U.S. News and World Report

Remember the good old days when you only needed to master a plastic rectangle when you wanted to buy something on credit?

Nowadays, it may involve using your smartphone as a virtual wallet or tapping your contactless credit card instead of swiping or inserting it. Although there are new options for using credit cards, the process behind the scenes is almost the same.

Why do you need to understand how credit cards work? Because once you master the life cycle of a credit card transaction, you will have a clearer understanding of how to use a credit card responsibly and avoid debt. You will also know how to use a credit card to benefit you.

It's like mastering any other subject. Learn it from scratch, and you will know how to fix it without destroying it.

— How does credit card payment work?

— How to use the grace period.

— How does credit card interest work?

— Credit and debit cards.

[Read: The best cash back credit card. ]

How does credit card payment work?

Suppose you are in a mall and your bill is $100. You insert your Chase Visa reward credit card into the payment device and start the payment cycle.

Here is what happened next:

1. Your credit card details will be sent to the retailer's bank, which is the acquiring bank. Assume that the acquiring bank is Wells Fargo Bank. The bank must obtain payment authorization from the credit card network (Visa in this case).

2. This request is also routed through the credit card issuer Chase to verify the number, credit limit and CVV (secure code). Please note that the CVV for Visa, Mastercard and Discover is three digits, but the CVV for American Express is four digits. Chase approves or rejects the transaction and sends this response to Visa and Wells Fargo.

3. After Wells Fargo is authorized to accept the payment, your card issuer Chase will put the money in your account, which will reduce your available credit limit.

4. The retailer includes your transaction with the batch of all other transactions of the day and sends it to Wells Fargo.

5. Next, the liquidation process begins. Wells Fargo sends the batch to Visa for processing.

6. The Visa network then sends the transaction to Chase. Chase responds and sends the payment amount (minus the exchange fee) to the Visa network.

7. Visa then pays Wells Fargo the fees after deduction of applicable fees. After deducting the cost, the retailer will receive approximately $97 to $98 as compensation for your purchase of $100.

8. Chase will send you a bill for the purchase amount of $100, which you will pay in full before the due date to avoid interest.

[Read: Best student credit card. ]

How to take advantage of the grace period

The grace period is the length of time between your purchase date and the due date on your statement. It varies by credit card issuer, but most grace periods are between 21 and 25 days. Assuming you don’t have a previous month’s balance, if you pay the bill in full before the due date, you don’t have to pay interest.

This is where people mess up. They decide whether to carry the balance this time is not important. But once you fall into that rabbit hole, you will get deeper and deeper. If you don't believe that you will soon fall into debt trouble, please read the next section.

How does credit card interest work?

All credit card interest rates are displayed as APR, which represents the annual interest rate. APR measures the annual cost of borrowing. It does not include additional costs, such as annual fees.

Most credit cards use variable APR, so your interest rate will vary based on the fluctuations in the prime rate set by the Federal Reserve. For example, if the prime interest rate is 4.75% and the base interest rate of the credit card is 10.74%, your variable annual interest rate is 15.49%.

Now, if you have a balance, you will eventually pay compound interest. When it is a savings account, compound interest is a good thing. But when it comes to your credit card balance, this is a bad thing. I will show you an example so that you can clearly understand what might happen.

Suppose you have a balance of $5,000 and a variable annual interest rate of 20%. We assume that your initial minimum payment is $133.33 (including interest plus 1% of the balance). If you pay the minimum monthly amount, it will take 277 months to pay off. It's been over 23 years! You will pay $7,723.49 in interest, for a total of $12,723.49, and a relatively small balance of $5,000.

According to a 2019 US News survey, more than 11% of consumers still believe that you must maintain a balance to build a good credit score. This is completely wrong. You can get high scores without incurring interest charges. Just pay off the balance every month and pay on time. Only 41% of respondents understand that if they do not pay the balance in full, they will charge interest.

Tip: If you do find yourself in debt, your goal should be to at least double the minimum repayment amount. In the example above, if you pay about $266 a month, you will pay off your debt and pay $1,045.44 in interest within 23 months.

Rules for using credit cards? Pay your balance in full every month before the due date. You will pay zero purchase interest and get an interest-free loan during the grace period.

If you cannot comply with this rule, please do not use a credit card. I was serious. Rotating balance will lead to stress and financial disaster.

[Read: The best secure credit card. ]

The Loan Truth Act (Regulation Z) requires every credit card quote to disclose its interest rate and fees. These laws are designed to protect you when you apply for a credit card. But you still need to research different types of credit cards online. When you apply for and receive a new card by mail, please read all the disclosures attached to the credit card. Yes, all the fine prints!

Purchase APR. According to U.S. News, the average annual interest rate for credit cards is between 17% and 24%. But the interest rate you get may be higher or lower than average, depending on your credibility. Please note that reward credit cards tend to have a higher APR.

Balance transfer APR. If you transfer your balance from a credit card to a balance transfer card, you will get an APR for the transferred amount. If your credit is good, you may be eligible for an introductory balance transfer card with an annual interest rate of 0%.

Balance transfer fee. Most balance transfer credit cards charge this fee, which is usually between 3% and 5% of the transfer amount.

Cash advance APR. If you use a credit card to obtain cash, you will be charged a higher APR for the withdrawal amount. The average APR for cash advances is about 26% or even higher. For most cards, interest on prepaid cash will begin to accumulate immediately, so please try to avoid obtaining cash in this way.

Cash advance fees. Most credit cards charge 2% to 5% of the withdrawal amount.

annual fee. Some credit cards charge an annual fee for using the card. The amount varies according to the rewards and features provided by the card.

Fine in April. If your bill payment is delayed by at least 60 days, some cards will charge a higher APR. Some issuers charge APR fines up to 29.99%. This should be enough to motivate you to pay your bills on time!

Foreign transaction fees. If you are shopping abroad, you may have to pay this fee, which is about 3% on average. Many credit cards no longer charge this fee, so if you travel a lot, get a credit card that is free of foreign transaction fees.

Overdue fines. If you delay payment, we will charge you this fee. The amount varies based on how often you are late. The credit card issuer can charge you $28 for your first default. Some card issuers do not charge late fees, but will pay your bills on time because it can provide you with a good credit history.

The following are the most popular types of credit cards.

Ordinary vanilla credit card. The annual interest rate of these cards is usually lower, but no rewards are provided. So the vanilla label. This type of card is suitable for financial emergencies. If you have to make a balance within a few months, using a low-interest card can save you money.

Reward credit card. These are very popular because you can get rewards through purchases. In this category, there are many different types, including cash-back cards, travel reward cards, and hotel and airline branded cards.

To truly profit from rewards credit cards, you need to look at your consumption patterns. Where do you spend your money? Do you travel often?

Be sure to check the fees and rates. Rewards credit cards tend to have a higher APR, so don’t deposit a balance on the rewards card. You can use these cards strategically and profit from your cards.

Balance transfer credit card. If you have a balance on a card with a higher APR, then transferring the debt to a balance transfer credit card with an introductory APR of 0% can save you money.

Nearly three-quarters of credit cards charge a 3% balance transfer fee on the transfer amount. Be sure to take this into consideration, as it will increase the balance you owe. Also, please pay attention to the duration of the introductory period. After the introductory period ends, your rate will increase to the APR you purchased.

Student credit card. The student card is designed for college students with limited credit. These cards are different, but many offer good APRs and rewards. If you are under 21, you must obtain a co-signer unless you can prove that you have enough income to pay off the debt you owe.

A secured credit card. If you have no or poor credit, obtaining an unsecured card can be challenging. The security card is designed for consumers who need a little help to establish or rebuild their credit history.

With these cards, you need to pay a security deposit, which is usually your credit limit. As long as you pay your bills on time, you can establish credit and eventually qualify for an unsecured credit card.

Commercial credit card. You can also apply for a credit card for your small business. You can use these cards to get various rewards, so please choose a business card that meets your consumption needs.

Credit and debit cards

There is a big difference between a credit card and a debit card. Credit cards are considered revolving credit. This means that you have a credit line, and you can purchase goods on credit and repay them before the due date.

If you do not pay in full before the due date, you will be charged interest because you borrowed money from the credit card issuer. The good news is that using a credit card responsibly can help you build credit because your card issuer will report your credit history to the major credit bureau.

However, a debit card does not help you build credit. Your debit card is linked to your own bank account. Therefore, you are actually spending your own money instead of reporting to the credit bureau. For people who don’t have or don’t want to use a credit card, a debit card is undoubtedly a payment method.

However, for online consumption, it is best to use a credit card. They provide more consumer protection than debit cards. In addition, it can also improve your credit score.

More from U.S. News

What is revolving credit-how does it destroy your credit score?

How often should I use my credit card?

Credit card difficulties plan you should know

The working principle of credit cards first appeared on usnews.com

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