How does a credit card work?

There were almost 378 million credit card transactions made in the UK in August 2023, with cardholders spending a total of £20.6 billion.¹ That's a glimpse of how embedded credit cards are in the financial lives of many people in this country.

This article includes tips, suggestions and general information. We recommend that you always do your own research and consider getting independent tax, financial and legal advice before making any important decision.

In this guide, explore what credit cards are, their potential benefits and drawbacks, and some important financial considerations around interest charges, responsible credit use, and credit scores.

How a credit card works

A credit card allows people to buy goods or services up to a predetermined credit limit. When people use credit cards, they are borrowing money. The credit card provider will usually provide a monthly statement which shows their transaction history, a minimum payment that must be made and a payment due date (as well as other information). The customer can typically choose to pay off the full amount they have borrowed by the due date to avoid being charged interest or make a payment of a lower amount and carry the remaining balance over and potentially incur interest charges on the remaining debt.

• Paying off credit cards: Paying off a credit card involves settling the outstanding balance accrued through purchases. If people do not pay the full balance, the remaining amount carries over to the next month, and they may incur interest on that outstanding sum.
• Interest-free period: Some credit cards offer an interest-free period, typically between 20 to 60 days. During this time, if people pay the full amount by the due date, no interest is charged. However, it's important to be aware of the specific terms and conditions as they may vary between cards.
• Interest: With credit cards, the interest rate may be high, which can be an expensive way to borrow money over time. Failure to make at least the minimum payment each month may also lead to late fees and can negatively affect credit scores.

People who own a credit card will usually receive a paper or digital statement monthly. These statements typically contain:

• Transaction history: covering what was bought, for how much, and when.
• Minimum payment: outlining the smallest amount cardholders must pay by the payment due date.
• Payment due date: stating when the minimum repayment must be made.
• Total balance: detailing what the total amount owing, including what the interest is.
• Credit limit: which is the amount of credit available to the customer. This will usually also show the available credit limit that the customer can spend.

Potential pros and cons of credit cards

Credit cards could help people manage their finances. On the other hand, there are potential downfalls.

Potential benefits of credit cards

Here are some possible advantages to using credit cards:

• Convenience: Credit cards may offer a convenient way to make purchases, whether in store or online, eliminating the need for carrying large amounts of cash.
• Credit history: Responsible use of a credit card, such as making timely payments, could help build credit history. Credit history may be considered during future applications for financial products and other services.
• Emergency needs: Credit cards could serve as a financial safety net during emergencies, providing quick access to funds when needed for unexpected expenses. These can then be repaid flexibly, over time.
• Card rewards: Some credit cards include rewards programs, which provide cardholders with points that could be redeemed for future purchases.

Potential risks and things to look out for

Consider some of the potential drawbacks to using credit cards:

• Interest charges: When people carry a balance on a credit card, they may accrue interest charges, which can accumulate quickly and lead to additional costs over time.
• Overspending: Access to credit may tempt some individuals to spend beyond their means, leading to increased debt that could be challenging to manage.
• Fees and charges: Credit cards may come with various fees, such as annual fees or late payment penalties, which may contribute to the overall cost of using credit.
• Credit scores: Mismanagement of credit cards through overspending, late payments, or high credit use could negatively affect people's credit scores. This may make access to other financial products more difficult or more expensive.

What can a credit card be used for?

Choosing a credit card may boil down to how people intend to use it. Here are some examples:

Credit purchases

Buying on credit involves using a credit card to buy goods or services, with an understanding that the amount spent will be paid back later. A potential benefit is the flexibility to make immediate purchases. However, this could bring a risk of accumulating interest if the full amount isn't paid by the due date.

Balance transfers

Balance transfers entail moving existing credit card debt to a new card, typically with a lower interest rate. This may help individuals potentially save on interest payments. However, there may be transfer fees involved and a temptation to continue accruing debt on the original card.

Cash transactions

Cash transactions involve withdrawing money from an ATM using a credit card. Some providers allow credit card cash withdrawals. However, there may be high-interest rates and potential cash advance fees associated with these transactions, making it an expensive form of borrowing.

How could credit cards affect your credit score?

Making timely payments, keeping balances low relative to credit limits, and having a mix of credit types may improve a credit score.

Mismanagement of credit cards through overspending, late payments, or high credit use could negatively affect people's credit scores. This may make access to other financial products more difficult or more expensive.

Deciding if a credit card is suitable

Credit cards may offer convenience and the potential to build credit when used responsibly. But they also come with drawbacks such as interest charges and a risk of overspending. The suitability of a credit card often depends on an individual's personal financial habits and needs.

In addition to credit cards, there are other forms of credit people can access, such as buy now, pay later. This payment method splits purchases across a number of repayable instalments but may be associated with fees, interest charges, and other potential risks.

Learn more about PayPal Credit.