How Credit Cards Work

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How Credit Cards Work

A credit card is a small plastic card that draws on a line of credit made available by a bank or credit union. Cardholders can use the card to purchase goods and services from merchants who accept that card. Once a purchase is made, the cardholder is bound by his or her contract with the card to pay back the money, with any interest required. Many merchants now use electronic verification systems to determine whether the card is valid and has sufficient credit for the purchase.

In addition to purchases, a cardholder can take out a cash advance from the card’s line of credit. Any amount spent, whether for a purchase or a cash advance, is considered a short-term loan made to the user.

Revolving credit

Because you can draw on your credit limit over and over within your credit limit, credit cards are known as revolving credit. This differs from standard loans, which loan you a set amount of money with no revolving use.

Every month, the cardholder receives a statement showing the purchases made, any fees levied, interest charges, and the total amount owed. The cardholder must pay the minimum payment in order to avoid a penalty. If the balance is not paid in full, it will carry over to the next month and will accrue interest.

Why your credit risk matters

Your ability to use a credit card is based on your credit risk, which the issuing company assesses before offering you a credit card. If you are deemed a good risk, you will be offered credit. If you are deemed a very good risk, you may qualify for a lower interest rate or additional perks. One popular perk is rewards, in which your purchase of goods earns you points that you can redeem for goods and services or else receive as cash.

Though your credit risk affects your ability to enjoy a credit card, your credit card will in turn affect your credit risk. The balance on your card(s) compared to your credit limit is noted by the credit reporting bureaus, as is your history of paying on your debts. If your balance is high, or if you have a lot of late or missed payments, your credit score will go down. (The ideal balance is about one-third of your credit limit: e.g., a $1,000 balance on a $3,000 credit limit.)

Credit card ownership

Credit card ownership takes several forms. There is individual credit, in which you alone are responsible for its use and payback. There is joint credit, in which you and another person are responsible for its use and payback. There is also authorized usership, in which someone else has the use of the card. However, with authorized usership, you alone are responsible for paying back the debt. In all these forms of ownership, the credit that is extended to you is based on your income, your assets, and your credit history.

Benefits to merchants

Credit cards are ubiquitous partly because merchants like them. For one thing, payment is secure because the bank that issued the card will pay the merchant. This is not always the case when you write a check to the merchant. Even with cash, which may seem like a shoo-in, there is the possibility of it being counterfeit and thus unusable. Another advantage to merchants is that people tend to spend more freely with credit than cash because they do not need to pay it back just yet.

Costs to merchants

Of course, there are costs to merchants. They are charged a small commission for each purchase made by a credit card. There may also be an interchange fee paid between the merchant’s bank and the card user’s bank. Because these fees can eat into a merchant’s profit margin, some will offer a discount to you if you pay with cash instead.