What is a credit card?

What is a credit card?

What is a credit card? It’s hard to think of a simpler question to ask, but credit cards can be difficult to understand

If you’ve never had a credit card before or you’re looking for your first credit card, then it’s worth knowing how it all works before making a decision.

We explain exactly how credit cards work, what types of credit cards exist, how to use them, and crucially, when not to use them.

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What is a credit card?

The easiest answer to the question ‘what is a credit card’ is simply that credit cards are a way of loaning money from your bank or building society.

When you spend money on your credit card, your card provider is picking up the bill. You then owe your credit card provider the money, but you can pay it back at a later date.

If you pay back the amount you owe, known as your ‘balance’, relatively quickly they can be a great way to borrow small sums of money.

However, if you don’t pay back your balance within a certain period of time, known as the ‘interest free period’, you pay an additional percentage of the amount you borrowed and possibly a penalty fee if you don’t even pay the minimum amount.

This percentage is calculated using your card’s interest rate, also known as the APR (annual percentage rate) or EAR (effective annual rate).

And since this interest is calculated on the amount you owe, it will grow proportionately over time as it accumulates interest.

For instance, if you owe £200, pay £100 back during the interest free period of say 56 days, but still owe £100, you will owe the £100 you spent plus a percentage of that £100.

Credit cards vs debit cards

Most credit cards will require a minimum repayment per month, and will charge you a penalty fee if you miss this payment.

This minimum repayment is usually around £5 to £25, but this depends on the credit card provider and your circumstances.

Obviously, the higher the amount you repay, the less you will owe in interest.

The amount you can spend on a credit card depends on how much your bank is prepared to lend you. This spending amount is known as your ‘limit’.

Compare that to a debit card. With a debit card you are spending your own money, so if you have £300 in the bank, you can only spend £300 (excluding overdrafts for a minute).

With a credit card, you could have £300 in the bank, but if your limit is £2,000, you can spend up to £2,000 on your credit card.

What is a credit card

How to use credit cards

The secret to using a credit card is the interest free period, and that should be the first thing you look for.

If you can always pay back your balance within the interest-free period, then a credit card lets you borrow money for free.

To guarantee your repayments the easiest thing to do is set up a Direct Debit from your current account to pay back the full amount each month.

That way you guarantee that you always pay back the full amount – but what if you don’t have enough money in your account?

Defaulting on a Direct Debit because you don’t have enough money is bad for your credit file and could affect your ability to borrow in future.

If you don’t have enough to pay back the full amount try and pay back as much as you can to lower your interest payments, and clear your balance as soon as possible.

There are other ways to use credit cards, but it depends on what type of card you are using.

What types of credit cards are there?

Now you understand the basics of credit cards, we can look at the different types of card available.

The main types are: 0% balance transfer, 0% purchase, credit-builder cards, reward cards, low-APR cards, cashback cards, and travel cards.

0% balance transfer cards are used to transfer existing debt from one card to another. They are a way of shopping around for a better interest rate, and are a great way to take advantage of introductory rates.

Bear in mind that your 0% offer will only last for a given period of time after which the card will revert back to a higher interest rate though.

0% purchase cards are the best kind of introductory rate. They ensure that you pay no interest for a fixed period of time – a year say – so you don’t have to worry about repayments.

Credit builder cards are suitable for people with a poor credit history who don’t have access to traditional credit. They typically have a high APR, but will be offered to people with a poor credit history.

Reward cards are all about shopping habits and are linked to retailers or airlines. For instance, the popular Nectar credit card gives you extra Nectar points when used in Sainsbury’s stores.

Low APR cards are the ‘all rounder’ of the credit card world. They offer a low interest rate, so you won’t be punished too severely if you can’t clear your balance each month.

Cashback cards are amongst the most popular type of card, offering you cash rewards for certain types of spending. Watch out though, the cashback often only lasts for a short period of time.

Finally travel cards give you commission-free purchases overseas, so you won’t pay a premium for being out of the country, but the interest rate may be higher if you don’t pay off the balance in full.

When not to use credit cards

Credit cards are a great way to stagger your spending and still be able to make large purchases while you wait for the next paycheck to come in.

However, if you can’t make a repayment in full you will pay interest, which quickly accumulates over time, and worse still, if you miss a repayment you will pay a further penalty and your credit file could be damaged.

You should therefore only use a credit card if you know how much you can afford.

You should also make sure you get the right card for you. See our credit card page to see our most popular cards and the differences between them.

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