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How Exactly Do Credit Cards Work?

by Refi.me Staff on June 8 2021

Using a credit card to buy something is pretty straightforward. You swipe your card in a credit card machine, enter your pin, and your purchase is paid for. There’s no cash transaction involved. On the surface, it seems so simple. But have you ever wondered how exactly do credit cards work behind the scenes?

  • Where does the money come from when you swipe your card?
  • Who pays the merchant and when do you actually pay for whatever you’ve bought using your card?
  • What happens if you don’t pay your credit card bill?
  • It’s interesting to take a look at the mechanics of how credit cards work behind the scenes.

In this article, we see what happens when you apply for a card and when you swipe your card. We also look at the payment mechanics and examine whether or not having a credit card is a good idea.

How Credit Cards Work: The Basics

When you get approved for a credit card, the credit card issuer allows you to make purchases or pay bills on credit. You can spend up to a set credit limit, which the issuer will specify at the time of approval. Every card holder has a different credit limit, which could range anywhere from a few hundred to several thousand dollars. Your limit will be determined by your credit score and other financial credentials. That is the maximum amount you can spend.

As you keep charging purchases to your card, your available credit gets reduced by that much. You can keep charging purchases against your credit till your credit limit reaches zero.

When you reach your credit limit, you can no longer use your card till credit limit gets refreshed. This will happen after you pay the outstanding on your credit card bill, which is due at the end of the specified billing cycle.

Let’s say you’ve reached your credit limit and want to replenish it before the due date. You can do this by paying off at least part of what you owe. This will instantly free up additional credit for you to use.

How Credit Cards Work When You Submit An Application

When you apply for a credit card, the issuer will first want to determine if you are credit worthy. This is to ensure that they can trust you to pay back what you owe them.

The issuer will first pull your credit report to check your payment history, credit utilization, and length of credit history. They will also want to know if you are earning a consistent income.

If you meet the issuer’s requirements and your financials are strong, you’ll get approved for the credit card.

How Credit Cards Work When You Make A Purchase

When you make a purchase at a local store, you insert your card into a card reader and enter your pin. The device reads the security chip on your card and if your pin is correct, your purchase is successful. With online purchases, it’s slightly different. You enter your card number, name on the card, expiry date and security number. If all the details entered are accurate, the purchase goes through successfully.

A lot happens within seconds behind the scenes when you swipe the card or enter your details online. The merchant’s credit card terminal verifies the validity of your card with your credit card issuer. It also verifies whether or not you have sufficient credit available. If all is okay, your credit card issuer will approve the transaction. If the details are wrong or you don’t have sufficient credit, the transaction will be declined.

How Credit Cards Work: Payment Mechanics

Your credit card issuer will have specified your billing cycle and payment due date when issuing your credit card. At the end of the billing cycle, you’ll receive your credit card statement showing details of all transactions for that period. Ideally, you should make the full payment by the due date.

Missing a payment deadline can cost you dearly in terms of a late payment fee. If the payment is delayed more than a certain number of days, the late payment will be reported to the credit bureaus. It will then get marked on your credit report and will also damage your credit score.

You do have an option to pay at least the minimum amount stated on the bill, by the deadline. While this can help to avoid a late payment fee, you will still pay interest on the outstanding balance. This can eventually become an expensive way to pay off your bill.

Is It Worth Getting A Credit Card?

There’s no doubting the convenience that a credit card offers. It’s easy to carry and easy to use at any neighborhood brick-and-mortar store or an international online store. You never need to worry about making sure you have sufficient cash on you. Besides, if your card gets stolen you can report the theft and cancel the card. If cash gets stolen, the chances of getting it back are slim to none.

In addition to the convenience, credit cards are the best way to build your credit. This is provided that you make your payments on time, every time. One late payment can defeat this objective.

Last but not least, credit cards come with varied perks and benefits. The way this works is you earn points on every purchase you make. You can then redeem your points for various types of rewards. The rewards differ from one card to another. Depending on your card, you could redeem your points for traveling, hotel stays, fine dining, or discounts at certain outlets. These perks add to the appeal of owning a credit card.

Overall, getting a credit card is a powerful tool with several significant benefits. It’s definitely worth using a credit card but only if you use it responsibly. This means charging only what you can afford and paying off the balance in full every month.

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