How credit cards work

What you need to know before applying for a credit card.

What is a credit card?

A credit card is a type of ongoing loan.

When you use a credit card to make a purchase you essentially borrow the money from the credit card provider and they pay the merchant on your behalf.

As you have borrowed the money you will need to pay it back. Depending on the timing of the transaction and the terms and conditions of the credit card you may also be required to pay interest.

Interest rate

The interest rate on credit cards is typically higher than other forms of credit as they are a form of unsecured loan. This means there is no asset, like a house or a car, as collateral against the money borrowed on the card so it is a higher risk to the credit provider.

Credit cards use compounding interest to calculate the interest charged.

Premium vs low-rate cards

Most credit cards can be divided in to either premium or low-rate cards.

Premium cards can have interest rates on purchases as high as 25%, while low-rate cards have a comparatively lower interest rate (this can be up to 15%).

Interest-free period

Understanding how the interest-free period applies can help you determine if a card suits your needs.

The interest-free period will usually be expressed as “up to XX days on purchases”, which is the maximum number of days from a purchase to when interest will be charged. However, depending on when the item is purchased, it could be less.

For example, if your credit card offers 55 days interest free and the statement period begins on 1 March and ends on 30 March. This means that you have until 25 April (55 days from the beginning of the statement period) before payment is due and interest is charged.

If you made a purchase on 1 March, you would have 55 days before interest would be charged. If you made another purchase on 30 March, you would only have 25 days before payment is due on 25 April and interest is charged.

If the full balance is paid by the end of the statement period then you won’t be charged interest.

If you only pay the minimum amount or pay less than the full balance, interest will begin to accrue. No interest-free period will apply until the balance is paid in full.

Credit card fees

Fees associated with credit cards include annual fees, cash advance fees, international transaction fees and late fees.

Annual fees are paid every year, regardless of how often you use your credit card, and are typically higher for card that come with additional features such as rewards programs. Some credit cards don’t have an annual fee and other offer to waive the first year’s annual fee as part of a promotion, but you will have to pay the fee after the first year.

Most credit cards charge a fee (and higher interest rates) for each cash advance. A cash advance is withdrawing cash from your credit card at an ATM or transferring money to a bank account. You can avoid cash advance fees by using your debit card to withdraw cash.

International transaction fees apply anytime you use your credit card outside of Australia or if you make an online purchase from a company that is based overseas. This fee is usually a percentage of the purchase cost. Some credit cards waive international transaction fees which can be beneficial if you travel overseas regularly.

If you don’t pay the minimum monthly repayment on time each month, you could be charged a late fee in addition to the interest that will begin to accumulate. A late fee is usually a fixed dollar amount.

Other fees that won’t appear in your statement include credit card processing fees. This fee is charged by merchants and will be included in the total cost of items purchased. Credit card processing fees can depend on the type of card used with Diners Club and American Express typically charged more than other credit cards.

Credit limits

A credit limit is the total maximum amount your credit card provider will lend you at any one time.

When choosing a credit card limit consider how much you are likely to spend each month and if you will be able to repay the amount in full.

When you apply for a credit card, the provider must assess whether you can repay the maximum credit limit within three years. This means you can be approved for a much higher credit limit than you need.

Credit card providers can’t offer you credit limit increases on an existing credit card, but you can request an increase at any time.

You are also able to reduce your credit limit at any time, however many cards will have a minimum credit amount.

Additional features

Credit cards can also provide additional features and benefits. These should be considered bonuses and you should not choose a credit card based on additional features. Often the annual fee will exceed any benefit from additional features.

Some of additional features include:

  • Frequent flyers points
  • Cash back
  • Rewards programs
  • Travel insurance
  • Purchase protection
  • Concierge services
  • Extended warranties
  • Price protection insurance

Terms and conditions may apply to additional benefits such as extra fees, minimum spend or expiry of rewards points.

How do debit cards work? Find out here.

The information in this article has been prepared for general information purposes only and not as specific advice to any particular person. Any advice contained in the document is general advice and does not take into account any person’s particular investment objectives, financial situation or needs. Before acting on anything based on this advice you should consider its appropriateness to you, having regard to your objectives, financial situations and needs.