How do credit cards work?

Credit cards offer a fast, convenient way to pay in person or online. A transaction occurs when your credit card issuer and the merchant’s bank exchange funds through a payment network. But after you swipe, insert or tap your card, what happens behind the scenes? How exactly does a credit card work? And why use a credit card, anyway? 

Read on to learn all about credit cards.

What you’ll learn:

• Credit cards are a convenient way to make purchases. 

• When you make a purchase, your account details are sent to the merchant’s bank and forwarded by the card’s network for authorization by the issuer. The funds are then sent to the merchant. 

• You receive a statement from the credit card issuer once a month that details your purchase history.

• You can use a credit card to build credit by using it responsibly. That means doing things like paying your monthly statements on time.

In simple terms, a credit card allows you to use a line of credit to borrow money to make purchases.

When you make a purchase, your available credit is reduced by the purchase amount, and that amount is owed to your credit card issuer. Any amount that isn’t paid back by the due date could be subject to interest charges. The amount you can borrow is known as your credit limit, which is based on factors like your creditworthiness and determined by things like your payment history.

And since credit cards are a form of revolving credit, funds can be borrowed and paid back repeatedly—up to the credit limit.

Credit card payments are generally processed the same way, whether you’re paying in person or online. Here’s how a credit card transaction might work when you check out at the grocery store:

1. You use your card to buy groceries at a point-of-sale (POS) system. If you’ve added your card to a digital wallet, you may also use a mobile device.

2. The POS system sends your account information to the acquiring bank.

3. The acquiring bank uses a payment network to get authorization from your credit card issuer.

4. If your card issuer approves the transaction, it sends the money through the payment network to the grocery store’s bank.

5. The total purchase amount is subtracted from your credit card’s available credit.

Card issuers send their customers a monthly credit card statement through the mail or electronically. Statements include purchases and other transactions made during the current billing cycle plus any interest, fees and previous unpaid balances. 

In most cases, the payment is due on the same day each month. But if the due date is on a holiday or weekend, the payment may be due the following business day. Making a credit card payment on or before the due date is one way to keep your account in good standing.

To understand how credit card payments work and how much to pay, it can be helpful to know some of the terms you might see on a credit card statement:

• Minimum payment: A minimum payment refers to the least amount of money you have to pay each month to keep your credit card account in good standing.

• Available credit: Your available credit is the amount of credit you have left to spend on your credit account. You can calculate your available credit by subtracting your card’s current balance from its credit limit. 

• Statement balance: A statement balance is what you owe at the end of a billing cycle, which is usually every 28-31 days. If you pay your statement balance in full each month, you typically won’t have to pay interest on new purchases during this time. 

• Current balance: As you swipe your credit card, each purchase is added to a running total called the current balance. This is the most up-to-date amount owed on the credit card. As your current balance grows, your available credit shrinks.

Here are some common credit card fees you might see on a credit card statement, depending on your card, issuer and how you use the card: 

• Annual fee: Some cards come with an annual fee. Think of it as a kind of membership fee you’re charged once a year to offset some of the benefits the card offers.

• Late fee: If your credit card payment is late, the card issuer may charge a late fee. Missing two or more payments could result in higher fees and a higher penalty APR. 

• Balance transfer fee: A credit card balance transfer allows you to move credit card debt to a different card from another issuer. You also might be charged a fee for completing a balance transfer.

• Cash advance fee: You may be able to use your credit card to withdraw cash against the card’s line of credit. This is called a cash advance. Cash advances may have a higher interest rate than other credit card purchases. And they may come with additional fees.

Credit-scoring companies like FICO® and VantageScore® take a number of factors into account when calculating credit scores. 

Here’s how using a credit card could impact these factors:   

• Payment history: Credit scores can be positively affected when you make on-time payments each month. Missing payments, even one, could negatively impact your credit scores.

• Debt: Credit-scoring models analyze how much total debt you have along with your credit utilization ratio, which is a measure of how much credit you’re using versus how much you have available.

• Credit age: Your credit age indicates how long you’ve had your credit accounts open. Typically, a longer positive credit history can have a positive impact on your credit scores.

• Credit mix: Credit mix describes the different types of credit accounts you have. It considers two types of loans: revolving credit, like credit cards or personal lines of credit, and installment loans, like mortgages, student loans and car loans. Generally, using different types of credit responsibly can positively impact your credit scores.

• New credit: This factor takes into account how many times you’ve recently applied for credit. The effect on your scores might be minor, but a lot of new hard credit inquiries could still give a negative impression to lenders.

Regularly monitoring your credit can help you understand how the different factors affect your credit. One way to monitor your credit is with CreditWise from Capital One. CreditWise lets you access your free TransUnion® credit report and VantageScore 3.0 credit score anytime. CreditWise is free and available to everyone, even if you’re not a Capital One cardholder.

You can also get free copies of your credit reports from all the credit bureaus. Visit AnnualCreditReport.com to learn more.

Here are some frequently asked questions about how credit cards work:

Understanding how credit cards work could help you decide whether a credit card is right for you.

If you’re thinking about applying for a credit card, Capital One has a credit card comparison tool that helps you search by credit requirements, rewards and other factors to find the right credit card for you. And with pre-approval from Capital One, you can check for potential card offers before you apply. It’s quick and won’t hurt your credit scores.