What is a credit card? And should you own one?

A father and daughter cross a creek as he gives her a clear and simple credit card definition while learning about financial literacy.Image: A father and daughter cross a creek as he gives her a clear and simple credit card definition while learning about financial literacy.

In a Nutshell

A credit card is a tool that lets you borrow money up to a certain limit from a bank or other issuer, with the understanding you’ll pay it back. Credit cards can help you build credit and cover emergency costs, but they may also lead to debt if you charge more than you can comfortably repay on time.
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A credit card is a tool that can help you borrow money, cover expenses in a pinch and establish a good credit history.

You can borrow money, up to a certain limit, from a bank or other issuer, with the understanding you’ll pay back the borrowed amount as agreed in the future.

The risks and benefits of credit cards come from how well you use and manage them. You may be aware of one major drawback of credit cards: overspending. Spending more than you can afford can lead to debt that’s difficult to repay. But when used carefully, a credit card can be useful and helpful.

Here’s how credit cards work and what to consider before opening one.

What is a credit card?

A credit card is a line of credit that can be used to borrow money to make purchases, transfer balances and get cash advances, with the agreement that you’ll pay back the money borrowed — plus any interest you owe on it — at a later date.

There are two main types of credit cards: secured cards and unsecured cards. Secured credit cards require you to pay an upfront security deposit, which serves as collateral if you miss a payment. Unsecured credit cards don’t require a security deposit when you apply, and they typically offer better terms. While those with poor credit histories might not qualify for an unsecured card, they may have better luck applying for a secured card. But no matter which type of card you’re considering, it’s best to look for one with minimal fees.

To be considered for a credit card, you’ll need to fill out a credit card application through a credit union, bank or other card issuer, which will then review the application and check your credit reports. This helps the lender determine the likelihood you’ll repay what you borrow. If you’re approved for a credit card, you’ll sign an agreement that lists information like your balance transfer interest rate, purchase interest rate, credit limit and any fees, along with a statement that says you’ll pay back any money borrowed. Make sure you know the APR and the date your credit card bill is due every month.

How do credit cards work?

It’s a good idea to get to know the basics of credit cards before you start swiping. If you’re approved, the issuer will open your account and grant you a credit limit, which is the maximum amount you can borrow. The issuer will also set your interest rate. The credit limit on a secured card is typically equal to the amount of your security deposit. On an unsecured card, the issuer will base your credit line on your income, credit scores and other factors.

Your interest rate is the price you pay for borrowing money, usually expressed as an annual percentage rate, or APR. Each month, your card issuer will send you a statement that lists your credit card account balance, statement balance, the individual transactions you made that month, the minimum payment due and the due date.

You’ll need to pay at least part of the balance due, called the minimum payment, each billing cycle. And though paying off the entire balance before the due date is ideal, even just paying the statement balance by the due date will help you avoid paying interest in most cases. This is because most credit cards come with an interest-free grace period on new purchases, typically somewhere between 21 and 25 days. If you only make the minimum payment, you’ll be charged interest on any remaining statement balance at the rate set when you were approved for the card.

Should you open a credit card?

Consider these factors before deciding whether you should get a credit card.

Credit card prosCredit card cons
Helps build creditCan lead to debt if you don’t stay on top of payments
Can be used to cover emergency costsMaxing out your card or missing payments could hurt your credit scores
May earn rewards 

Helps you build credit

Credit cards can be a good way to demonstrate to lenders that you can use credit responsibly, which can help build your credit. The credit card issuer typically reports your account information, like payment history and balance, to the three main consumer credit bureaus every month. If you use credit wisely, you could improve your credit scores and maintain good credit health. This is important if you want to apply for an auto loan, mortgage or other type of loan in the future.

If you’re choosing between a credit card and debit card, here’s an important distinction to keep in mind: Credit cards can help you build credit, while debit cards can’t. A credit card extends a revolving line of credit, up to a certain limit, that you agree to pay back in the future, whereas a debit card is linked to a bank or credit union checking account and deducts from the money that you have in that account.

Covers emergencies

If you’re caught without an emergency fund, a credit card can help you cover a surprise cost, like car repairs or a medical cost, in a pinch. But again, you’ll want to have a plan to quickly pay off any surprise costs (in full and on time) so you don’t go into long-term credit card debt.

Helps you earn rewards

If the credit card offers a rewards program, you could earn cash back or points/miles that you can redeem for things like flights, hotel stays and gift cards. But you’ll want to make sure you don’t fall into the trap of spending more than your budget allows just to earn rewards.

Why you might not want a credit card

Before applying for a credit card, there are some things to keep in mind.

Credit cards could lead to credit card debt

This might happen if you spend more than you can afford to repay each month. If that scenario seems familiar, you might want to hold off getting a credit card for now.

Potential hit to your credit

Maxing out your credit line or missing a payment can negatively impact your credit scores. One workaround is to automate your payments so that even if you forget, payments will continue to be made. Also try to use less than 30% of your credit limit as a rule of thumb.

What’s next?

Those with excellent credit may be more likely to be approved for favorable rewards credit cards and lower interest rates. But if you’re new to credit cards and have little to no credit history, your options might be limited. Using a credit card that helps you build credit from scratch can help set you up for a strong financial future. To get the best out of your card, try to avoid late payments and charge only what you can easily pay off every month.

About the author: Kim Porter is a writer and editor who has written for AARP the Magazine, Credit Karma, Reviewed.com, U.S. News & World Report, and more. Her favorite topics include maximizing credit card rewards and budgeting. Wh… Read more.