Understanding How Credit Cards Function

Credit cards have become essential financial tools today, offering convenience at the tap or swipe of a card. They enable us to make purchases without immediate payment, but how does this system work? Who actually covers the costs? Do credit card companies profit from our usage? This article sheds light on these questions.

What is a credit card?

A credit card is a plastic payment device that extends a predetermined credit limit for spending. This allows users to buy now and pay later, as long as repayment occurs per the issuer’s rules. Essentially, it functions as a renewable loan that restores after each repayment.

When you use a credit card, funds are electronically transferred from your account to the merchant via the payment network. The transaction involves multiple entities: the issuer, the network, the merchant, and the cardholder. During purchase, the merchant’s terminal checks with the issuer if the card is valid and if sufficient credit exists. Based on this, the transaction is either approved or denied, and funds are transferred accordingly.

The functioning of credit card companies involves two main players: the issuer (usually a bank or credit union) and the processing network (such as Visa, Mastercard, American Express). They handle transaction approval and settlement processes.

Credit card companies generate revenue through various channels. Key sources include interest charges on outstanding balances, fees for services, and interchange fees paid by merchants. Interest is applied when users fail to pay on time, with rates varying among providers. Fees encompass annual charges, cash withdrawal fees, late payment penalties, and balance transfer costs. Interchange fees are paid by merchants' banks to the issuer for processing transactions. Timely payments can help avoid much of these charges, benefiting users financially.