How credit cards work – how they may affect your credit rating

How do credit cards work?

A credit card allows you to borrow money for purchases, services, or cash withdrawals. They’re issued by banks, finance companies and retailers, and can be used anywhere the card is accepted.

Each time you spend, the amount is added to your balance. You’ll be given a spending limit, known as a credit limit, which is agreed upon with the card provider based on your circumstances. This limit ensures you can only borrow up to a set amount.

Is it good to have a credit card?

Before deciding to get a credit card, it’s important to take a close look at your finances. Think about any current debts or financial commitments you already have.

If you find it challenging to manage money or feel you might be tempted to overspend, carefully consider all borrowing options. A credit card can be a helpful financial tool, but it’s not always the right choice for everyone.

The advantages and disadvantages of credit cards

Credit cards can be a useful financial tool, offering convenience, safety, and flexibility. However, they also carry risks and potential costs if not managed carefully.

Below, we explore the key benefits and drawbacks to help you make an informed decision.

Advantages of credit cards

• Convenience and global acceptance: Credit cards are widely accepted, making them an easy payment method, especially for booking travel, accommodation, or car rentals.
• Building your credit score: Responsible use, such as making on-time payments and staying within your credit limit, can improve your credit score and boost your chances of getting future credit.
• Safer than carrying cash: If your card is lost or stolen, you can cancel it through your provider. Fraudulent transactions may be easier to recover compared to cash losses.
• Managing large purchases: Credit cards can help you spread the cost of big-ticket items, such as home improvements or a holiday.
• Cost-effective borrowing: Some cards offer interest-free periods, which can make them a cheaper option than loans if balances are cleared on time.
• Purchase protection: Purchases between £100 and £30,000 may be covered under Section 75 of the Consumer Credit Act 1974. This offers financial protection if something goes wrong, such as a company going out of business.

Disadvantages of credit cards

• High-interest payments: If you don’t pay off your balance in full each month, you could face high interest rates once introductory offers end.
• Risk of debt: Missed payments or overspending can quickly lead to mounting debt. This can become difficult to manage if balances continue to grow.
• Potential harm to credit score: Missing payments or exceeding your credit limit can negatively impact your credit score, reducing your future borrowing options.
• Additional fees: Over-limit fees, late payment charges, and higher interest for cash withdrawals can add up. Some cards also charge annual fees.
• Costly abroad: Standard credit cards may carry extra charges for overseas use, particularly for cash withdrawals. Specialised travel cards can reduce these costs.

Credit cards and your credit rating

You’ll be required to make monthly repayments on your credit card spending. You can repay the minimum monthly amount, a fixed amount (above the minimum payment) or the full balance. Missing payments can harm your credit file, potentially making it harder to secure credit in the future. 

A credit card can help you build your future credit options if used responsibly. Regular spending and on-time repayments show lenders that you can manage credit effectively. This could boost your creditworthiness for loans or mortgages.

If your credit score is low, responsible credit card use can help improve it over time. Lenders review your credit history when you apply for credit. A strong credit score can increase your chances of approval and may secure better interest rates.

Before applying for a credit card, consider checking your Equifax Credit Report and Score. Free for the first 30 days, it can help you identify areas for improvement on your credit file and get an idea of your overall creditworthiness.

Frequently asked questions

What is a cash advance on a credit card?

A cash advance lets you withdraw money using your credit card from a cash machine, as you would with a debit card. However, cash advances typically come with additional fees, higher interest rates, and no interest-free period. This makes them more expensive than regular credit card purchases.

You can request a cash advance through a cash machine, bank branch, or online banking. 

Does cancelling a credit card impact your credit score?

Cancelling a credit card can affect your credit score, depending on your financial circumstances.

One potential impact is on your credit utilisation, which is the percentage of your total available credit that you use. For example, if cancelling a card lowers your total credit limit, your utilisation rate could increase, which may impact your credit score. 

Keeping long-held, well-managed credit accounts can also benefit your credit score , as it demonstrates reliability as a borrower. Before cancelling a card, consider how it might affect your overall credit usage and account history. 

What happens if you don't use your credit card?

If you don’t use your credit card for an extended period, your card issuer may reduce your credit limit or close the account altogether.

To avoid this you may consider making small, occasional purchases and paying them off in full at the end of the month. Paying off your balance in full at the end of month means you won’t be impacted by interest rates increasing the debt and may also indicate to a potential lender that you are responsible with credit. 

Loan or credit card - which is better?

Your choice depends on your financial goals and repayment preferences.

There can be advantages and disadvantages to each type of credit. Your choice depends on your financial goals. Always do your own research into what may suit your circumstances and ensure repayments are affordable for you.