Credit card basics
Want to know how credit cards work or whether they'll work for you? Below we tackle the most frequently asked basic questions about credit cards including how they work, how to use them and how to choose the right one.
What is a credit card?
A credit card is a way of borrowing money that combines some of the characteristics of a bank account and some of those of a bank loan. You can use your card to pay for purchases in the shops and over the Internet, you can withdraw cash, and you can transfer other debts such as store card loans and existing credit card balances onto your account.
How do credit cards work?
When you successfully open a credit card account you are given a credit limit, which is the maximum amount you can borrow. A credit card account will stay open indefinitely, unless you close it, and you can use it for as many transactions as you please, for whatever amount you need, and as regularly as you see fit, so long as your balance remains within the limit you are set.
Once per month you will be issued with a statement that details your spending for the previous month and overall balance. If you have a negative balance the statement will set a billing date, by which time you will need to have made a payment into your account. This payment has a minimum level but no maximum. You are then charged interest on any balance that remains after this date.
Who provides credit cards?
Credit cards are provided by an extensive range of high street banks and building societies. They are also provided by major retail companies with established financial arms, credit unions, and other specialist financial institutions.
Some of the more niche companies specialise in providing credit cards to people with blemished or underdeveloped credit records who are turned away from the more established market players. However, these companies sometimes charge much higher rates of interest to hedge against the higher risk they ostensibly face.
Does it matter whether my card is Visa, MasterCard or American Express?
Credit cards require a payment processing company to act as a middleman between the issuing bank and the places you spend money. The biggest of these companies are Visa and MasterCard - both are accepted near universally where credit payment is an option, in the UK and abroad. There is very little difference between the two in their primary application as a credit card, however each company does offer slightly different terms in the reward schemes, privileges, insurance and loss protection that they offer to cardholders.
The only other competitor prevalent in the UK is American Express - sometimes known as Amex. It is less widely accepted but, unlike MasterCard or Visa, provides its own accounts. It also offers a more extensive range of additional rewards and benefits.
How does interest work on credit cards?
Interest is charged on anything that you borrow using your credit card, at a rate stipulated when you open the account. There are sometimes different rates of interest to pay depending on how you have accessed the borrowing - in shops, through cash withdrawals, or as a balance transfer.
Interest is calculated on a daily basis. However, it is not applied to your account until the monthly billing period after your next due date. This means that if you pay off your credit card balance, in full, on or before the due date, you will not pay any interest at all.
The rates can also change over time - your account provider will inform you if it does.
What is credit card 'APR'?
'APR' stands for 'Annual Percentage Rate'. It is used for comparing the value of credit cards and loans.
Expressed as a number, it indicates the percentage of your debt that you would pay back in interest, assuming the debt remains constant for an entire year. It also takes into account any maintenance or service charges you have to pay, giving a rounded view of the value proposition on offer.
As interest is calculated on a daily basis, the APR takes into account the compounding of interest (interest on interest).
How do '0%' and 'interest free' periods work?
Credit card providers offer interest free periods on different elements of borrowing to entice new customers. These interest free periods can either apply to purchases, balance transfers, or both. It is very rarely applied to cash advances.
During the interest free period, no interest will be applied to the account but you will still need to make at least partial monthly repayments on balances.
Interest free periods can last between three months and two years. When the interest-free period ends, you will then begin to accrue interest on all debts built up over the life of the account so far, not just new instances of borrowing.
How do repayments on credit cards work?
You will be required to pay down at least a portion of any debt you have on your credit card account during each billing period. There will be a minimum level that you have to pay which is set by your credit card provider. Government mandates that this level must be at least 1% of the debt, in addition to any interest or charges that have been applied to the account.
There is no maximum that you can pay off the account. You can pay off the whole balance if you wish, and even leave the account with a positive balance. If you clear your credit card debt each month, you will not pay any interest for that period. You only accrue interest on debt that that carried over from one billing period to another.
You are at liberty to make as many separate payments to your account as and when you choose. You can usually make repayments over the Internet or telephone, by direct debit, or in branch. You can sometimes make payments within banks or building societies that aren't your provider, although you may be charged a fee.
Which of my debts do my credit card repayments go towards?
Purchases, cash withdrawals and balance transfers can carry individual rates of interest. In the majority of cases, your repayment pays down the debt with the highest rate of interest first. You should query this matter with your prospective provider and ask specifically whether there are any circumstances where this is not the case.
What fees and charges do I have to pay on my credit card?
Credit card charges are generally separated into penalty fees and service fees.
Penalty fees are incurred when you break the terms and conditions of your account, such as missing a repayment by the due date or spending more than your credit limit. You will typically be charged a one-off fee of between £10 and £30 fee, or you'll be charged a daily fee of around £5 for every day you're over your limit.
Service fees are small charges imposed by the bank for particular transactions, including drawing cash out, using the card abroad, and transferring balances from other debts onto the account. These charges are usually calculated as a percentage of the transaction, with 2.5% a typical level. Sometime the bank will make an additional standing charge of around £2.50 per transaction on cash and foreign transactions too.
Can missed repayments and credit card charges affect my credit profile?
Instances of credit card charges you incur will be visible on your credit profile to other financial institutions that you apply for financial products with. They can therefore affect your chances of being accepted for mortgages, loans, credit cards and other banking services in the future.
Can having a credit card improve my credit profile?
When you seek financial products that require a credit check, an instance of running a credit card within the correct terms an conditions, with no late payments or exceeded limits, may be taken by the prospective provider as a positive endorsement of your credit worthiness.
However, many reported measures of improving credit worthiness such as maintaining a balance at a certain ratio of your credit limit or paying off the card in full each month are incorrect. This level of granularity in account maintenance is not included on credit files.
How do I choose the right credit card?
The biggest factors in choosing a credit card should be cost and service level. The APR interest rate, fees and service charges (including penalty charges), interest-free periods, and cash-back and other reward schemes should all be considered. You will also need to weigh up the credit limit you are offered.
The specific interest rate and credit limit you'll be offered can only be identified by undertaking an application process with the provider. Any 'typical' levels the provider advertises are based on the terms offered to as little as 60% of customers. Your specific terms will be dependent on the provider's interpretation of your credit profile.
You should also look to compare peer reviews of providers' customer service levels and the ease of access to the account, including through branches, Internet banking, and telephone services, as per your circumstances and preference.
You can also use the choice of Visa, MasterCard or American Express as payment processing partner as a way to differentiate between offerings. The rewards that one of these companies offers may be particularly useful or appealing to you, or there may be a specific outlet you want to use that accepts one type of card but not the other. Some banks offer a choice between the types of card you can be issued with; others offer only one option.
Who can get a credit card?
You have to be at least 18 years old to hold a credit card in the UK. You do not need to be a British citizen to open an account with a UK provider.
Will I be accepted for a credit card?
Whether or not you will be accepted for a credit card is dependent on your credit profile. This includes your financial history and your personal circumstances, such as your employment status and spending habits.
It is possible to have your application declined because you have a lack of experience in managing debt products; because you've had financial difficulties the past; if you've regularly received bank charges or missed repayments on loans; or due to your income being unstable.
Being accepted for a credit card, and under what terms, is largely at the bank's discretion.
Some of the more niche companies specialise in providing credit cards to people with blemished or underdeveloped credit records that are turned away from established providers. However, they often charge higher rates of interest.