Credit cards work by allowing you to borrow money up to a set limit to make purchases or get cash advances, which you then repay to the card issuer. Here’s a detailed overview of how they function:
How Credit Cards Work
- Credit Limit: When you get a credit card, the issuer sets a maximum amount you can borrow, called your credit limit. This limit is based on your creditworthiness, income, and credit history
- Making Purchases: When you use your credit card to buy something, the merchant sends your card details to their bank, which forwards them through a payment network to your card issuer for authorization. The issuer checks your account and either approves or declines the transaction. If approved, the purchase amount is deducted from your available credit
- Billing Cycle and Statements: Your credit card issuer sends you a monthly statement showing all transactions, your previous balance, new balance, minimum payment due, and payment due date. You have a set billing cycle, usually about a month, after which you must pay at least the minimum amount
- Interest and Payments: If you pay your full balance by the due date, you typically avoid interest charges during an interest-free period (usually 20 to 55 days). If you pay less than the full balance, interest is charged on the remaining amount, calculated based on your card’s annual percentage rate (APR)
- Revolving Credit: Credit cards offer revolving credit, meaning you can borrow, repay, and borrow again up to your credit limit repeatedly
- Fees and Charges: Credit card companies earn money from interest charges on unpaid balances, fees paid by merchants for processing transactions, and sometimes annual fees charged to cardholders
Transaction Process Summary
- You present your card for payment.
- The merchant’s bank submits the transaction for authorization.
- The card issuer verifies and approves the transaction.
- Funds are transferred to the merchant’s bank.
- The transaction amount is added to your credit card balance, reducing your available credit
In essence, a credit card is a loan that lets you buy now and pay later, with the flexibility to manage payments over time, but with potential interest costs if balances are not paid in full on time
