How do credit cards work? Our finance expert explains how to use them sensibly

Credit cards can be useful to help you manage your money, but how do credit cards work?

It's an important question to answer as families are concerned about how to save money amid the cost of living crisis. While it helps to know how to make extra money, sometimes a credit card can be a suitable choice to help spread the cost of more expensive items.

It’s fair to say that credit cards can be something of a hazard. Get carried away and it can be easy to spend more than you can afford. And if you can't repay, you could see yourself in debt and your credit score negatively effected, making it harder for you to borrow money in the future. But, if they’re used correctly, they can actually help you manage your money and even let you borrow for free.

Personal finance editor at Interactive Investor, Alice Guy, explains: “A credit card can be a great way to spread the cost of bigger purchases. Some cards offer a 0% interest for up to 24 months. You could replace a big appliance with a 0% credit card and pay for it gradually.”

How do credit cards work? 

When you pay for something with a credit card, that money is lent to you by your credit card provider. Over the course of a month your credit card provider will tot up everything you spend on it and issue you with a statement showing how much you owe.

You’ll have to pay something off each month – there’s normally a minimum repayment of around 3% of the amount you have spend on your credit card or £10 – but how much more you repay than that is up to you.

This is where credit cards can be dangerous. The longer you take to repay the debt, the more it will cost you overall. Only make minimum repayments and your debts will spiral and could take years to pay off. This is because you’ll start seeing interest charges added to unpaid interest charges from previous months. This is called compounding your debt.

You’ll typically have up to 56 days to pay the money back interest-free. After that point, interest charges will be added to any money you’ve not paid back – unless you have a credit card with an extended 0% interest-free period. Always check the terms and conditions for your credit card - you should receive these as paperwork when you receive your card. 

In an ideal world you’d pay off your balance before interest is charged – that way you haven’t paid a penny to borrow that money. 

How much interest will I pay?

Interest rates on credit cards vary a lot. There are plenty of cards offering 0% interest, but the ‘typical’ rate on a standard credit card from a high street bank is currently around 23% or 24%.

This is the APR or Annual Percentage Rate and it shows how much interest you’ll pay on the money you have borrowed over the course of the year. Check out our handy guide if you're wondering what does APR mean.

But, just to confuse matters, you’ll also see a representative APR on adverts and promotions. This is the rate that at least 51% of applicants will get, but isn’t necessarily the rate you’ll get – you should treat it more like an indication. Your actual APR will depend on your credit record. People who have borrowed before and have a good record of making payments on time will get the best deals. Find out how to improve your credit score if you want to benefit from the best rates.

Head of consumer affairs at Experian (where you can check your credit score), James Jones, explains: “It’s harder to get a credit card if you have a poor credit record, but not impossible.” You’ll likely get a lower borrowing limit and pay a higher rate of interest.

It’s also important to understand that different types of spending may carry different interest rates, for example new purchases and balance transfers you might carry over from another credit card.

The real sting, though, can come from using you card to withdraw cash from a cash machine. This is because interest will be charged straightaway – there’s no interest-free period at all.

Types of credit card 

To use credit cards to your advantage, you need to get to grips with the different types of credit card that are available:

• Purchase credit cards
• Balance transfer credit cards
• Rewards credit cards
• Travel credit cards.

Personal finance analyst at Hargreaves Lansdown, Sarah Coles, says: “Different cards are useful for different things. A card with 0% period on purchases is useful If you need to make a one-off purchase, and want to pay it off before interest is due.

“One offering a 0% period on balance transfers is a useful way to consolidate debts and repay them before you’re hit with interest charges. However, if you rack up new debts on your card, they may attract interest and they’ll definitely make repayments more difficult.”

How to choose a credit card

Once you have identified a reason to take out a credit card and have worked out which type will suit you best (see table above), it’s easy to shop around for the best deals at comparison websites, such as our sister site Go.Compare.

Look for cards offering the lowest interest rate for the job you need it to do, keeping an eye out for any additional charges or fees.

Before you apply for any card it’s a good idea to take advantage of free-eligibility checkers on comparison sites. These will let you find out what credit cards you’ll be eligible for without formally applying and risking damage to your credit record.  

James Jones from credit agency Experian explains: “Each time you apply for credit the lender will carry out a hard credit check which other lenders can see. Too many hard credit checks in a short space of time can ring alarm bells, as lenders may see it as a sign of financial difficulty or even fraud.”

Once you know you’re eligible, you can apply for the credit card online.

Should I get a credit card? 

“Before you take out a credit card you need to think about why you need it,” suggests Experian's James Jones. That could be to spread the cost of a big purchase – a new TV or washing machine perhaps - or to cut the cost of spending on holiday.

To make sure you don’t end up saddled with debt, it’s best to only use your card for its designated ‘job’ and have a clear plan for how you’ll repay it.

Personal finance analyst, Sarah Coles agrees: “Whatever you do, don’t think of your credit limit as an amount that you have available to spend.”

If you don’t have a specific need for your credit card or don’t have a plan for how you’ll repay the money, you’ll likely be better off without one.

Alternatively, if you’re considering a credit card to help you pay for regulars costs like food and bills, it’s usually better to think twice. This is because, if you can't pay it off in full each month, you may well struggle with repayments and see your money worries intensify.

What happens if I can’t afford to pay off my credit card? 

“If you can’t afford to pay your credit card bill you have a few different options,” says Alice Guy from Interactive Investor. “If you have a good credit rating, you may be able to apply for a balance transfer card with a low or 0% interest period. You can then reduce your payments and pay the balance off gradually. There are also some balance transfer cards designed for people with poor credit ratings.”

If that’s not an option the next step is to get in touch with your credit card provider to explain your situation. “They may offer to reduce or pause your payments,” she adds.

You can also contact debt charities that offer free debt advice like Citizen’s Advice or Step Change. They can talk to lenders on your behalf and come up with a repayment plan for you.

The very worst thing that you can do is simply hope the problem goes away. If you can’t make repayments, you’ll start paying late payment penalties which will only make your problems bigger. The sooner you get help, the easier it will be to turn your situation around.