Understanding Credit Cards & How Do Credit Cards Work

What is a Credit Card? 

 

A credit card is a payment card or a financial service provided by a bank to its customers that allows an individual to borrow funds in order to purchase goods or commodities up to a standard limit. 

 

Any merchant that accepts credit cards, allows a customer to purchase an item or a service in return for the money transacted through a credit card. This credit card is provided to the individual by a bank on the condition that credit cardholders pay back the borrowed amount of money with additional interest charges. 

 

The borrowed amount is required to be returned within a prescribed time either in full or through EMIs (Equated Monthly Installment). In a way, credit card holders are accustomed to a set amount of ‘credit’ money that they can use at any point in time. 

 

(Must read: 5 Ways to Improve Credit Score)

 

This credit can then be paid back after a period of time as agreed on by the user and the provider. Perhaps a credit card establishes a relationship between a lender and borrower who exchange money at various intervals of time. 

 

The lender is the credit card company and the borrower is the credit card user. The money borrowed from the lender is charged at an interest rate that is determined at various intervals. 

 

A thin, rectangular piece of card, known as the credit card, is provided by a bank to its users who are allowed to purchase goods and commodities without actually using their own money. 

 

Instead, at the time when they are purchasing a particular commodity, the user uses the bank’s credit money. Later, when the user pays back the borrowed credit money to the bank, s/he is charged with an interest amount that is added to the total amount. 

 

Another facility that credit cards offer is credit card cash advance. This is the official term for withdrawing money from your credit card from the ATM. Even though one can use his/her personal finance, credit cards allow one to withdraw cash in advance.   

 

Even though credit cards are used for transactions at stores and outlets, the credit card cash advance is an additional facility offered to credit card users. However, there is also a credit card cash advance limit that one has to adhere to. 

 

 

How do Credit Cards work? 

 

A lot of people do not really understand how credit cards work. While some believe that it is similar to a debit card, others are unsure of its debt policy. In this segment, we are going to learn about credit cards and the way they work. 

 

A credit card is a payment card that lets one purchase products or services with the credit available through it. Provided by a bank for financial services, a credit card lets one borrow money up to a set credit card limit which is used to purchase commodities. 

 

This borrowed credit is required to be paid back with additional interest charges applied, as agreed by both the credit card holder and the provider. 

 

The way through which credit card companies determine credit limits for their users is quite interesting to know about. Through a mathematical algorithm that is confidential in nature, credit card companies compute various results - who to approve, at what limit, and at what interest rate. 

 

A credit card limit, also known as a credit line, is the determined amount of credit that a credit card issuer lets its user borrow. Determined on the basis of the applicant’s income level and other specifics, the credit line can be adjusted in the future according to the demands of the user. 

 

"Credit cards can be secured or unsecured. A secured credit card requires a cash deposit to open, which typically doubles as your credit limit. "

Secured Credit Cards 

 

Factors that play a key role in this decision are as follows - user’s repayment history, personal loans, mortgages, and income level. 

 

For instance, you visit a nearby shopping mall and pick up a few clothing items that you find suitable. At the time of billing, you give your credit card to the billing person who initiates the billing process. 

 

Primarily, the billing details are sent to the merchant’s bank which seeks approval from the credit card holder’s bank. The bank then receives authorization from the credit card provider to process the transaction. 

 

After this, your credit card provider verifies information related to the same, and depending on the verification process, the bank either approves the transaction or declines the same.

 

If the transaction is successfully approved, the billing process is done and the amount is paid from your credit card. At the end of the month, the same amount reflects in your credit card statement that you are required to pay back to your credit card provider. 

 

Along with the payment due, the bank also notifies the credit card holder of the due date. The due date specifies the time that the user has in order to pay back the specified amount to the bank. 

 

It is important to note that a grace period is given to the credit cardholder. The grace period is the time between your credit card bill’s end date and the due date of payment to the bank. 

 

(Suggested reading: Equity Financing: Advantages & Disadvantages)

 

Example:

 

Let us suppose your bank notifies you that you have a total amount of INR37,000 to be paid back to the bank. This notification is sent to you on the last date of a month. Now, it is also stated in the notification that you are supposed to pay your dues by the 15th of the next month. 

 

Perhaps the time period between the bill’s end date and the due date is known as the grace period. Generally, a 3 days grace period for credit card payment is given to users. Well, one might wonder why the grace period is so important to know about. Perhaps here is your answer. 

 

Grace period is defined as a time period wherein your financial service provider cannot apply interest rate on your payment dues. If in case, one fails to pay back the dues within the grace period, then the bank is liable to apply additional interest charges for late payment.

 

"The grace period is a window of time during which a consumer owes money to a credit card company for new purchases made during the last billing cycle but isn’t being charged interest." Grace Period Credit Card Payment. 

 

While there is a provision that one can pay back his/her dues on a monthly basis, a different concept of Annual Percentage Rate (APR) allows one to pay back the payment dues on an annual basis. 

 

Herein, the bank applies an annual percentage rate of charge that is predetermined. For instance, an APR or annual rate of 24% is specified by a bank that is to be applied to your credit card expenses. 

 

This means that a total of 24% of interest rate on credit card expenses of 12 months/ 1 year will have to be paid back by the credit cardholder. 

 

Although this rate is predetermined before the issuance of the credit card, it is subject to changes under the CARD Act of 2009. 

 

 

Characteristics of Credit

 

Although we have understood the way a credit card works, we will now enlist the characteristics of credit. Here is a brief introduction of the characteristics of credit that play a key role in structuring the concept of credit cards and how they work.

 

1. Character

 

The first and foremost feature of credit involves the character/ credit history of the credit cardholder. The credit history length defines your repayment history that convinces a credit card company to issue you a credit card. 

 

Before issuing the credit card, a credit card company looks into the credit history of the applicant that includes his/her personal loans, income levels, and mortgage, if any. 

 

Based on one’s credit score, a credit card company determines the credit rating of an applicant and decides whether to issue a credit or not. 

 

2. Capacity

 

The second feature is capacity. While issuing credit to applicants, a credit card company looks at the economic capacity of the applicant and determines the capital limit for a credit card.   

 

This means that the debt-to-income ratio of an applicant is considered before issuing him/her a credit card. This is a very essential aspect because it indicates whether an applicant will be able to repay the debt or not. 

 

(Read also: What is Capital in Economics?)

 

3. Collateral

 

Even though a majority of credit card companies issue unsecured credit cards to an applicant, collateral usually defines any economic asset that the credit card holder gives as a guarantee to the issuer. 

 

Usually, credit card companies do not secure their services before issuing them to the user.

 

Credit Cards v/s Debit Cards 

 

A lot of us have confusion between a credit card and a debit card. In this segment, we will be understanding the differences between the two. 

 

While a credit card, as we have already read, is a financial service that lets a credit card holder borrow money from the issuer to pay for commodities and services, a debit card is directly linked to the holder’s bank account and transacts money that is already deposited. 

 

A major difference between the two is that a credit card requires you to repay the debt afterward, whereas, in the case of a debit card, one is not required to repay any debt. 

 

Another difference between the two is that credit cards help you to build a credit history that can be added to your credit score report and later used for loan purposes. 

 

On the other hand, a debit card does not help you to build a credit history. Instead, it is a no-debt financial payment service that allows you to spend as much money as there is held by your savings/current account. 

 

 

In the End

 

In the end, credit cards are financial services through which we can pay for various products or services up to a certain limit. 

 

(Recommended blog: Types of financial risks)

 

Unlike debit cards wherein we can only spend the money that we deposit in our bank account, credit cards allow us to 'borrow' credit money from our credit card issuer and repay it when the time comes. 

 

Although many people think that owning a credit card can be a financial burden, a major chunk of the population holds credit cards that let them spend it as and when they like.