How do credit cards work?

What are the two rules of credit cards?

You don't need to know exactly how credit cards work to use them, because the right way to use a credit card is easy to summarise in two rules:

1. Always pay your statement balance by the due date
2. Only use your card for purchases - not to access cash

If you find your statement balance and due date on your monthly statement, and make sure you pay that statement balance by that due date, and you do that every single month, and if you only use your card for purchases, then you will be using your card perfectly, even if you don't know the nuts and bolts.

That said, understanding how a credit card works will help you understand why you need to follow those two rules, and know what to do if you ever break one of them.

What is a credit card?

A credit card account is a line-of-credit. That means that it is a standing offer from the bank to lend you any amount of money up to your credit limit, without needing to apply for a separate loan each time you use the card for a purchase. You can add to your amount borrowed at any time by making purchases, or reduce your amount owed by making payments to the account.

Your credit card has an interest rate associated with it, which is the amount per year that the bank charges you for borrowing their money. On a card with no interest free period, a bank would look at the amount you owe them at the end of each day (your account balance), calculate the interest payable on that balance, and charge that interest to your account. Usually credit cards have a very high rate of interest, so it is a very expensive way to borrow money.

Banks set the minimum amount you need to pay each month so that you will pay off all of the interest that they have charged for that month, and a very small amount of the actual amount you've borrowed. Paying just the minimum can take decades to pay off your full balance, because almost all of your payments are just to cover the interest.

What is the interest-free period?

Given the high interest rates on credit cards, you might wonder why many people still use them when they have the money available to cover their purchases each month from savings. The answer is the interest-free period, which you can think of as the bank agreeing not to charge you any of the interest they have been calculating on your balance so long as you follow the two rules above, which to remind you, were:

1. Always pay your statement balance by the due date
2. Only use your card for purchases - not to access cash

So the effect of the interest-free period is that by following the rules then you will never pay any interest, but what are the actual mechanics of it? What period is it referring to, and what do the different number of days in the interest-free periods offered by different cards mean?

To answer those questions, here is a timeline showing some important dates for a credit card account across three months:

In this diagram, each statement period is given a different colour, and in this example they happen to line up with the months of the calendar. Any purchases made during the same statement period will be combined and totalled to give the statement balance at the end of the statement period, which is known as the statement date.

So, if you made a $50 purchase on January 6, and a $400 purchase on January 20, you would be sent a statement showing a statement balance of $450 on the statement date, January 31. That $450 will be due for payment some time later, on the due date, which in this case is about 25 days after the statement date, well into February. That 25 day period between the statement date and the due date is sometimes called the grace period, and it can vary in length between credit cards.

In the time between the January statement date and the January due date, you may be making purchases in the February statement period, which will increase your current balance, but won't increase the January statement balance that is due to be paid. Those purchases in February will be totalled on the February statement date, and due on the February statement due date (which will be some time in March).

Take a moment to imagine making a purchase at some point in the few months shown above and work out which statement the purchase would be added to, and when payment for that purchase would be due.

Now we're finally ready to talk about the interest free period. Remember that so long as you follow the two rules of credit cards, the bank will never charge interest on your balance. Given that, let's look at how long you're able to borrow money from the bank without paying any interest for purchases made at different times.

Above we imagined a $50 purchase made on the January 6, that won't need to be paid for until the January statement period due date, on the February 25. That's a 50 day loan between purchase and eventual payment without any interest. Now consider the $400 purchase on the 20th of January. That still needs to be paid on the February 25, so this time you'll only get a 36 day period between purchase and payment, interest-free. The fact that the length of the period between purchase and payment can vary from 55 days for a purchase made on January 1, and only 25 days for a purchase made on January 31 is why credit card interest-free periods always say "up to" a certain duration.

What happens if you break either of the two rules?

The effect of breaking the two rules is slightly different, so I'll talk about both of them separately.

Rule One: Always pay your statement balance by the due date

The thing to remenber about credit cards is that at their core they are loans from the bank with very high rates of interest. Every day, the bank is looking at the amount you've borrowed, and is calculating interest on that amount, waiting (and maybe hoping) to be able to charge you that interest. But, in order to attract customers, they offer a challenge: if you can follow Rule One, then they will completely cancel all of that interest they've been calculating, as if your interest rate had been 0% the whole time. If you slip up, then the deal is off - suddenly all of that interest they've been calculating is no longer cancelled, and is applied to your account retroactively.

That means if you only make the minimum payment on your due date, then pay off the full statement balance only a day later, you won't be paying only a day of interest on that balance, you'll have to pay interest all the way back to when you made the purchase, which could be up to 56 days earlier.*

If you end up in this situation by accident or necessity, your absolute priority needs to be to pay off your full current account balance (because you've also lost the interest-free period for future statement periods). You may be able to call your bank and ask them to cancel the interest if you're only a day or two late, but they would be within their rights to refuse.

Most banks will have a way to set up automatic payments which will ensure that you always pay the statement balance by the due date, meaning you will never have to pay interest on your purchases.

Rule Two: Only use your card for purchases - not to access cash

This rule exists for a straightforward reason. The interest-free period offered by banks does not apply when you use your card for cash advances, which is the term used to describe using your credit card to access cash, instead of for purchasing items or services. 

Examples of cash advances are drawing money from an ATM using your credit card, loading online gambling accounts, or purchasing travellers cheques. What counts as a cash advance varies between banks, so you need to be a little careful. For example, some banks will count paying for gift cards as a cash advance.

From the moment you use your card for a cash advance, the bank will start calculating and charging interest on that amount, and may also charge you a separate cash advance fee. With many banks, your interest free period for your purchases will not be affected, but you should call your bank to check.

If you receive a cash advance, you should prioritise paying that off immediately, and should call your bank to find out whether your interest-free period on purchases will be affected by the cash advance.

Why use a credit card?

Given the risk of an expensive interest bill if you happen to break either of the two rules, why do people still choose to use a credit card?

There are several benefits to using credit cards, some of which will depend on the exact card you choose to take out. Here are a few:

• Many credit cards offer points which have a value of 0.5% to 2% of the amount you spend on the card
• The interest-free period is free loan, that leaves money in your savings account for longer, earning you interest
• In the event of a fraudulent transaction, credit cards tend to give more protection than debit cards
• Many credit cards offer perks, such as free travel insurance when certain travel expenses are paid for using the card, extended warranties on goods bought with the card, and so on
• Having a line of credit available for true emergencies can give piece of mind, although it is better to build an emergency fund of savings instead

*Recent legislation in Australia has meant that credit card providers can only start charging interest from the due date when you first lose your interest-free period.

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