How do Credit Cards work? Definition, Types, Uses, Cost, and Benefits

What is a Credit Card?

A credit card is a plastic card allowing the cardholder to use a virtually borrowed fund to purchase goods or services. The card is issued by a financial institution that contains necessary information of its holder. Usually the issuer allocates a credit limit to the credit card for its holder.

Two parties of Credit Card – Lender and Borrower

Financial Institutions extending financial backing are the Lender or issuer of Credit Cards. Contrarily, the cardholder using the financial support allotted to the card is the borrower or user of Credit Cards. The lender offers credit limit to the borrower through the plastic card.

Types of Credit Cards

Types of Credit Cards actually implies the network provider of cards. The following are the most famous types of Credit Cards in terms of captured market:

1. Visa
2. Mastercard
3. Citibank
4. Chase
5. American Express/Amex
6. Capital One
7. Bank of America
8. Discover 9. Synchrony Financial
10. Wells Fargo
11. Barclays US
12. US Bank
13. USAAs
14. Credit Onedstg15. PNC

You can read more about different types of credit cards from our previous study on credit card types.

Vocabulary of Credit Cards

Some of the terms are very relevant to Credit Cards and a cardholder should be acquainted with these terminologies.

  • Authorized User – The person who is allowed by the issuer to use the card
  • APR – Annual Percentage Rate is the total cost for using the card, both interest and charges
  • Average Daily Balance – Average outstanding balance of each day on a card during a billing period
  • EMV Chip – Stands for Europay, Mastercard and Visa Chip containing all information of the cardholder and records every transactions on the card
  • Billing Period – Period for which a Credit Card Statement is prepared
  • Grace Period – Time between the billing cycle and due date to make payment for outstanding amount plus interest and other charges
  • Finance Charge – Fees charged by the issuer for using the card
  • Balance Transfer – Transfer of available amount on a Credit Card to another card or account
  • Cash Advance – Withdrawal from ATM or bank teller out of available cash advance amount on a Credit Card

How does a Credit Card works?

Usually Credit Cards provide short term loans to the user from the issuer. These loans carry out the regular monetary transactions on credit. The holder uses the issuer’s money and the issuer bills the holder at a later time. Let’s take a sneak peak of Credit Card mechanism.

Issuance of a Credit Card

Financial Institutions like banks or credit unions issue Credit Cards to their customers. Upon satisfactory meet up of the criteria by an individual, banks issue a Credit Card with a certain credit limit.

Usage of Credit Cards

Since its inception, the primary objective of launching Credit Cards has been to purchase goods or to make payments for rendered services with no money in the picket or even in the bank account. But with the lapse of time, usage of Credit Cards are more dynamics these days.

POS transactions: Most commonly we use Credit Cards at POS machine after buying any item from the groceries or supermarket. We even can make payments to our service provider, e.g. tuition fees at colleges, medical charges to hospital, premium to insurance companies, and so on. After purchasing the desired items, we require to swipe out card in to POS terminal. If the card is magnetic tape based, the terminal will deduct the bill after reading the required information from it. If it is a chip based card, the user will get a One-time-password (OTP) for validating the transaction. Once the OTP is given to the terminal, it will charge the money for the purchase.

Ecommerce transactions: We can utilize our credit limit to transact on ecommerce websites like amazon, ebay, steam, play store, etc. After adding items to online cart, we will be redirected to a payment completion page for billing. The page will ask for some information such card number, expiry, security digits and name on the card to read into the account. If everything is correct, the payment getway will send a OTP to our contact number or email of designated by iur card issuer. Once we enter the OTP and proceed, the transaction would be authenticated and completed.

Tap and pay: Another commonly seen usage of Credit Cards these days is tap and pay. In this sort of payment, we have to scan to merchant’s QR code and from the smartphone app we can payoff the dues.

Bill payment

Credit Card billing system is cyclical and one cycle usually covers a month. Outstanding amount during this billing cycle is called total payable amount. The cardholder must payoff the due within the due date. The due date usually is set at fifteen days later to the billing date. And altogether the forty five days (thirty days billing cycle and 15 days grace) are interest free period.

The cardholder is suppose to pay off the total outstanding amount or the minimum payable amount. In this way he can avoid being reported as a borrower with past due payments. The minimum payment is generally calculated as five percent of total outstanding on a card.

How banks rips out the benefit from credit cards? 

The banks benefit their cause by letting their customers using Credit Cards in both direct and indirect way. If a user pays for his purchases from his checking account then the money goes away from the bank. But if he uses his Credit Card then the money stays in the bank for some more days until he pays off his bills on the card. Even if he pays off the bills, it goes to the merchant’s account which is also with the same bank. In this way, the money circulates in the same bank and they can utilize it recurrently.

Credit Card costs

Banks charge interest and other financial charges over Credit Card usage. If cardholder fails to repay his payable amount within the due date, bank charges interest at APR for the due period. And this cycle goes on until he flushes out the whole payable amount from his card.

Bank also charges if the outstanding balance crosses the card limit. Moreover, for every transaction bank gets a revenue from the merchant at two percent of the transaction amount. Besides, bank also earns from the user for several facilities like cash advance, check processing, balance transfer, new card or PIN generation, etc.

Perks and benefits

Other than facilitating with credit, using Credit Cards really pay off with lots of perks and rewards. User gets reward points for card usage and gets to redeem those for paying off outstanding amount. Moreover, points are also used for gift cards of renowned stores.

Occasionally, banks carryout cashback campaign. Users get cashback on the transaction amount on their cards. Some of the networks also facilitates with buy one get one/two/three offer, prize contest, vacation trip, etc.

Pros and cons of Using a Credit Card

Pros

  • Credit Cards help someone to build a sound credit history towards getting a bigger loan like automobile or mortgage loan.
  • One can meet up his daily needs with Credit Card and pay off the due later without paying any extra money.
  • Using Credit Cards pay off with a lots of perks and benefits.
  • Expensive items are easy to buy with EMI facility with Credit Cards.
  • Any dispute on billing errors can be sorted out with proper investigations, so the cardholder does not get charged wrongly.
  • Credit Cards security features are strong enough to keep the users apart from any trouble or fraudulent activities.

Cons

  • Credit Card charges are quite high. APR is 12% to 16% on an average.
  • If not paid within the due time, interest is charged on the payable amount. Someone paying only the minimum due will definitely stuck under a huge debt burden in no time. And it will take him ages repay the full amount in this way.
  • High usage of Credit Cards reduce potentiality of future earnings.

How banks make money form Credit Cards?

Banks’ primary head of revenue out of Credit Card services is Interest. Banks charge interest on the outstanding amount of a billing period if it is not paid within the due date. If the accumulated amount is still not cleared further interest is charged on the basis of compound interest principle.

Suggested Reading: Differences between debit cards and credit cards

Other service charges in Credit Cards

Besides interest, banks earn money from other charges for using Credit Cards. Major heads of those are annual fees, supplementary card fees, finance charges, cash advance fees, check processing fees, late payment fees, excess over limit fees, balance transfer fees, etc. Apart from these, banks charge for their services like statement fees, credit information fees, notification fees, card or PIN regeneration fees, etc.

How do you get a Credit Card?

To get a Credit Card, you need to fulfill the below criteria:

  • Get a Social Security Number
  • Get an acceptable income source to satisfy that you are able to take a card.
  • Alternatively, you can provide some leverage with fixed deposit to securitize the card.
  • You must have a sound credit history. Your credit history can be obtained from credit bureau or rating agencies.

Bottom Line

If all the criteria are found out to be satisfactory, banks will issue a Credit Card to you. But sometimes banks have their own policy to decide whether to issue a card or not. So meeting with all the criteria may not get you a Credit Card necessarily.