How Does a Credit Card Work?

Being nothing more than a small rectangular piece of plastic issued by a bank, a credit card leaves most people in awe when it takes care of huge bills and payments in just a single swipe. You can’t help but wonder about the ease of the entire process and how it works. Here we are going to answer just that.

What is a Credit Card?

A credit card is a financial instrument issued by a bank by means of which you get access to funds generated on demand. Based upon your credit profile and consumer behaviour, the issuing bank puts a cap over the amount of funds you can extract through your credit card. You are required to pay a joining fee for availing the facility and an annual renewal fee for continuing to enjoy the perks of using a credit card. The bank grants you many benefits as welcome gift, perks and spending based rewards such as access to premium airport lounges, spa services, gift vouchers, reward points, etc. The bank encourages you to use your credit card more often by rewarding your spends with reward points. These points can later be redeemed as cash back, gift vouchers or for purchasing everyday commodities.

How Do Credit Cards Work?

You can use your credit at a retail store or online. Here, we are discussing both the processes.

Using Credit Card at a Retail Store

When you propose to pay for your purchases by a credit card, the retailer would need to swipe your card over an electronic data capture machine. The machine will read your card information which is encoded on your card in the form of an electronic chip and a magnetic strip (the black strip that you see at the back of your card). The retailer will further ask you to enter your Personal Identification Number.  All this information will be sent to your bank in the form of a payment request via electronic channels that are fully encrypted.

The bank, on receiving the request, will assess your card information and check if the card expenditure is within the prescribed limit or not. If so, the bank approves the transaction and sends an approval message.

On receiving the approval, the machine will generate two copies of the payment receipts. The retailer may ask you to sign one of the copies, which he will keep with himself and give you the other. The money will be transferred to the retailer’s account within a single working day.

Using Credit Card for Online Payments

When you are shopping online and choose credit card as your preferred payment option, the e-commerce website will direct you to a payment page. On this page, you will first need to choose whether the card is a Visa, MasterCard, RuPay or AmEx. Then, you will have to enter your card details which include the name of the cardholder, the 16-digit card number, expiry date and CVV. After entering the information, you will need to click on the “Pay” button.

This information will be sent to your credit card issuing bank via end-to-end encrypted payment gateways. The bank will verify your details and sends a one time password to your registered mobile number. You will need to enter this one time password at the payment page in order to authorise the transaction. If the one time password is correct, your payment gets approved. 

Credit Card Bill

All your monthly transactions will be recorded by the bank and will be sent to you every month in the form of a billing statement. This bill is to be paid on the due date which is normally 18-25 days from the date of issuing the bill. If you pay the entire bill amount, the bank will not charge any interest or fee from you.

However, if you fail to pay your bill on time, the bank will impose a late payment charge. In this case, interest will also be charged, on a daily basis, starting from the date of the transaction. You can escape the late payment penalty by paying the minimum amount due, mentioned on your credit card bill statement. The rest of the amount will be carried to your next billing statement. It is to be noted that interest will be charged over the amount carried forward.

How do Banks Make Money?

You may be wondering that since banks do not charge any interest on your credit card and even reward your spendings, they may be suffering huge loss. But, on the contrary, banks make a lot of profit by means of credit cards. But how do they do it? The answer is simple. Defaults and revolving credit facility. Banks generally make money by failure of paying the total bill amount on time. The high interest rates and penal fee associated with the failure of timely payments make a big chunk of money for the issuing bank.

Also, banks charge some amount from the merchants as credit card acceptance fee. So whenever you choose to pay by using a credit card, the merchant has to pay some amount for each swipe.

How to Make the Most Out of a Credit Card?

A credit card has many perks. For starters, it enhances your purchasing power by providing the ‘buy now pay later’ option at zero interest rate. Most credit cards come with global acceptance so you do not need to worry about cash conversions on your trip abroad. Besides being the safe and easy payment method, they also help strengthen your credit score. The fact that all your spends are rewarded with points is just a cherry on the cake.

Using your credit card every now and then for your regular expenses such as fuelling, grocery shopping, movie ticket bookings is a good idea since all your expenditure is rewarded with points and other benefits. Thus you can earn upon your daily expenditures.

Apart from the benefits of credit card, there are also certain drawbacks attached to credit cards. Since you do not need to worry about the unavailability of cash, credit cards encourage impulse buying and promote overspending. The failure of repayment of these out-of-the-budget expenses attracts penalty fees and high rate of interest. Since interest is charged on a daily basis, it does not take a lot of time for you to get buried under the continuously exponifying debt. In such cases, it even tarnishes your credit report. Therefore, you need to exercise a great degree of self-control while using your credit card. Do not let yourself get overwhelmed with the purchasing power attached to a credit card as it is just a temporary benefit.

Takeaway

As it is said, do not judge a book by its cover, do not judge the capabilities of a credit card by its size. It may be a small rectangular piece of plastic but grants you super magic powers that help you make big purchases. However, all these transactions once verified and approved come back to you in the form of credit card bills. You should be careful to not spend more than your capacity or it will land you in trouble. A credit card can become either a Ginnie or a pandora box depending upon how you use it.

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