How do credit cards work?

What is a credit card?

A credit card is a card you can apply for from a bank or card provider that can be used to borrow money for your spending.

Unlike a debit card, where the money is taken from your bank account, when you buy goods or services with a credit card the payment comes from the lender.

Once you’ve used the card, you’ll need to pay back what you owe at a later date. If you don’t pay the balance off in full every month, your lender will typically charge you interest.

How does a credit card work?

When you use a credit card, the card provider pays for what you’re buying and the amount is added to the balance you owe.

If you repay what you’ve spent in full and clear the balance on the card each month, you won’t have to pay any interest.

But if you can’t afford to repay the full amount, you’ll need to pay at least the minimum monthly repayment - an amount that’s set by the provider.

Anything you don’t pay off is carried over to the next month and you’ll be charged interest on the whole balance until it’s repaid.

Any missed repayments will show on your credit history and can negatively affect your credit score.

Things to know about credit cards

There are several factors to consider when you’re deciding whether to take out a credit card:

You’ll need to pass a credit check

Before you can receive a card, your lender will do a hard credit check to assess your reliability as a borrower. Every time a hard credit check is done it appears on your credit history, so it’s best to use our eligibility checker to find out your chances of being accepted before you apply.

Your credit score can be affected

How you use the card can also impact your credit rating. If you use it responsibly and make your payments on time it can help to increase your credit score. But any missed payments will appear on your credit report and can have a negative impact.

You’ll be given a credit limit

A credit card doesn’t mean unlimited spending power. Instead, your lender will give you a credit limit which is based on your financial situation and credit history. This limit is usually reviewed every six months, so there’s a chance it could be increased if you need it to be.

You’ll need to repay a monthly minimum

Each month you’ll need to pay at least the minimum repayment amount set by the lender. You’ll incur a fee for late or missed payments and it’ll be added to your credit report, so it’s wise to set up a Direct Debit.

You could face compound interest

If you don’t pay off the full balance each month, interest is added and carried over to the next month. The risk is that you could soon find yourself paying compound interest - when interest is added to the interest as well as the balance - and your debt quickly spirals.

Your credit utilisation ratio is important

It’s best not to spend up to your maximum credit limit as this could indicate you’re having money difficulties and it may be marked on your credit report. Instead, try to stick to using around 30% or less of your agreed limit each month.

What’s the APR?

Another important factor to consider when you’re looking into and comparing credit cards is the annual percentage rate (APR).

This tells you how much it’ll cost you to borrow on the card if you don’t pay the balance off in full each month.

Credit cards usually have higher APRs than other types of lending, but this is partly because they’re an unsecured method of borrowing.

And different APRs may be applied, depending on what you’re using your card for.

For example, the APR for cash withdrawals is usually higher than the APR you’d be charged for making a purchase. So it’s a good idea to check the small print.

Which credit card is best for me?

This depends on your circumstances and how you plan to use the card. There are several types of cards available that are designed for different purposes, these include:

Purchase card

This can be a cheap way to borrow and help spread the cost of a big purchase. They normally come with an introductory interest-free period which can span several months, but you’ll usually need a good credit score to be eligible for one.

0% balance transfer card

If you’ve already got a credit card or store card, you can move any existing debt from them onto a balance transfer card with a 0% or low interest period. The low interest can help you to repay what you owe more quickly, but transfer fees will apply.

Travel credit card

A travel credit card will help you avoid steep foreign transaction fees if you’d like to use your credit card abroad. It can help to keep your spending costs down while you’re away, but if you don’t clear your balance each month you could be charged a high amount of interest.

Rewards credit card

With this type of card, you can earn points, cashback, airmiles or other rewards as you spend. The points may only be applied for certain types of spending and these cards often charge an annual fee, so you’ll need to weigh up whether the rewards are worth it.

Credit building cards

If you’ve got little or no credit history, or a poor credit rating, a credit builder card can help you to improve it. Making sure you pay your minimum repayments each month can help to increase your score over time and could make borrowing cheaper and easier in future.

Are there any charges and fees to consider?

Yes, sometimes there are charges and fees that can apply, so it’s a good idea to consider these before you take out a credit card.

Some credit cards, like rewards cards, can come with annual fees. So it’s important to factor these in and decide whether this type of card will be worth it.

It’s usually possible to use a credit card to take out cash - this is known as a cash advance. But typically, you’ll be charged more interest for using the card this way so it’s not advisable.

And if you miss or are late with any of your repayments, your card provider will charge you a late payment fee and it can be flagged on your credit history.