How do credit cards work? A guide

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APR, credit limit, minimum payments… understanding credit card terms can be confusing at first. While they can be useful for making large purchases, it’s important to know how credit card interest rates work. In this guide, we’ll answer some common questions, such as “How do credit cards work?” and “How is credit card interest calculated?”. We also compare credit cards vs. debit cards.

A credit card is a way of borrowing money up to a specific limit, called your credit limit, which is agreed upon when you open the account. You can use it to pay for goods and services in-store, online, or over the phone, as long as the seller accepts credit cards. Instead of paying them directly, however, the credit card provider pays on your behalf. Later, you repay the provider.

At the end of each month, you’ll receive a statement containing the following:

• Total amount you owe (balance)

• Minimum payment required

• Payment due date

• Details of each purchase and withdrawal since the last statement

• Interest charges and other fees applied

• How and where to make payments

• Contact information for your credit card provider.

You can choose to pay off the full balance before the payment date to avoid interest charges, or pay a smaller amount (above the minimum payment) and carry the rest over to the next month. With the second option, interest will be added to the remaining amount you owe until it’s repaid. You’ll also pay interest if you make any cash withdrawals.

Credit cards operate on a ‘buy now, pay later’ principle. Unlike car loans or mortgages, where you borrow a lump sum and repay it in fixed instalments, with credit cards, you can borrow, repay, and borrow again within the given limit. This is sometimes known as a ‘revolving line of credit’.

You can find credit cards offering perks like cashback, discounts, or rewards points. At the same time, credit cards can cause issues. If you miss a payment or spend beyond your limit, your credit score will be impacted.

The information provided here is for informational and educational purposes only and does not constitute financial advice. Please consult with a licensed financial adviser or professional before making any financial decisions. Your financial situation is unique, and the information provided may not be suitable for your specific circumstances. We are not liable for any financial decisions or actions you take based on this information.

The minimum payment is the smallest amount you’re required to pay towards your credit card balance each month. This is set by your card provider, and is based on the balance shown on your most recent statement. It might include any late fees or additional charges you’ve accrued. Alternatively, the minimum could just be a fixed percentage of the total balance.

If you only pay the minimum amount, you’ll still be charged interest on the unpaid balance. So, how do credit cards work if you pay more than the minimum? If you are able to do this, you’ll likely reduce your debt faster and pay less in interest over time. The best case is you pay off the entire amount you owe.

Maxing out your card, which is when you use the entire credit available to you, can lower your credit score. Consistently staying at or near your limit signals risk to the credit bureaus, which could lead to worse loan rates in the future. If you go over your credit limit, some card issuers will charge an overlimit fee each month your balance stays above the limit.

Missing a payment won’t affect your credit score immediately, as issuers usually wait 30 days before reporting it. If you catch up within this window you’re less likely to face problems, but the longer it goes unpaid, the more it could damage your score and make it harder to get back on track. Depending on the terms of your card provider, it can also trigger declined transactions and increased minimum payments.

It is generally recommended to pay down the balance as soon as possible. Following a budget, such as the 50/30/20 rule, can help you keep your spending under control and free up money for repaying any debt. Your credit card provider might even be able to set up a direct debit for you, which means they’ll automatically take out the payment amount each month.

There are no set-up fees when you get a credit card in Ireland, but you will need to pay a Government stamp duty of €30 each year for every credit card account you have. This fee is charged once per account, even if you have multiple cards tied to it. The stamp duty is typically collected on 1st April each year in arrears. Aside from stamp duty, you won’t face any other fees unless your credit card offers rewards or bonuses. These types of credit cards usually come with their own monthly or annual fees.

Credit cards vary widely in terms of the features they offer. Here are some of the most common credit card types you can find in Ireland:

1. Purchase credit cards. Here, you get 0% interest on new purchases for a limited time. They can be suitable for making large purchases and paying them off over time.

2. Balance transfer credit cards. These cards let you move existing debt from other cards to reduce interest. Many offer low or 0% interest for an introductory period to entice you over, though there may be a small transfer fee of around 3 - 5% of the total balance.

3. Money transfer credit cards. You can transfer money from your credit card to your bank account, often with low or 0% interest for a set period. You may have to pay a small fee.

4. Rewards credit cards. Rewards cards offer bonuses like cashback, travel rewards, or points for every purchase. They tend to be used by frequent travellers or shoppers.

5. Student credit cards. Designed for students with lower credit limits and interest rates. You’ll typically need to provide proof of enrolment at an eligible institution.

6. Pre-paid credit cards. These are different to credit cards in that you need to load money on to them beforehand, but they offer similar payment protections.

7. Travel credit cards. Designed for using while abroad, travel credit cards typically offer better exchange rates and no foreign transaction fees.

Cashback credit cards are fairly simple to use, and you won’t be hit with an annual fee. They give you a small percentage back on your day-to-day purchases, meaning you can save some money without needing to get involved with complicated reward schemes. However, the downside is that they generally don’t offer things like sign-up bonuses.

Rewards cards can be worth the annual fee if you travel often, or you have specific benefits in mind, such as travel points, lounge access, or bonus points on certain purchases. Those who travel frequently for business, for example, can benefit by using the points on flights or hotel stays. If you’re weighing up your options, it can be worth comparing the rewards and making sure what you earn actually offers better value than what you’d get from a cashback card or other options.

You can still be approved for a credit card if you have no credit history, or you’ve had credit problems in the past, but your options might be slightly more limited. Banks and lenders offer credit cards specifically for those without a credit history, but they do charge higher interest rates.

One option is a credit builder card. These cards usually have much higher interest rates, which can reach as high as 60%. However, as long as you pay off your balance in full each month and avoid withdrawing cash, you won’t pay interest.

The APR (Annual Percentage Rate), which is the rate you typically see on credit card promotional material, is shown as a yearly amount, but it is actually calculated daily. To find the daily rate from the APR, the APR is divided by 365. So an APR of 18.99% means a daily rate of around 0.052%.

It’s important to understand how credit interest works, including compound interest, as this explains why keeping a balance on your credit card can cause your debt to grow faster than you might expect. It also underlines why it is so important to pay off your balance if you are in a position to do so.

The APR advertised on your credit card doesn’t always reflect the actual interest rate you’ll pay. This is because credit card companies want to know how much risk they are taking by lending to you, so they usually look at your credit history before deciding how much they’ll charge.

If you’ve missed payments in the past, your credit score will likely be lower. This increases the risk for lenders and could lead to a higher interest rate. Credit card companies may also consider your income when deciding your rates or credit limit.

Interest rates typically range between 13% and 23%. By law, credit card providers in Ireland cannot charge more than 23%, but many credit card accounts are still being charged more than that*. That’s why it can be worth shopping around and comparing offers from different providers.

You might be wondering, “How do credit cards work compared to debit cards?” With a debit card, you’re using your own money directly from your bank account. You can only spend what’s in your account, unless you have an overdraft, which is a sort of credit limit attached to your account. When you make a purchase with a credit card, however, you’re borrowing money from the card provider, before repaying it later.

With debit cards, the money is usually deducted from your account directly after purchase. You can also usually withdraw cash from your account more easily than with a credit card. With a credit card, the purchase is charged to your line of credit, which gives you some breathing space before paying the amount back.

Having seen how credit cards work, why might you need to use them rather than a debit card? This really depends on your personal situation and spending habits.

When a debit card might be better:

• If you’re concerned about overspending, since you’re limited to the funds in your account.

• Everyday purchases, especially if you’re trying to avoid accumulating more credit card debt.

• Withdrawing cash from ATMs, since credit cards don’t typically offer this option without charging a fee.

When a credit card might be better:

• If you need to boost your credit score. Some people recommend using credit cards for recurring payments, such as a streaming subscription, that you know you’ll be able to pay off each month. Showing you can regularly repay in full is a major factor considered by the credit reporting agency when calculating your score.

• Online transactions and larger purchases, like paying for a holiday, because credit cards can offer an extra layer of protection.

• Credit cards can provide benefits like rewards or cashback.

If you’re on top of your credit and managing to save some of your income, why not put those savings to work? By opening a savings account through Raisin Bank, you can find competitive interest rates from a variety of trusted banks from across Europe.

Opening an account is free and only takes a few minutes. Once registered, apply to open your chosen account, deposit your savings securely, and watch them grow over time!

*https://www.independent.ie/business/personal-finance/up-to-400000-paying-high-legacy-credit-card-rates-but-they-could-make-big-savings-says-central-bank/a889887921.html