How credit cards work

CREDIT CARD

A credit card is a system of payment named after the small plastic card issued to users of the system. A

credit card is different from a debit card in that it does not remove money from the user's account

after every transaction. In the case of credit cards, the issuer lends money to the consumer (or the

user). Playboy is also different from a charge card (though this name is sometimes used by the public to

describe credit cards), which requires the balance to be paid in full each month. In contrast, a credit

card allows the consumer to 'revolve' their balance, at the cost of having interest charged. Most credit

cards are the same shape and size, as specified by the ISO 7810 standard.

How credit cards work

An example of the front of a typical credit card: Issuing bank logo EMV chip Hologram Card number Card

brand logo Expiry Date Cardholder's name

An example of the reverse side of a typical credit card: Magnetic Stripe Signature Strip Card Security

Code A user is issued credit after an account has been approved by the credit provider, and is given a

credit card, with which the user will be able to make purchases from merchants accepting that credit

card up to a pre-established credit limit. Often a general bank issues the credit, but sometimes a

captive bank created to issue a particular brand of credit card, such as Chase, Wells Fargo or Bank of

America issues the credit. When a purchase is made, the credit card user agrees to pay the card issuer.

The cardholder indicates their consent to pay, by signing a receipt with a record of the card details

and indicating the amount to be paid or by entering a Personal identification number (PIN). Also, many

merchants now accept verbal authorizations via telephone and electronic authorization using the

Internet, known as a Card not present (CNP) transaction. Electronic verification systems allow merchants

to verify that the card is valid and the credit card customer has sufficient credit to cover the

purchase in a few seconds, allowing the verification to happen at time of purchase. The verification is

performed using a credit card payment terminal or Point of Sale (POS) system with a communications link

to the merchant's acquiring bank. Data from the card is obtained from a magnetic stripe or chip on the

card; the latter system is in the United Kingdom commonly known as Chip and PIN, but is more technically

an EMV card. Other variations of verification systems are used by eCommerce merchants to determine if

the user's account is valid and able to accept the charge. These will typically involve the cardholder

providing additional information, such as the security code printed on the back of the card, or the

address of the cardholder. Each month, the credit card user is sent a statement indicating the purchases

undertaken with the card, any outstanding fees, and the total amount owed. After receiving the

statement, the cardholder may dispute any charges that he or she thinks are incorrect (see Fair Credit

Billing Act for details of the US regulations). Otherwise, the cardholder must pay a defined minimum

proportion of the bill by a due date, or may choose to pay a higher amount up to the entire amount owed.

The credit provider charges interest on the amount owed (typically at a much higher rate than most other

forms of debt). Some financial institutions can arrange for automatic payments to be deducted from the

user's bank accounts. Credit card issuers usually waive interest charges if the balance is paid in full

each month, but typically will charge full interest on the entire outstanding balance from the date of

each purchase if the total balance is not paid. For example, if a user had a $1,000 outstanding balance

and pays it in full, there would be no interest charged. If, however, even $1.00 of the total balance

remained unpaid, interest would be charged on the $1,000 from the date of purchase until the payment is

received. The precise manner in which interest is charged is usually detailed in a cardholder agreement

which may be summarized on the back of the monthly statement. The general calculation formula most

financial institutions use to determine the amount of interest to be charged is APR/100 x ADB/365 x

number of days revolved. Take the Annual percentage rate (APR) and divide by 100 then multiply to the

amount of the average daily balance divided by 365 and then take this total and multiply by the total

number of days the amount revolved before payment was made on the account. Financial institutions refer

to interest charged back to the original time of the transaction and up to the time a payment was made,

if not in full, as RRFC or residual retail finance charge. Thus after an amount has revolved and a

payment has been made that the user of the card will still receive interest charges on their statement

after paying the next statement in full (in fact the statement may only have a charge for interest that

collected up until the date the full balance was paid...i.e. when the balance stopped revolving). The

credit card may simply serve as a form of revolving credit, or it may become a complicated financial

instrument with multiple balance segments each at a different interest rate, possibly with a single

umbrella credit limit, or with separate credit limits applicable to the various balance segments.

Usually this compartmentalization is the result of special incentive offers from the issuing bank,

either to encourage balance transfers from cards of other issuers, or to encourage more spending on the

part of the customer. In the event that several interest rates apply to various balance segments,

payment allocation is generally at the discretion of the issuing bank, and payments will therefore

usually be allocated towards the lowest rate balances until paid in full before any money is paid

towards higher rate balances. Interest rates can vary considerably from card to card, and the interest

rate on a particular card may jump dramatically if the card user is late with a payment on that card or

any other credit instrument, or even if the issuing bank decides to raise its revenue. As the rates and

terms vary, services have been set up allowing users to calculate savings available by switching cards,

which can be considerable if there is a large outstanding balance (see external links for some on-line

services). Because of intense competition in the credit card industry, credit providers often offer

incentives such as frequent flier points, gift certificates, or cash back (typically up to 1 percent

based on total purchases) to try to attract customers to their program. Low interest credit cards or

even 0% interest credit cards are available. The only downside to consumers is that the period of low

interest credit cards is limited to a fixed term, usually between 6 and 12 months after which a higher

rate is charged. However, services are available which alert credit card holders when their low interest

period is due to expire. Most such services charge a monthly or annual fee.
Grace period

A credit card's grace period is the time the customer has to pay the balance before interest is charged

to the balance. Grace periods vary, but usually range from 20 to 30 days depending on the type of credit

card and the issuing bank. Some policies allow for reinstatement after certain conditions are met.

Usually, if a customer is late paying the balance, finance charges will be calculated and the grace

period does not apply. Finance charge(s) incurred depends on the grace period and balance, with most

credit cards there is no grace period if there's any outstanding balance from the previous billing cycle

or statement (ie. interest is applied on both the previous balance and new transactions). However, there

are some credit cards that will only apply finance charge on the previous or old balance, excluding new

transactions.

The merchant's side

An example of street markets accepting credit cardsFor merchants, a credit card transaction is often

more secure than other forms of payment, such as checks, because the issuing bank commits to pay the

merchant the moment the transaction is authorized, regardless of whether the consumer defaults on their

credit card payment (except for legitimate disputes, which are discussed below, and can result in charge

backs to the merchant). In most cases, cards are even more secure than cash, because they discourage

theft by the merchant's employees. For each purchase, the bank charges a commission (discount fee), to

the merchant for this service and there may be a certain delay before the agreed payment is received by

the merchant. The commission is often a percentage of the transaction amount, plus a fixed fee. In

addition, a merchant may be penalized or have their ability to receive payment using that credit card

restricted if there are too many cancellations or reversals of charges as a result of disputes. Some

small merchants require credit purchases to have a minimum amount (usually between $5 and $10) to

compensate for the transaction costs, though this is not always allowed by the credit card consortium.

In some countries, like the Nordic countries, banks guarantee payment on stolen cards only if an ID card

is checked and the ID card number/civic registration number is written down on the receipt together with

the signature. In these countries merchants therefore usually ask for ID. Non-Nordic citizens, who are

unlikely to possess a Nordic ID card or driving license, will instead have to show their passport, and

the passport number will be written down on the receipt, sometimes together with other information. Some

shops use the card's PIN code for identification, and in that case showing an ID card is not necessary.
Parties involved