Explain it Like I’m Five: How Do Credit Cards Work?

Explained like you’re 5: What is a credit card?

A credit card is a type of payment card that lets you borrow money from a bank, credit union or credit card company.

When you use a credit card to buy something or pay a bill, you’re not spending your own money right away; the bank pays for it first. At the end of the month, the bank sends you a bill and asks you to pay them back.

How credit cards work

Credit cards are a type of revolving credit. That means they let you borrow up to a set credit limit, and you can repeatedly borrow and pay off your balance. If you pay the full bill on time, you usually don’t pay extra. If you don’t, the bank charges you interest, which is like a fee for borrowing their money longer.

Since credit cards report payments and purchasing activity to the major credit agencies, you can build strong credit scores just by using your credit card responsibly. That means paying off your balance in full and on time each month and keeping your credit utilization low— or in simple terms, not using too much of your available credit at once.

Related: How to Build Credit

Other things to know about credit cards

If you’re new to credit cards, here are a few other important things you should know before you start swiping one.

Credit card limits

Your credit limit is the maximum amount you’re allowed to spend on the card. If your limit is $1,000, you can’t spend more than that without getting declined or charged fees.

Related: High Limit Secured Credit Cards

Credit card minimum payments

Each month, the bank lets you pay a small minimum amount instead of the full balance. For most credit cards, your minimum payment is around 3% of your outstanding balance plus interest.

Making your monthly minimum payments keeps your account in good standing. However, only paying the minimum balance means you’ll pay interest, and it will take a while to pay off what you owe.

Credit card interest

Interest is the extra money the bank charges if you don’t pay your balance in full. It’s usually shown as a percentage called an annual percentage rate (APR). The higher the APR, the more expensive it is to carry a balance.

The average credit card interest rate is around 20% to 24%, depending on the bank and credit card company you go with. And the better your credit rating is, the lower rates you may qualify for.

How credit cards impact credit scores

The amount of debt you owe on your credit card is one of the biggest factors affecting your credit score. Generally, it’s not a good idea to max out your card. You’ll also want to avoid missing payments, since that could hurt your credit score as well.

Credit card rewards

Some credit cards offer reward programs like cash back, points or miles. These are perks for using the card, but they’re only worth it if you avoid interest and fees.

How do I get started with credit cards?

Credit cards are pretty straightforward to use. Here’s how to get started.

1. Check your credit. Before applying, know where you stand in terms of your creditworthiness. If you’re new to credit, you may need a beginner or student card. If you already have some credit history, you could qualify for more options.
2. Choose a starter card. If you barely have any credit history, start with credit cards designed for beginners, students or people rebuilding credit. These typically have lower limits and fewer fees, which makes them easier to manage and qualify for.
3. Apply online. Credit card applications typically take no longer than a couple of minutes to complete. You should get a decision right away or within a few days.
4. Don’t overuse it. Start with small purchases you can easily pay off, like gas or groceries.
5. Pay on time every month. Paying your full balance by the due date helps you avoid expensive interest charges and build good credit habits.

Bottom line

Credit cards can be a great financial tool when you use them responsibly. But if mismanaged, they can easily lead to a debt trap that can be difficult to escape. So, before swiping that card, make sure to only spend what you can afford and pay your balance on time and in full each month.

If you want to improve your FICO score but aren’t ready for a credit card yet, look into these debit cards that could also help build credit.

Frequently asked questions

• Do I have to pay interest on a credit card?

  Yes, but only if you don't pay off your full balance by the due date each month. If you pay off your entire balance before the end of the billing cycle, you won't incur any interest charges.

• Is it bad to only make the minimum payment?

  You're allowed to only make the minimum payment, but it can get expensive because interest keeps adding up. And depending on your overall balance, it may take a long time to fully pay off what you owe.

• How many credit cards should I have?

  There isn't a specific ideal number of credit cards you should have, but one to three is typically a solid start for most people.