Credit cards 101: What they are, how they work, and potential benefits and risks

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.

There are potential benefits and risks to buying on credit. For example, using a credit card could help a person make a large purchase and manage their budget by paying off the expense over time. On the flip side, if not responsibly managed by a consumer the fees and interest could add up and make the purchase more costly.

This article focuses on a common type of credit: credit cards. It explores what they are, how they may work, where they can be used, and some potential pros and cons.

Types of credit

There are different types of credit. Some examples include: overdrafts, mortgages, personal loans, credit cards, and buy now, pay later, amongst others.

Credit cards are considered one of the most common methods people use to buy goods and services in the UK.¹ This type of financing can make shopping convenient and help consumers to spread the cost and budget effectively. Many cards have interest-free offers on new purchases for a given period of time which can make purchasing larger ticket items or unforeseen expenses more manageable as they allow for monthly repayments.

The key to having a credit card is responsible borrowing and maintaining the repayment schedule. It’s important to note that credit cards can come with costs such as the addition of interest to your balance and the risk of late payment fees. Failure to keep up your repayments may also make future borrowing more difficult as lenders report your details to the Credit Reference Agencies. People should carefully consider if a purchase is affordable and how repayments will be made before deciding to use a form of credit.

What is a credit card and how does it work?

Cardholders can use credit cards to make purchases up to an agreed credit limit. Each time a purchase is made, the cardholder may make purchases within their available credit limit. The amount of available credit goes up once the cardholder makes a repayment. A credit card requires a minimum repayment to be made monthly. The amount of credit that each cardholder gets can vary significantly and will depend on individual financial circumstances.

Credit card providers often conduct soft credit checks before an applicant applies. This type of credit inquiry is normally used to provide an indication of whether an application may be successful. Soft credit checks typically don’t impact an individual’s credit rating and won’t show up on their credit report.³

Most credit card providers carry out hard credit checks on applicants when they apply. These include checking an individual’s credit report. Hard credit checks show up on an individual’s credit report and may affect their credit score.²

Credit card holders will receive a statement showing what they’ve spent each month and be required to pay off at least the minimum amount due. The minimum amount is set by the credit card provider. Other charges and fees may apply.

If someone pays back the full amount they borrowed in a given month, they'll typically avoid paying interest. If a monthly statement is not paid in full, the cardholder will be charged interest on the outstanding balance. Repaying the balance on time and in full each month may help a credit card user stay within their credit limit and avoid the pitfall of interest and late payment fees.

There are different ways to repay a credit card balance. Some examples include: setting up a direct debit, using a debit card to repay online or by phone, transferring money from an online banking account to the credit card provider, or sending a cheque. Available payment methods may vary depending on the credit card provider.

As with any spending option, it’s important for an individual to only use a credit card if it’s within their financial means.

What can credit cards be used for?

Credit cards may be used in a variety of ways. Here are some potential examples:

• In-store or online purchases: This can apply to both large retailers or smaller merchants. The business needs to accept credit card payments for this to be possible.
• Bills: Credit cards can be used to pay for unexpected bills such as home appliance repairs or car expenses.
• International travel expenses: A cardholder could use their credit card to pay for things when traveling abroad. Foreign transaction fees and other costs may apply.
• Travel cards and travel season tickets: Credit cards can be used to buy annual travel tickets.

Credit card fees, interest, and other associated costs

Making purchases with credit cards can come with fees, interest, and other associated costs. These may vary depending on the product offer chosen and the credit card issuer.

Potential credit card fees

Credit cards can come with many different types of fees. Even if minimum monthly payments are met, there’s still the possibility of incurring extra costs. Examples of credit card fees include: annual or monthly fees, late payment fees, foreign transaction fees, fees for spending over the credit limit, and cash withdrawal fees. Others may apply.

Interest rates on credit cards

An interest rate is the amount a lender charges a cardholder on money borrowed. Credit card interest rates can depend on many factors.

In the UK, the Bank of England sets the bank rate, also known as the base rate.⁴ This bank rate can impact the interest rates set by financial institutions, such as banks, that issue credit cards.

The rate offered to an individual if their application is considered successful by credit card issuers may depend on said individual’s credit history, payment history, unpaid balances, and the risk of the debt not being paid. Different providers may use different criteria.

What is an APR for a credit card?

APR stands for Annual Percentage Rate. It is the cost of borrowing for a 12-month period expressed as a percentage. It takes into account the interest rate plus any additional fees and costs associated with taking out the credit.

Lenders may offer different interest rates based on individual applications. A Representative APR for a credit card is an advertised rate so that an easier and fairer comparison can be made. It’s the typical total cost of the credit card expressed as a percentage, spread over 12 months. The Representative APR is the rate that at least 51% of those accepted will get.⁵

The rate a cardholder receives can depend on their personal circumstances and will take into account things such as their credit history. An individual’s APR could be the same as the advertised representative rate, or it could be different, depending on individual’s circumstances.

Potential benefits of using a credit card

Buying on credit cards can come with benefits. Some potential upsides include:

• Easy to use: Using a credit card in store or online can be a simple and fast way to check out.
• Spreading the cost of larger expenses: Using a credit card may help shoppers spread the cost of larger purchases and stay in control of their budget.
• Rewards and loyalty programs: Some credit cards come with bonus perks such as reward points, which cardholders may be able to put toward future purchases.
• Section 75: If someone has used a credit card to purchase something over £100 but less than £30,000, their purchase could be covered by S.75 Consumer Credit Act.⁶ This means that if there’s a problem with a purchase or the company that sold it fails, the credit card company may have equal liability with the seller.

Potential risks of buying on credit

Buying on credit cards can come with risks. Some potential drawbacks include:

• Fees, interest, and other associated costs: It’s important for people to carefully consider their financial situation before applying for and using a credit card. Fees, interest, and other associated costs can add up and possibly cause a cardholder to go into debt.
• Missed payments: It’s important for cardholders to pay off at least the minimum monthly repayment. Missed or late payments could affect an individual’s overall credit health and make borrowing more difficult and expensive.
• International usage costs: Some credit card providers may charge international transaction fees and other charges.
• Impact on credit health: Credit reports record how many times someone has applied for credit and other details, such as repayment history and outstanding credit. These factors could affect an individual's credit score.

It’s important for anyone applying for or using a credit card to carefully consider their individual financial situation. They should be confident that they can keep up with repayments and that they can afford what they’re buying.

PayPal Credit⁷ is like a credit card, without the plastic. It’s a credit limit that’s attached to an individual’s PayPal account which can be used to spread the cost of online purchases. Representative 23.9% APR (variable).