits through cards such as access to airline lounges, discounts and travel insurance.

Payments

You will need to pay off a certain amount each month. Your credit card statement includes information about the minimum payment you need to make each month. Paying late or not paying can negatively affect your credit score with this information stored on your credit report. This is information compiled by credit bureaux, including your payment history, defaults and the amount of debt you already have. It gives lenders a good understanding of the borrower’s history paying off debts.

However, it’s a good idea to only apply for one card at a time. This is because making multiple, consecutive applications can negatively affect your credit score.

Credit cards are a very useful way of making payments. If you are considering taking out a credit card, it’s recommended to review different options available to you, given your individual circumstances. Compare fees, charges, interest rates and any special features the card offers when deciding which one to take out. Importantly, make sure you are comfortable meeting the repayments and responsibly making repayments when you do take out a card.

Now that you know how do credit cards work in Australia, be careful about how you use it

As a beginner, opt for a basic card with a low-interest rate. Such cards help you get comfortable with the idea of buying on credit while you still get used to paying off the dues regularly.

You can also opt for no annual fee credit cards. Since there is zero cost involved in getting such a card, you can get one and use it to build your credit history. You don’t have to use the card -- simply owing the card is enough for your credit file.

Getting a credit card is a double-edged sword. If you are on the fence about how to choose a credit card as a beginner, evaluate the pros and cons.

On the one hand, a credit card allows you to make large purchases on deferred payment terms and helps build your credit history from scratch. But if you are not careful, you can end up spending beyond your means. Since credit cards affect credit score, failure to repay dues on time can be bad news for your credit report.

Pick credit cards that work for your current financial situation, including your ability to repay. Make sure to consider credit card features closely to see whether you can truly afford to get one.

Before you apply for a new credit card, make sure to check your credit score in order to assess your eligibility for the different credit card offers.

With ClearScore, you can check credit score and your detailed credit report in just a few clicks. Take a look.