Money Basics: How credit cards work

Welcome to Money Basics, Yahoo Finance’s new personal finance series offering quick explanations for some of the most important terms involving your money.

Credit cards can be great for making big purchases. After all, it’s a lot easier to swipe a card than hand over hundreds or even thousands of dollars in cash.

When you use a credit card to purchase items, you are essentially borrowing money from a short-term lender—the credit card company. This short-term loan can affect you in different ways, depending on how much you use it and when you pay back what you’ve borrowed.

Credit card companies collect interest on balances not paid back in full after a billing cycle expires. Interest is money paid at a particular rate for the use of money lent. At the end of the billing cycle you have an option to pay the full amount outstanding, less than the full amount or a minimum payment.

Racking up too much debt or paying your credit card bills late can hurt your credit score.

Paying less than the full amount you owe can trigger interest to accumulate on your balance, which can get very expensive over time. If you only make the minimum payment you can be paying off your balance for quite a long time and pay a large amount in interest. If you default, or fail to pay back your credit card, your credit score will take a big hit.

Having good credit can potentially help you get a lower interest rate. When you apply for a card, the credit card company will look at your creditworthiness, or level of trust in paying back the loan. Your credit history and credit score are the two major parts of your creditworthiness check. It will also want to know if you have a job with a stable income to ensure that you are able to pay back outstanding balances. The better your history, score and income reliability, the more likely you will be granted a line of credit.

Many credit cards offer some form of cash back or rewards programs based on your purchases. Make sure to research any card you are interested in thoroughly and pick the one that best fits your lifestyle.

Credit cards usually offer protection if your card is lost, stolen or compromised. If you are quick to notify your credit card company of fraud or a lost card, you are usually covered for any fraudulent charges.

Understanding how credit cards work is an important step to controlling your finances.

More from Money Basics:

• What is APR?
• What’s your net worth?
• What’s the Dow Jones?
What’s the NASDAQ?
• What is a credit report anyway?