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How Does a Credit Card Work?

Credit cards have made it easy for a lot of people around the globe to make purchases on credit. It is a form of plastic money and can be used to make payments offline and online. It seems almost magical that by swiping a plastic card you can pay for products and services, but in actual there is advance technology and multiple players involved in making the whole credit card system work.

The credit card functions differently for a cardholder and for the other parties.

For a credit cardholder:

When you apply for a credit card, the card provider will check if you are financially eligible to own it or not. If you are eligible, then based on the amount you earn, the bank or Credit Card Company will set a credit limit for you.

Once you receive your credit card, you can use it to make payments on credit. By using this card, you are borrowing money from your card provider (Credit Card Company or bank). Every billing cycle you can use either the full credit limit or a portion of it.

If you exceed your credit limit, you will have to pay a penalty. At the end of every billing cycle, the lender expects you to repay the amount you have borrowed.

There is a fixed interest free credit period, within which the cardholder is supposed to pay either the full amount due or a part of it. Credit card providers generally specify the minimum amount that cardholders have to pay every billing cycle, to avoid being considered a defaulter.

If the cardholders pay the full amount due, they do not have to pay any interest on their card. In case they pay only the minimum amount due or do not repay any money, then they will have to pay an interest on the outstanding balance and on the new purchases. The card provider will keep charging the interest until they pay the full outstanding balance.

For the other parties:

The other parties involved in the credit card system are:

Merchants or sellers – They use the POS (Point of Sale) Terminals to swipe the credit cards of the customers to get their money.

Payment Gateway – It is the online version of the POS machines used at retail outlets. The payment gateway authorises the purchases that are made using a credit card online.

Credit Card Issuers – These are the banks or Credit Card Companies that offer credit cards, collect the monthly bills and deal with the customers.

The Acquirer – It is the bank or financial institution that process the credit card payments on behalf of the merchants. The Acquirers provide the POS machines to the merchants.

 

Association or Network – It refers to the payment processing network, which collect information from the processors, authorizes and collects the payments for the purchases, etc. For example - Visa, MasterCard, American Express, etc.

 

Payment Processors – The payment processors take care of collecting the data and sending it to the Network. The right network is identified by the first and last digits of the credit card numbers.

 

Process:

When a cardholder swipes his/her credit card to make payment at a merchant outlet, a request is submitted by the merchant to the acquirer via a phone or network connection. The acquirer forwards this request to the card issuer to authorize the transaction.

 

The card issuer has to check if the cardholder has enough credit available in his/her account to make the purchase. If yes, then an authorization code is sent by the issuer to the acquirer, who then approves the transaction and the purchase is made.

 

A merchant does not swipe just one card on the POS machine in a day. Depending on the number of customers, there can be many requests sent by the merchant to the acquirer.

So, in order to track the sales, merchants send the requests to the acquirer in batches through the card association or network to the issuers to get the payment. The association distributes the transactions according to the issuers.

 

The issuers deduct the interchange fee and transfers the amount to the acquirer, who after deducting their share, sends the balance to the merchants. The transaction rates varies from merchant to merchant and is dependent on the transaction numbers, type, category, etc.

 

The payment process is same in case of online purchases as well except that the payment are processed by payment gateways such as PayUMoney, VeriSign, etc.

 

The Cost of Charging a Credit Card Balance

 

The credit card issuer gives you a certain amount of time to pay back the entire amount that you’ve borrowed before your charged interest. The period of time before the interest is charged is called the grace period, which is typically between 20 and 25 days. If you don’t pay off your full balance before the end of grace period, a fee or finance charge is added to your balance. The finance charge is based on the interest rate and your outstanding balance.

 

The interest rate is the annual rate you pay for borrowing money on your credit card. Interest rates are generally based on market interest rates, your credit history, and the type of credit card you own. If you have a good history of paying back your credit card bills, you’ll usually qualify for lower interest rates than what's typically charged.

 

You have to pay your balance in full before the end of the grace period if you want to avoid paying interest. However, the credit card issuer usually doesn’t require you to pay back all of what you owe at once, but you must pay at least the minimum payment by the due date to avoid a late penalty. Paying only the minimum is the slowest and most expensive way to pay off your credit card balance.

 

However, it's important to always pay at least the minimum amount on time each month to maintain a good credit history and to avoid late fees. As you build a stable credit history, you may qualify for a lower interest rate on the card.

 

Reviewing Your Credit Card Activity

 

Each month, the credit card issuer will send you a billing statement that includes your minimum payment, the due date, and a list of the transactions that have been posted to your account since your last billing statement. It’s a good idea to review these transactions to make sure that all of the transactions were made by you and that there are no discrepancies. You also want to make sure your last payment was correctly applied to your account. If any fees have been added to your balance, make sure they are legitimate.

 

Other Types of Plastic

 

Physically, a credit card is a piece of plastic measuring 3-1/8 inches by 2-1/8 inches. Typically, there are 16 digits embossed on the front (15 digits for an American Express card). Note that there are other types of cards that fit this description that aren't credit cards, but mimic a credit card in that you swipe to make a purchase.

 

For example, a check card or debit card will also have 16 digits imprinted on the front. However, purchases on a debit card are taken from your checking account. Also, a prepaid card looks and works very much like a credit card, but purchases are deducted from the prepaid account balance.

The Acquirer – It is the bank or financial institution that process the credit card payments on behalf of the merchants. The Acquirers provide the POS machines to the merchants.

Association or Network – It refers to the payment processing network, which collect information from the processors, authorizes and collects the payments for the purchases, etc. For example - Visa, MasterCard, American Express, etc.

Payment Processors – The payment processors take care of collecting the data and sending it to the Network. The right network is identified by the first and last digits of the credit card numbers.

Process:

When a cardholder swipes his/her credit card to make payment at a merchant outlet, a request is submitted by the merchant to the acquirer via a phone or network connection. The acquirer forwards this request to the card issuer to authorize the transaction.

The card issuer has to check if the cardholder has enough credit available in his/her account to make the purchase. If yes, then an authorization code is sent by the issuer to the acquirer, who then approves the transaction and the purchase is made.

A merchant does not swipe just one card on the POS machine in a day. Depending on the number of customers, there can be many requests sent by the merchant to the acquirer.

So, in order to track the sales, merchants send the requests to the acquirer in batches through the card association or network to the issuers to get the payment. The association distributes the transactions according to the issuers.

The issuers deduct the interchange fee and transfers the amount to the acquirer, who after deducting their share, sends the balance to the merchants. The transaction rates varies from merchant to merchant and is dependent on the transaction numbers, type, category, etc.

The payment process is same in case of online purchases as well except that the payment are processed by payment gateways such as PayUMoney, VeriSign, etc.

The Cost of Charging a Credit Card Balance

The credit card issuer gives you a certain amount of time to pay back the entire amount that you’ve borrowed before your charged interest. The period of time before the interest is charged is called the grace period, which is typically between 20 and 25 days. If you don’t pay off your full balance before the end of grace period, a fee or finance charge is added to your balance. The finance charge is based on the interest rate and your outstanding balance.

The interest rate is the annual rate you pay for borrowing money on your credit card. Interest rates are generally based on market interest rates, your credit history, and the type of credit card you own. If you have a good history of paying back your credit card bills, you’ll usually qualify for lower interest rates than what's typically charged.

You have to pay your balance in full before the end of the grace period if you want to avoid paying interest. However, the credit card issuer usually doesn’t require you to pay back all of what you owe at once, but you must pay at least the minimum payment by the due date to avoid a late penalty. Paying only the minimum is the slowest and most expensive way to pay off your credit card balance.

However, it's important to always pay at least the minimum amount on time each month to maintain a good credit history and to avoid late fees. As you build a stable credit history, you may qualify for a lower interest rate on the card.

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