What is a credit card?
A credit card is a spending card which lets you make purchases, up to a previously agreed total limit, regardless of how much money is available to you as cash at that particular point in time.
Your purchases are paid for on credit, meaning that the initial transaction is financed by your credit card provider.
They do this on the understanding that you’ll either pay back your statement balance in full each month or pay additional interest on any amount which is borrowed for an extended period.
How does a credit card work?
To get a credit card you need to apply directly to the card provider.
Each provider has an eligibility checker that looks at your credit history and credit rating to gauge whether or not they believe you’ll pay your bills, and decide if you’ll be accepted for credit.
Your credit card provider will also use your credit score to determine how much credit they are willing to give you. The total amount that you can spend on your card is called a ‘credit limit’.
You can make purchases using your credit card in exactly the same way that you would with a normal bank debit card. The difference is that you defer paying your credit card provider until later.
Each month, your credit card provider will issue a bill which shows a breakdown of your current credit card balance.
You’re given the option to either repay the amount you’ve spent in full or to continue spending and adding to the balance, with the only stipulation that you must pay the minimum monthly repayment amount. Interest is charged on anything that is not repaid in full.
Each time you borrow and repay money like this you show that you’re creditworthy. These details are recorded in your credit history and reflected in your final credit score, which in turn means you should be offered credit on more favourable terms in future.
Once your monthly credit card statement is issued, you’re allowed a few weeks to pay the balance, before any interest is charged.
Credit card providers make money if you don’t pay your monthly statement balance, either in full or on time. When that happens, they’ll issue fees or charge interest on the amount you still owe.
The interest they charge you is far higher than the rate at which they are able to borrow money, and this markup is their profit.
Credit card APRs explained
The Annual Percentage Rate (APR) of charge is the interest rate for a year applied to a personal loan, mortgage or credit card.
A credit card APR is a financial charge, expressed as a percentage of the balance you owe at an annual rate.
What are the advantages and disadvantages of a credit card?
The pros of using a credit card
The most immediate benefit of a credit card is that it allows you to use money that might otherwise not be available to you.
That can be a lifesaver if your issue is simply one of cash flow because it lets you spread the cost of a big purchase across many months. Provided you can keep up with the interest payments.
If you use credit cards for long-term borrowing then they sometimes offer promotional interest rates on balance transfers or money transfers which can help you consolidate and pay off your debts.
However, for many people, the main reason to use a credit card is to build up a good credit history. If you aim to own your own home then borrowing and repaying money can improve your credit score, which improves the mortgage deals you might be offered.
Another advantage of a credit card is that it can offer enhanced levels of consumer protection versus a debit card.
3 ways that credit cards are safer than debit cards:
1. Your bank account is not compromised if you are a victim of fraud, which means you can still withdraw cash even if your credit card is frozen.
2. You have extra cover in the event of fraud vs. your bank, so as long as you quickly report unauthorised activity then your card provider should cover fraudulent transactions.
3. You don’t have to do the hard work if you dispute a transaction because your credit card provider will deal with the seller directly (your bank would expect you to do this).
In addition to enhanced security, a credit card can offer more immediate and tangible rewards like cash back and air miles (see our section on how to choose a credit card below).
The cons of using a credit card
The most obvious pitfall when using a credit card is the ease and speed with which it’s possible to run up considerable debts.
The interest rate charged on an outstanding credit card balance can be extremely high, which means they are really not a suitable solution for planned long-term borrowing.
In addition, failure to pay the minimum repayment amount can quickly do long-term damage to your credit score, limiting the availability of reasonably priced credit in the future.
Of course, it is also possible to minimise the risk of falling into debt, should you be hit with an unexpected expense. You can build up a financial safety net by creating an Emergency Fund. This stash of savings can help protect you should the worst happen (if you lose your job or become ill, for instance), and prevent you from relying on your credit card to get by.
Another potential drawback of credit cards is that they’re better suited for making purchases than they are for cash withdrawals.
If you withdraw cash with your credit card then you will likely be charged an additional cash advance fee.
How does a prepaid card work?
A prepaid card isn't technically a credit card at all, because you can only spend money that you've loaded onto the card in advance.
Unlike a debit card or a credit card, a prepaid card works by letting you choose how frequently you want to top up (just like using a pay-as-you-go phone), and ensuring you stay in control of how much money you load onto the card.
For this reason, a prepaid card is great if you don't have a bank account but want the convenience and security of cashless transactions. This can be especially useful if you use the card while travelling 🎒
Prepaid cards can be helpful when it comes to budgeting, and because you're not borrowing any money, it means you don't need to pass a credit check in order to get one.
How to use a credit card
Credit cards can be a useful personal finance tool, and when used responsibly might actually help you achieve your long-term goals.
Before applying for a new credit card, there are a few things worth checking to ensure it’s the right thing for you:
1. Cool down if you’ve been rejected for credit before applying for any other credit cards because each failed application can harm future chances (for up to a year).
2. Don’t use the card if you need to withdraw cash as this normally incurs a cash advance fee (either a fixed rate or a percentage of the amount, from the moment you withdraw).
3. Always make the minimum monthly repayment when you receive your monthly statements, or you may find that you lose access to any introductory promotions.
4. Keep an eye on introductory interest rates to make sure any balance transfers or big purchases made have been paid off before the more punishing, regular rate kicks in.
5. You can manage debt by shuffling plastic if your current card provider is willing to offer a deal on balance transfers (though you might incur a one-off balance transfer fee).
Credit card FAQs
Can I have two credit cards from different banks?
Yes, it is possible to have a credit card from two different banks, and in fact, applying for a card from a rival baking group might be a way to get access to their lower introductory rate of interest.
Can I transfer money from a debit card to a credit card?
Yes, you can make a payment to your credit card provider using your debit card, to either reduce the interest being paid on an outstanding balance or to prevent you from hitting your credit limit.
Can I transfer money from a credit card to a bank account?
Yes, you can transfer money from a credit card to a bank account, but to do so you’ll need to have a specific money transfer credit card (this is very similar to a balance transfer card).
How does a credit card build my credit score?
A credit card can improve your credit score by allowing you to build up a healthy credit history. You increase your credit rating when you show that you can borrow money and pay it back on time.
What is credit card fraud?
Credit card fraud is a broad term for any criminal attempt to use a payment card (either a credit card or a debit card) in order to obtain goods or services, or to pay money into another account.
How to compare credit cards?
Finding the right credit card for you will be dependent on your own priorities, but thankfully there are many to choose from!
Here’s a summary of the things to look out for:
1. Check the APR, as this is what you’ll end up paying in interest over the long term if you borrow on the card.
Top tip 💡
The term ‘Representative APR’ means the interest rate will be dependent on your credit history, and the card provider may set a higher rate of interest based on your credit rating.
2. Consider additional fees that will be charged if you fail to make the minimum monthly repayments etc.
3. Calculate the value of reward benefits, because while air miles, cash back, insurance or even a personal concierge service might be tempting… are these perks really worth the additional price you’ll inevitably pay in terms of the APR or additional monthly/annual fees for the credit card.
Check out our website to learn how you can manage your budget and spending with Plum, the smart money app!