How Do Credit Cards Work? The Ins and Outs Explained in Simple Terms
Credit cards are one of the most widely used payment methods in the U.S., with 84% of the country’s adults owning one. A credit card is associated with a line of credit that allows you to spend up to a certain limit and pay your balance at a later date. Though the concept seems relatively straightforward, failing to understand how these cards operate may lead to severe consequences like damaged credit scores and financial delinquency.
To help you grasp the specifics of this popular payment option, we’ll cover topics like:
- How do credit cards work?
- Where can you use a credit card?
- How do credit card repayments work?
- How do credit cards compare to debit cards?
What Is the Purpose of a Credit Card?
The concept of credit is as old as commerce—you buy the product and pay for it later. Customers used to make credit purchase arrangements with merchants—they’d receive the goods and pay the seller in the future. The problem with this system was that not every seller was willing to extend credit, so an intermediary entered the market.
Credit cards follow the same buy-now-pay-later principle. However, the merchant is paid instantly by a third party—the credit card issuer. The customer then repays the cost of the purchase to the card issuer, not the merchant.
This convenient service provided by the credit card company is not free. The following is added to the original sum:
- Interest on the loaned amount
- Predetermined fees or charges for using the service
The following four sections will give you a thorough perspective on credit cards:
- Where does credit card money come from?
- What are credit cards used for?
- What are the types of credit cards available?
- How does credit card billing work?
Where Does Credit Card Money Come From?
Every time you pay with a credit card, you are using the credit line extended to you by a bank, credit union, card company, or another financial institution. These financial institutions fund the credit line, so their position is similar to that of a money lender.
The issuer will only honor your transactions up to the predefined credit limit, which can be as low as $500 and as high as $500,000, depending on your credit score and financial standing.
What Are Credit Cards Used For?
Credit cards can be used for any purchase as long as the merchant accepts the card. They are widely accepted at most stores, airlines, restaurants, hotels, and gas stations, including online vendors.
Besides serving as a purchasing tool, you can use credit cards for:
- Getting cash advances—Many credit card providers allow you to withdraw cash from your card at the ATM or the bank branch. Though a convenient option, cash withdrawals typically entail high interest charges because the annual percentage rates (APRs) on cash advances are higher than those for regular credit card shopping.
- Paying bills—Credit cards can be set up to pay recurring expenses like phone and utility bills, letting you defer the actual payment by one month. Some credit card companies also offer rewards and cashback for such transactions, helping you save on recurring expenses.
- Building credit—You can establish a positive credit history and boost your credit score by adopting responsible credit card habits, such as paying your card bill on time and using only a small portion of your credit limit. Maintaining a healthy credit score comes with benefits like:
- Qualifying for loans with lower interest rates
- Saving on excessive insurance payments and security deposits
- Qualifying for higher credit limits
What Are the Types of Credit Cards Available?
Over the decades, credit card providers have added multiple functionalities to these cards to attract different consumer groups. Here are the main credit card types:
How Does Credit Card Billing Work?
As a credit card user, you accumulate a monthly balance that will need to be paid off. The balance includes the cost of your purchases, any cash advances taken, the interests calculated according to predetermined APRs, and potentially, fees and penalties. Here's how it works:
- The customer completes a billing cycle. Credit card providers typically follow a monthly billing cycle with a preset cut-off date. For instance, if your provider generates bills on the 5th of each month, the billing cycle would be from the 6th to the 5th of the following month.
- The card provider generates and delivers a credit card bill. At the end of the billing cycle, the bank or the credit card company calculates the monthly dues and issues a comprehensive billing statement to the user. The statement presents a detailed breakdown of transactions and charges contributing to the balance. Other key elements of the bill include:
- Due date for payment
- Outstanding balance (total payable)
- Minimum amount due (a portion of the outstanding balance that must be paid in case the customer cannot cover the total payable).
- The customer pays the bill in full or covers the minimum due within 21 days or more. If the customer pays the complete amount due, the next bill only includes charges from the current billing cycle. If the customer only settles the minimum amount due, the outstanding balance would be added to the next bill with additional interest charges.
Paying your credit card bills on time gives you a reputable financial standing, while an inconsistent repayment history may damage your credit score.
Source: Tima Miroshnichenko
How Do Credit Card Payments Work When You Make a Purchase? The Technicalities
Credit card purchases—online or in-store—are processed via a credit card network, such as Visa®, American Express®, or Mastercard®. Here’s how a transaction generally works:
How Do Credit Cards Compare to Debit Cards?
Credit and debit cards look the same—both have a card number, expiration date, and CVV code and can be used online and in physical stores. Transaction processing is also comparable, but the similarities end there.
While credit cards are tied to a revolving credit line, debit cards are linked to a checking account. If you choose to pay with a debit card, you’re drawing funds directly from your bank account—no loan is taken, and by extension, no interest is charged.
Here are the basic differences:
Source: Diego Gennaro
Credit Cards or Debit Cards—Which Payment Method To Choose?
Credit cards have been popular among users because of the “free-money” feeling they provide, but they’re only beneficial when used responsibly. The areas for concern are as follows:
- Interest costs—Most credit card dues must be paid with high APRs. Some providers offer low to zero interest rates, but only during the introductory period.
- Overspending risks—When using a debit card, you typically cannot spend more than you have in your checking account. Credit cards may allow you to spend more than you have available in your checking account, which can lead to missed payments and debt accumulation. For instance, you purchase a $1,200 QLED 4K smart TV with your credit card on EMI (Equated Monthly Installment), committing to pay it off in 12 installments of $100. This estimate is incorrect because the actual installment would factor in interest rates and service fees, leaving you with higher monthly dues.
- Credit card debt—Since a credit card may allow you to spend more than you currently have, it’s easy to get caught in a debt cycle. The total credit card debt in the U.S. by the end of 2022 was a record-high $930.6 billion, showing an 18.5% jump from the previous year. With the rise in inflation and unemployment, some users fail to cover their dues on time, leading to credit card delinquencies.
Are There Any Benefits to Using Credit Cards Over Debit Cards?
Credit cards typically offer better perks (like reward points or cashback) than debit cards.
One of the biggest benefits of using a credit card is the low liability in the case of fraud. If your credit card is lost or stolen, your liability for unauthorized transactions is limited to $50 if certain conditions are met.
Debit card users have limited fraud protection. If your debit card is lost or stolen and you report the incident:
- Within two business days, your liability is limited to $50.
- After two business days, but within 60 calendar days of receiving the statement, your liability for unauthorized transactions is $500.
- After 60 calendar days, your liability is potentially unlimited.
Still, most banks enforce much more lenient liability policies to protect their clients from debit card fraud and typically don’t require them to pay even the $50 they are technically liable for. You can also take simple precautions to stay safe, especially when shopping online.
Fraudulent activities are typically tied to phishing and data breaches on merchant websites. While avoiding suspicious emails or websites may help with phishing, preventing a data breach is beyond your control. You can significantly reduce the risk of having your debit card compromised online with Privacy Virtual Cards.
What Are Privacy Virtual Cards?
Credit and debit card data can be stolen online when shared on merchant websites. According to Cyber Security Hub, more than 4,100 data breaches occurred in 2022, exposing around 22 billion customer records, many of which were card details. That’s where virtual cards, such as Privacy, may help.
Linked to your bank account or debit card, a Privacy Virtual Card has a unique card number, expiration date, and CVV code that masks your actual payment data online. The virtual card prevents the retailer from storing your debit card information, adding a layer of protection to your online payments.
You can use your Privacy Card to shop with most merchants that accept U.S. credit or debit cards, including international vendors. Sign up to create multiple virtual cards with Privacy, which is free for domestic transactions.
Source: Liza Summer
How Privacy Helps Protect Online Payment Activities
Besides making your actual financial details invisible to unauthorized third parties, Privacy offers other practical features. For example, you can:
- Lock your Privacy Card to a single merchant—A Merchant-Locked Privacy Card locks to the first merchant you use it with. If someone tries to steal the card numbers and use them with another vendor, Privacy will decline the payment.
- Create cards for one-time use—Privacy Cards can be customized to close after the first transaction, rendering them useless if stolen.
- Close, pause, and unpause cards—You can pause or close your Privacy Cards in a few clicks. Use the feature when you:
- Suspect a merchant website has been breached
- Want to stop paying for a sneaky subscription service (Privacy will instantly decline any attempts to charge the card in question)
Privacy also allows you to set a spending limit for each card, declining any transaction attempted above your predetermined limit.
You can also monitor your transactions easily using the platform’s centralized dashboard, as well as manage multiple cards. Enable push notifications to get real-time alerts whenever your virtual card is used or declined.
How To Generate Privacy Virtual Cards
You don’t need to go through credit checks to qualify for Privacy Cards. Here’s how to request a card:
- Go to the signup page
- Enter the details required for identity verification
- Link your checking account or debit card
- Customize and request your first Privacy Card
You can also create Privacy Cards using:
- Google Chrome, Firefox, and Safari browser extensions—Create new cards instantly while checking out. The extensions will autofill your payment data, making the checkout process fast and seamless.
- Android or iOS apps—Install the relevant Privacy app on your smartphone to create and manage virtual cards on the go.
Privacy allows you to create up to 12 virtual cards each month as part of the base plan. You can switch to a paid plan if you want to access more cards and additional benefits like 1% cashback on eligible transactions totaling up to $4,500 per month.
Source: Joslyn Pickens
 Econ Lowdown. https://www.econlowdown.org/v3/public/credit-history-the-evolution-of-consumer-credit-in-america, sourced June 2023
 Eric Bank. CardRates.com. https://www.cardrates.com/advice/credit-card-limits/, June 1, 2023
 Stephanie Ashe. Insider. https://www.insider.com/why-i-dont-have-a-credit-card-2018-8, August 6, 2018