How Do Credit Cards Work?

The Consumer Point of View

From a consumer point of view (your viewpoint), credit cards are simply cards made out of plastic that permit you to access a credit card issuer’s credit limit that they have provided to you. 

This credit line works something like a loan. 

A main difference is that the creditor does not deliver you the entire cash amount upfront. Instead the bank permits you to draw the credit amount that you wish to when you need it (on demand). They also let you use the “loan” again and again, so long as you repay the amount that you have borrowed. 

This is why credit cards are often referred to as revolving accounts. 

Every time that you buy something with your credit card, your available amount of credit decreases by this corresponding amount. Consider an example. If you have a $200 credit limit and you buy something for $50, then you will have $150 in remaining available credit. You owe your creditor (the bank) $50. You might charge something else for another $50 before your monthly statement arrives. In this case, you would owe the bank $100 and still have another $100 in remaining available credit. 

What separates these credit cards from traditional loans is that you will again have access to your credit limit each time that you pay the balance down on this card. In the previous example, if you repaid the $100 total balance you had charged, you would then have $200 of available credit to use again. 

It means that you can continuously spend as much as your available credit limit and pay off the balance as often as you wish, so long as you obey the credit card’s terms. These terms usually involve paying your payments on time every month and not going over your credit line limit with your purchases. As you are allowed to keep borrowing against this credit limit indefinitely, creditors commonly call these credit cards open ended accounts or revolving accounts. 

The Business Point of View

There is much that happens with credit cards beyond your consumer perspective. This behind the scenes activity explains why they offer you credit cards in the first place. When you give your credit card to the merchants to pay for your purchase, the credit card terminal of the merchant communicates with your card issuer electronically. 

It asks the creditor if your card is valid for you to use and whether or not you have sufficient available credit. Your issuer of the credit card instantly reviews the charge before sending a reply back that this transaction either has been approved or alternatively declined.

Why does the credit card issuer provide you with this convenience? They receive several percent (typically from one to three percent) of the charged amount from the merchant in fees. 

They also hope to make money off of your charges from you!

The creditor is providing you with a pre-set time limit to repay the entire amount that you have borrowed from them (usually a little less than a month). If you do not do this by the cut off date (the payment due date), then they will charge you interest. This amount of time before they assess interest charges is known as the grace period, and it typically lasts from 20 to 25 days. 

Should you choose not to pay down your entire balance by the time this grace period ends, then they assess a finance charge and add this on to your remaining balance. 

Your finance charge will be based upon the interest rate on your particular credit card multiplied by your outstanding balance. 

This interest rate amounts to the yearly rate that you pay to borrow money using your credit card. The creditors typically base these interest rates on the prevailing market interest rate, the kind of credit card that you possess, and your credit history. 

For those of you who have a good credit history of repaying credit card bills, you will secure a lower interest rate than the usually charged amount. Similarly if your credit history is less ideal, then you will generally pay a higher interest rate than the typical interest rate amount.

Businesses give you the chance to pay off your entire balance before this grace period ends so that you can avoid paying any interest. In reality, they would prefer that you did not repay it all at one time. 

You must at least make the minimum payment amount by the time the due date arrives or you will receive a late fee. From your perspective, paying the minimum amount only every month is not only the slowest way to pay off your credit card bill, it is also the most costly way to pay this credit card balance down. 

You should always pay at the very least the minimum amount due every month in order to have an on-time paying credit history. This will also save you late fees. 

Ideally you should pay off all or most of your balance every month. With enough months paying your credit cards down on time, you can qualify for a better interest rate on your credit card.