Credit card: Encyclopedia II - Credit card - How they work

Credit card - How they work

A user is issued a credit card after an account has been approved by the credit provider (often a general bank, but sometimes a captive bank created to issue a particular brand of credit card, such as American Express Centurion Bank), with which they will be able to make purchases from merchants accepting that credit card up to a preestablished credit limit.

When a purchase is made, the credit card user agrees to pay the card issuer. Originally the user would indicate his/her consent to pay, by signing a receipt with a record of the card details and indicating the amount to be paid, but many merchants now accept verbal authorizations via telephone and electronic authorization using the internet.

Electronic verification systems allow merchants (using a strip of magnetized material on the card holding information in a similar manner to magnetic tape or a floppy disk) 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. 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.

Each month, the credit card user is sent a statement indicating the purchases undertaken with the card, and the total amount owed. The cardholder must then pay a minimum proportion of the bill by a due date, and may choose to pay more or indeed pay 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).

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 for purchases and pays the entire $1,000. there would be no interest charged. If, however, even $1.00 of the total balance remained unpaid, interest would be charged on the full $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. (See The TD Gold Travel Visa Cardholder Agreement Retrieved January 3, 2006)

The credit card may serve as a form of revolving credit, or the user may choose to apply any payments toward recent rather than previous debt. 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. 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 profit margins in the credit card industry can be quite high, credit providers often offer incentives such as frequent flier miles, gift certificates, or cash back (typically 1 percent) to try 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. 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.

Credit card - The merchant's side

For 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 verified. The bank charges a commission to the merchant for this service and there may be a certain delay before the agreed payment is received by the merchant. 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.

Credit card - Secured credit cards

A secured credit card is a type of credit card secured by a deposit account owned by the cardholder. Typically, the cardholder must deposit between 100% and 200% of the total amount of credit desired. Thus if the cardholder puts down $1000, he or she will be given credit in the range of $500–$1000. This deposit is held in a special savings account.

The cardholder of a secured credit card is still expected to make regular payments, as he or she would with a regular credit card, but should he or she default on a payment, the card issuer has the option of recovering the cost of the purchases paid to the merchants out of the deposit.

Often, though, if the cardholder does not make the required payment, many issuers of secured credit cards consider that the account must be paid before the security is released instead of using the security to pay the balance due. The card is not cancelled, the balance is not set off the deposit, and interest continues to accumulate on the unpaid balance for considerable periods of time. In some cases the total charges may far exceed the original deposit and the cardholder not only loses their deposit but is left with an additional debt.

Most of these conditions are usually described in a cardholder agreement which the cardholder signs when their account is opened.

Secured credit cards are an option to allow a person with a poor credit history or no credit history to have a credit card which might not otherwise be available. They are often offered as a means of rebuilding one's credit. Secured credit cards are available with both Visa and MasterCard logos on them. Fees and service charges for secured credit cards often exceed those charged for ordinary non-secured credit cards.

Adapted from the Wikipedia article "How they work", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki