Apr 22, 2012

How do credit cards work?

Today credit cards became the essential and the most common way to perform money transactions between a customer and a merchant, but not all of the everyday credit cards users know how exactly it works from the inside.

A credit card is issued by the credit union or a bank for a particular individual. Credit card is connected to a revolving account and opens this person an access to a credit line with particular limit which is known as a credit limit. The size of the limit is usually determined by the type of the credit card, the person’s credit score and credit history. Credit limit is not a constant value – it is first defined when opening a credit card, but then it can be reviewed by the bank periodically based on the changes in credit score and the length of the relationships with the client.

Credit card is issued to be used in one of the leading multinational payment systems – Visa, Master Card, American Express, Discover, or a smaller national one. The actual plastic card will have a logo of the supported payment system on its face. Credit card processing companies provide services for merchants, from a small souvenir shop up to a big retailer, to enable them to accept credit cards of the international payment systems with an option to accept local payment systems (what is needed for example in a tourist areas).

Visa Master card AmEx logo at merchant

Valid credit card should have a 16 digit credit card number, card holders name and valid date embossed on the face side. The reverse side has a CVV code that is used to confirm the possession of the credit card by the person who makes payments online (in “card not present” transactions).

Credit card number and CVV

How it works for the cardholder

Your credit card has a starting balance that is equal to zero – that means you do not have any debt. The highest amount of money you can use for spending is your available credit that is equal to credit limit. When you pay for a purchase or a service with a credit card, the transaction is processed by the processing company and your bank sends money to the merchant account. Your balance increases by the amount paid, and your available credit decreases by the same amount.  For example, you had a $1000 credit limit and 0 balance when you opened a credit card account. After you bought a $100 iPhone4, your available credit becomes $900 and your balance is now $100.

On the next month you will receive a credit card statement with all your spendings in the last month. Statement includes information about your previous balance, all transactions in the last month, fees and interest owed to a bank for the last month, your current balance and available credit.

Previous Balance – your Payments and Credits + Fees and Interest Charged + Transactions = New Balance

For our example shown above it will be: $0 –$0 + $0 + $100=$100

You should pay your new balance in full or at least do the minimum payment (also shown in the statement) towards to it till the due date– usually due date is 20-30 days after the billing. If you do not have a debt on your credit card (that means your previous balance is zero) you have a so called grace period before the due date when the interest will not be charged. After the end of the grace period bank starts to charge you the interest on your new balance. If you already have a balance, a new debt will be just added to your balance and the interest will be calculated on your increased debt. It is also a good habit to read your statement carefully to check if all the claimed transactions are real and no fraud transactions are included there.

If in the current month you spend all your available credit, you will not be able to use your credit card until you make a payment towards your balance that will unlock available credit. If you use your credit card regularly and usually do all the payments in time, the bank reviews your credit limit periodically (1-2 times a year) and can increase it. Average credit limit on the customer’s credit cards in the US is about $10 000, but for the new customer with not an excellent credit, a bank can make a starting credit limit of only $500-$1000.

If you fail to do a minimum payment (which is in average about 1% of the balance + all fees and interest and no less than $15-$35) on the due date you’re in trouble. A bank adds a late payment fee to your balance, information about late payment will be sent to credit agencies, your bank can raise your APR or even close your account.

Now the good news – credit cards often offer rewards in a form of cash back, flexible rewards or air miles options. Cash back is the option when the bank sends a certain percentage (usually 1-2%) of your monthly purchases of particular goods or services (e.g. all travel spendings or purchases in participating retailers) back to your account. Flexible rewards instead of cash back award you virtual points that you can later combine and spend in a selection of participating businesses. Air mile cards are often issued in partnerships with air carriers and award you a certain amount of virtual air miles for every dollar spend with your credit card. After you collect enough air miles you can exchange them to the air tickets according to the conversion rate.

Another good option for most credit cards on the US market is the benefits they offer e.g. rental car insurance and travel medical insurance. These options are free of charge and provide a customer with secondary car insurance when renting a car or a basic medical insurance when travelling abroad. Best credit cards for high earners offer additional benefits like 24/7 concierge service and personal travel agent.

How it works for the merchant

Credit card processing explained

Merchants are provided with electronic devices to read credit cards – POS (Point of sales) and a service to accept electronic payments from the card holder’s account to the merchant bank account. Another old-fashioned way to receive credit card payments for a merchant is making a slip of a credit card with a valid credit card holder’s signature on the bill for the service or a purchase. Later these bills with slips are processed by the processing company and the money is transferred from credit card holder account to a merchant account. Today many alternative payment systems are offering convenient ways to collect payments and accept credit cards – for example PayPal, Square, Google Wallet and others. All these payment systems are competing for a share of the purchase or a service price that is collected from the merchant – a % of commission that stays for the system when the money is transferred from the card holder account to a merchant account. Average commission for a credit card processing for a “card is present” transactions (e.g. retail shop) is about 2%. It is even higher for businesses that use “card not present” transactions (online shop) and can reach 2.5%-3%. Simply put – all the goods and services are 2-3% more expensive because all the customers want to use credit cards. Because of the complicated commissions structure that includes a flat transaction fee and the % of the transaction, many small businesses do not accept credit cards for purchases less than a curtain amount (usually $3-$10). Some small businesses even use it as a selling point that they can offer lower prices because they do not accept credit cards.

Credit cards offer us a lot of convenience in our everyday life, but as any technology it involves certain risks for the customers who do not follow or just do not know the rules. First thing to start with a new credit card should be reading your credit card terms and conditions along with explanations of benefits – let it be your credit card bible or a bedside reading whatever is more important for you.

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