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There are millions of credit card accounts in the United States alone, and it’s estimated that 84% of adults in the U.S. have at least one credit card. Yet, many people don’t have a firm grasp on the basics of what a credit card is and how credit cards work.

If you have a credit card account, or plan on ever using one, it’s important to understand the fundamentals of credit cards. This ranges from what a credit card is to how credit card interest works to how credit cards relate to credit scores.

Recommended: Tips for Using a Credit Card Responsibly

What Is a Credit Card?

A credit card is a type of payment card that is used to access a revolving line of credit.

Credit cards differ from other types of loans in that they offer a physical payment card that is used to make purchases. Traditionally, credit cards are made of plastic, but an increasing number of credit card issuers now offer metal cards, usually for their premium accounts that offer travel rewards.

But a credit card account is much more than a plastic or metal payment card. A credit card account is a powerful financial tool that can serve many purposes. For starters, it can be a secure and convenient method of payment anywhere that accepts credit card payments. It also can be used to borrow money in a cash advance or to complete a balance transfer.

Additionally, credit cards can offer valuable rewards, such as cash back and travel rewards like points or miles. Cardholder benefits can also include purchase protection and travel insurance policies.

If used responsibly, a credit card can help you to build your credit score and history, which can open up new borrowing opportunities. Of course, credit cards can also damage your credit when used irresponsibly. If you rack up debt on your credit card, it can be hard to get it paid off and back in the clear (here, for instance, is what happens to credit card debt when you die).

Recommended: Does Applying For a Credit Card Hurt Your Credit Score?

How Do Credit Cards Work?

Credit cards offer a line of credit that you can use for a variety of purposes, including making purchases, completing balance transfers, and taking out cash advances. You can borrow up to your credit limit, and you’ll owe at least the minimum payment each month.

You can apply for a credit card from any one of hundreds of credit card issuers in the U.S. Card issuers include national, regional, and local banks, as well as credit unions of all sizes. Card issuers will approve an application based on the credit history and credit score of the applicant, among other factors.

There are credit cards designed for people with nearly every credit profile, from those who have excellent credit to those with no credit history or serious credit problems. As with any loan, those with the highest credit score will receive the most competitive terms and benefits.

Once approved, you’ll likely receive a credit limit that represents the most you can borrow using the card. Whether your limit is above or below average credit card limit depends on a variety of factors, including your payment history and income.

The credit card is then mailed to the account holder and must be activated before use. You can activate a credit card online or over the phone. So long as your account remains in good standing, it will be valid until the credit card expiration date.

Once activated, the card can be used to make purchases from any one of the millions of merchants that accept credit cards. Each card is part of a payment network, with the most popular payment networks being Visa, Mastercard, American Express, and Discover. When you make a payment, the payment network authenticates the transaction using your card’s account number and other security features, such as the CVV number on a credit card.

Every month, you’ll receive a statement from the card issuer at the end of each billing cycle. The statement will show the charges and credits that have been made to your account, along with any fees and interest changes being assessed.

Your credit card statement will also show your balance, minimum payment due, and payment due date. It’s your choice whether to pay your minimum balance, your entire statement balance, or any amount in between. Keep in mind that you will owe interest on any balance that’s not paid back.

If you don’t make a payment of at least the minimum balance on or before the due date, then you’ll usually incur a late fee. And if you pay more than your balance, you’ll have a negative balance on your credit card.

Credit Card Fees

There are a number of potential fees that credit card holders may run into. For example, some credit cards charge an annual fee, and there are other fees that some card issuers can impose, such as foreign transaction fees, balance transfer fees, and cash advance fees. Cardholders may also incur a late fee if they don’t pay at least the minimum due by their statement due date.

Often, however, you can take steps to curb credit card fees, such as not taking out a cash advance or making your payments on-time. For a charge like an annual fee, cardholders will need to assess whether a card’s benefits outweigh that cost.

3 Common Types of Credit Cards

There are a number of different kinds of credit cards out there to choose from. Here’s a look at some of the more popular types.

Rewards Credit Cards

As the name suggests, rewards credit cards offer rewards for spending in the form of miles, cash back, or points — a rewards guide for credit cards can give you the full rundown of options. Cardholders may earn a flat amount of cash back across all purchases, or they may earn varying amounts in different categories like gas or groceries.

The downside of these perks is that rewards credit cards tend to have higher annual percentage rates (APRs), so you’ll want to make sure to pay off your full balance each month.

Balance Transfer Credit Cards

Balance transfer cards allow you to move over your existing debt to the card. Ideally, this new card will have a lower interest rate, and often they’ll offer a lower promotional rate that can be as low as 0% APR. However, keep in mind that this promo rate only lasts for a certain period of time — after that, the card’s standard APR will kick back in.

Secured Credit Cards

If you’re new to credit or trying to rebuild, a secured credit card can be a good option. Generally, when we talk about credit cards, the default is an unsecured credit card, meaning no collateral is involved. With a secured credit card, you’ll need to make a deposit. This amount will generally serve as the card’s credit limit.

This deposit gives the credit card issuer something to fall back on if the cardholder fails to pay the amount they owe. But if you’re responsible and get upgraded to a secured credit card, or if you simply close your account in good standing, you’ll get the deposit back.

How Does Credit Card Interest Work?

The charges you make to your credit card are a loan, and just like a car loan or a home loan, you can expect to pay interest on your outstanding credit card balance.

That being said, nearly all credit cards offer an interest-free grace period. This is the time between the end of your billing period and the credit card payment due date, typically 21 or 25 days after the statement closing date. If you pay your entire statement balance before the payment due date, then the credit card company or issuer will waive your interest charges for that billing period.

If you choose not to pay your entire statement balance in full, then you’ll be charged interest based on your account’s average daily balance. The amount of interest you’re charged depends on your APR, or annual percentage rate. The card issuer will divide this number by 365 (the number of days in the year) to come to a daily percentage rate that’s then applied to your account each day.

As an example, if you had an APR of 15.99%, your daily interest rate that the card issuer would apply to your account each day would be around 0.04%.

Recommended: Average Credit Card Interest Rates

Credit Cards vs Debit Cards

Although they look almost identical, much differs between debit cards vs. credit cards. Really, the only thing that debit cards and credit cards truly have in common is that they’re both payment cards. They both belong to a payment network, and you can use them to make purchases.

With a debit card, however, you can only spend the funds you’ve already deposited in the checking account associated with the card. Any spending done using your debit card is drawn directly from the linked account. Because debit cards aren’t a loan, your use of a debit card won’t have any effect on your credit, positive or negative.

But since it isn’t a loan, you also won’t be charged interest with a debit card, nor will you need to make a minimum monthly payment. You will, however, need to make sure you have sufficient funds in your linked account before using your debit card.

Another key difference between credit cards vs. debit cards is that credit card users are protected by the Fair Credit Billing Act of 1974. This offers robust protections to prevent cardholders from being held responsible for fraud or billing errors. Debit card transactions are subject to less powerful government protections.

Lastly, debit cards rarely offer rewards for spending. They also don’t usually feature any of the travel insurance or purchase protection policies often found on credit cards. You likely won’t be on the hook for an annual fee with a debit card, which is a fee that some credit card issuers do charge, though you could face overdraft fees if you spend more than what’s in your account.

To recap, here’s an overview of the differences between credit cards and debit cards:

Pros and Cons of Using Credit Cards

Beyond knowing what a credit card is, it’s important to familiarize yourself with the pros and cons of credit cards. That way, you can better determine if using one is right for your financial situation.

To start, notable upsides of using credit cards include:

•   Easy and convenient to use

•   Robust consumer protections

•   Possible access to rewards and other benefits

•   Ability to avoid interest by paying off monthly balance in full

•   Potential to build credit through responsible usage

However, also keep these drawbacks of using credit cards in mind:

•   Higher interest rates than other types of debt

•   Temptation to overspend

•   Easy to rack up debt

•   Various fees may apply

•   Possible to harm credit through irresponsible usage

How to Compare Credit Cards

Since there are hundreds of credit card issuers, and each issuer can offer numerous individual credit card products, it can be a challenge to compare credit cards and choose the one that’s right for your needs. But just like purchasing a car or a pair of shoes, you can quickly narrow down your choices by excluding the options that you aren’t eligible for or that clearly aren’t right for you.

Start by considering your credit history and score, and focus only on the cards that seem like they align with your credit profile. You can then narrow it down to cards that have the features and benefits you value the most. This can include having a low interest rate, offering rewards, or providing valuable cardholder benefits. You may also value a card that has low fees or that’s offered by a bank or credit union that you already have a relationship with.

Once you’ve narrowed down your options to a few cards, compare their interest rates and fees, as well as their rewards and benefits. You can find credit card reviews online in addition to user feedback that can help you make your final decision.

Important Credit Card Terms

One of the challenges to understanding how credit cards and credit card payments work is understanding all of the jargon. Here’s a small glossary of important credit card terms to help you to get started:

•   Annual fee: Some credit cards charge an annual fee that users must pay to have an account. However, there are many credit cards that don’t have an annual fee, though these cards typically offer fewer rewards and benefits than those that do.

•   APR: This stands for annual percentage rate. The APR on a credit card measures its interest rate and fees calculated on an annualized basis. A lower rate is better for credit card users than a higher rate.

•   Balance transfer: Most credit cards offer the option to transfer a balance from another credit card. The card issuer pays off the existing balance and creates a new balance on your account, nearly always imposing a balance transfer fee.

•   Card issuer: This is the bank or credit union that issues the card to the cardholder. The card issuer the company that issues statements and that you make payments to.

•   Cash advance: When you use your credit card to receive cash from an ATM, it’s considered a cash advance. Credit card cash advances are usually subject to a much higher interest rate and additional fees.

•   Chargeback: When you’ve been billed for goods or services you never received or that weren’t delivered as described, you have the right to dispute a credit card charge, which is called a credit card chargeback. When you do so, you’ll receive a temporary credit that will become permanent if the card issuer decides the dispute in your favor.

•   Due date: This is the date you must make at least the credit card minimum payment. By law, the due date must be on the same day of the month, every month. Most credit cards have a due date that’s 21 or 25 days after the statement closing date.

•   Payment network: Every credit card participates in a payment network that facilitates each transaction between the merchant and the card issuer. The most common payment networks are Visa, Mastercard, American Express, and Discover. Some store charge cards don’t belong to a payment network, so they can only be used to make purchases from that store.

•   Penalty interest rate: This is a separate, higher interest that can apply to a credit card account when the account holder fails to make their minimum payment on time.

•   Statement closing date: This is the last day of a credit card account’s monthly billing cycle. At the end of this day, the statement is generated either on paper or electronically, or both. This is the day on which all the purchases, payments, fees, and interest are calculated.

Credit Cards and Credit Scores

There’s a lot of interplay between credit cards and your credit score.

For starters, when you apply for a new credit card, that will affect your score. This is because the application results in a hard inquiry to your credit file. This will temporarily ding your score, and it will remain on your credit report for two years, though the effects on your credit don’t last as long.

Further, how you use your credit card can impact your credit score — either positively or negatively. Having a credit card could increase your credit mix, for instance. Or, closing a longstanding credit card account may shorten the age of your accounts, resulting in a negative impact to your score.

Making timely payments is key to maintaining a healthy credit score, as is keeping a low credit utilization rate (the amount of your overall available credit you’re currently using). If you max out your credit card or miss payments, that won’t bode well for your credit score. Conversely, staying on top of payments can be a great step toward building your credit.

The Takeaway

Credit cards work by giving the account holder access to a line of credit. You can borrow against it up to your credit limit, whether for purchases and cash advances. You’ll then need to pay back the amount you borrowed, plus interest, which is typically considered to be a high rate vs. other forms of credit. For this reason, it’s important to spend responsibly with a credit card.

Whether you're looking to build credit, apply for a new credit card, or save money with the cards you have, it's important to understand the options that are best for you. Learn more about credit cards by exploring this credit card guide.

FAQ

How does a person shop for a credit card?

To shop for a credit card, start by looking at your credit score to determine what cards you may be able to qualify for. Then, decide what kind of card is best for your needs, such as a card that has a low interest rate, one that will allow you to build credit, or a card that offers rewards. Finally, compare similar products from competing card issuers to assess which is the most competitive offer available to you.

Can I use my credit card abroad?

Yes, most credit card payment networks are available in most countries. As long as you visit a merchant that accepts cards from the same payment network that your card belongs to, then you’ll be able to make a purchase.

How do you use a credit card as a beginner?

If you’re new to credit and working to build your score, you’ll want to make sure you’re as responsible with your card as possible. Pay your bill on time, and aim to pay in full if you can to avoid interest charges. Use very little of your credit limit — ideally no more than 30%. And make sure to regularly review your credit card statements and your credit report. But don’t let any of that scare you away from using your card either — it’s important to regularly use your card for small purchases to get your credit profile built up.

How do credit cards work in simple terms?

Credit cards offer access to a line of credit. You can borrow against that, up to your credit limit, for a variety of purposes, including purchases and cash advances. You’ll then need to pay back the amount you borrowed.

How do payments on a credit card work?

At the end of each billing cycle, you’ll receive a credit card statement letting you know your credit card balance, minimum payment due, and the statement due date. You’ll then need to make at least the minimum payment by the statement due date to avoid late fees and other consequences. If you pay off your full balance, however, you’ll avoid incurring interest charges. Otherwise, interest will start to accrue on the balance you carry over.

Photo credit: iStock/Katya_Havok

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Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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A synthetic long is an option strategy that replicates going long the underlying asset. The strategy is used by bullish investors who wish to use the leverage of options to establish a position at a lower capital cost.

As with going long in a particular asset, potential profits are unlimited, however, potential losses can be substantial if the underlying asset price goes to zero.

What Is a Synthetic Long?

First, a refresher on the two basic types of options: puts and calls. Options are a type of derivative that may allow investors to gain — not by owning the underlying asset and waiting for it to go up, but by strategically using options contracts to profit from the asset’s price movements.

Establishing a synthetic long requires purchasing at-the-money call options and selling put options at the same strike price and expiration. A synthetic long strategy has a bullish outlook since the maximum profit is unlimited while the downside risk, increases until the asset price goes to zero.

An investor puts on a synthetic long options position when bullish on the underlying asset, but wants a lower cost alternative to owning the asset. You can learn more about how options trading works with SoFi.

A synthetic long options position has the same risk and reward profile as a long equity position. The setup can be beneficial to traders since a lower amount of capital is needed to establish the position. The options exposure offers leverage while owning the asset outright does not.

A key difference between a synthetic long and a long position in the underlying asset is the time limit dictated by the option’s expiration date. The options trader also does not have shareholder voting rights and will not receive dividends.

How Do Synthetic Longs Work?

Synthetic longs work by offering the options trader unlimited upside via the long call position. If a trader was very bullish, they might buy only the long call.

However, the short put helps finance the synthetic long trade by offsetting the expense of buying the long call. In some cases, the trade can even be executed at a debit (profit) depending on the premiums of the two options.

By including the short put, the investor can be exposed to losses, should the asset price drop below the strike price of the short put, but no more than would be expected if the trader went long the underlying asset.

Setup

A synthetic long options play is one of many popular options strategies, and it can be constructed simply: You buy close-to-the money (preferably at-the-money) calls and sell puts at the same strike price and expiration date.

Your expectation is to see the underlying asset price rise just as you would hope if you were long the asset outright. If you’d rather own the asset outright, you can always purchase the stock directly through your brokerage.

Maximum Profit

There is unlimited profit potential with a synthetic long, just as there is with a long position. If the underlying share price rises the value of the call will increase and you can sell the call at a profit while covering (buying back) the short put to close out your trade.

Breakeven Point

A synthetic long’s breakeven point is calculated as the strike price plus the debit (cost) paid or minus the credit (profit) received at the onset of the trade.

Maximum Loss

The maximum loss is limited, but only because an asset’s price can’t drop below zero, but it can be substantial. Losses are seen if the underlying share price drops below the break even point and maximized if the asset price drops to zero.

In the event that the asset price drops below the strike price of the short put, the trader can be assigned shares and would be obligated to buy the asset at the strike price. The risk of assignment increases as the asset price drops and the option nears expiration, but it can happen at any time once the asset trades below the strike price.

The loss would be slightly higher or lower based on the credit or debit of the initial trade.

Exit Strategy

Most traders do not hold a synthetic long through expiry. Rather, they use options to employ leverage with a directional bet on the underlying asset price, then exit the trade before expiration.

To exit the trade, the investor sells the long call and buys back the short put. This tactic avoids buying the underlying asset and the increased capital outlay that would incur.

Recommended: Margin vs. Options: Similarities and Differences

Synthetic Long Example

Let’s say you are bullish shares of XYZ company currently trading at $100. You want to use leverage via options rather than simply buying the stock.

You construct a synthetic long options trade by purchasing a $100 call option contract expiring in one month for $5 and simultaneously selling a $100 put option contract at the same expiration date for $4. The net debit (premium paid) is $1.

   Net debit = Call Option Price – Put Option Price = $5 – $4 = $1 per share

   Note: The $1 net debit is per share. Since an option contract is for 100 shares, the debit will be $100 per option contract.

If the asset price falls, you experience losses. If the stock price drops to $90 after one week, the put premium rises to $12 while the call option price falls to $4. Your unrealized loss is $9 (the long call price minus the short put price minus the net debit paid at initiation).

You choose to hold the position with the hope that the stock price climbs back. Because the stock price has dropped below the $100 strike price you are at risk of your short put being exercised and assigned.

   Unrealized loss = Long Call Price – Short Put Price – Net Debit at Initiation

   Unrealized loss = $4 – $12 – $1 = Loss of $9 per share or $900 per option contract

A week before expiration, the stock price has risen sharply to $110. You manage the trade by selling the calls and covering the short put. At this time, the call is worth $12 while the put is worth $3. The net proceeds from the exit is $9. Your profit is $8 ($9 of premium from the exit minus the $1 net debit).

   Profit = Long Call Price – Short Put Price – Net Debit at Initiation

   Profit = $12 – $3 – $1 = Profit of $8 per share or $800 per option contract

You could hold the trade through expiration but would then be exposed to having to own the stock.

Calculating Returns

A synthetic long replicates a long position in the underlying asset but at a lower cost.

In the example above, an investor might have purchased 100 shares of XYZ at $100 each for a capital outlay of $10,000. If the shares closed at $110, the long position would be worth $11,000.

   $ Gain = Selling Price – Purchase Price

   $ Gain = $11,000 – $10,000 = $1,000

   % Gain = $ Gain / Purchase Price

   % Gain = $1,000 / $10,000 = 10% Gain

The synthetic long in the example above is substantially cheaper at a cost (debit) of $100 for one option representing 100 shares of XYZ. When sold, the options were worth $900.

   $ Gain = Selling Price – Purchase Price

   $ Gain = $900 – $100 = $800

Note this gain is approximately the same as the gain if the shares were bought.

   % Gain = $ Gain / Purchase Price

   % Gain = $800 / $100 = 800% Gain!

As you can see, while dollar gains are very similar, the percentage gains are larger due to the power of leverage using options. But leverage works both ways.

If we take a loss on a synthetic long, dollar losses will also be in line with losses on a long position, but percentage losses can be as outsized as the gains.

Pros and Cons of Synthetic Longs

Alternatives to Synthetic Longs

To have long exposure to a stock you can simply own the stock outright. Stock ownership carries with it the benefits of voting rights and dividends but at a much higher capital outlay.

Another alternative similar to a synthetic long options trade is a risk reversal. A risk reversal options trade is like a synthetic long, but the strike price on the call option is higher than the put strike price. A risk reversal is also known as a collar.

A synthetic long call can also be created with a long stock position and a long put.

A bearish alternative is a synthetic long put strategy. A synthetic long put happens when you combine a short stock position with a long call.

The Takeaway

Options synthetic long strategies combine a short put and a long call at the same strike and expiration date. It replicates the exposure of being long the underlying asset outright — but the investor needs a lower-cost alternative to owning the asset. It’s one of many options strategies that allow traders to help define their risk and reward objectives while employing leverage.

Putting on a synthetic long position means buying at-the-money call options and selling put options at the same strike price and expiration. This strategy has a bullish outlook because the maximum profit is unlimited, while downside risk increases until the asset price goes to zero.

If you’re ready to try your hand at options trading, SoFi can help. You can set up an Active Invest account and trade options onlinefrom the SoFi mobile app or through the web platform. And if you have any questions, SoFi offers educational resources about options to learn more. SoFi doesn’t charge commission, and members have access to complimentary financial advice from a professional.

FAQ

What is a long combination in options trading?

A combination is a general options trading term for any trade that uses multiple option types, strikes, or expirations on the same underlying asset. A long combination is when you benefit when the underlying share price rises.

How do you set up a synthetic long?

A synthetic long is established by buying an at the money call and selling a put at the same strike price. The options have the same expiration date. The resulting exposure mimics that of a long stock position.

What is the maximum payoff on a synthetic long put?

The maximum payoff on a synthetic long put happens if the stock price goes to zero. Maximum profit when the underlying stock goes to zero is the strike price of the put minus the premium paid to construct the trade.

Photo credit: iStock/FG Trade

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