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How Do Credit Cards Work? Demystifying Credit Art & Science

Understanding how credit cards work can help you use them to your best advantage. Peek behind the curtain of credit cards’ complex workings.

By Megan Doyle | American Express Credit Intel Freelance Contributor

7 Min Read | September 22, 2020 in Cards

 

At-A-Glance

To most of us, credit cards seem convenient and easy to use.

But they’re actually part of a complex system of card member agreements, terms and conditions, and intricate technology.

Understanding how credit cards work can help you reap rewards – and help keep you out of debt.  

When it comes to credit cards, it can be hard to resist the urge to “swipe and go” or “buy now, pay later.” And for good reason. Simply put, credit cards are convenient. With no need to count cash or make change, transactions can be made in seconds – even if you don’t have enough cash in your pocket or bank account to cover the expense. 

 

Zoom in a little closer, however, and you’ll find that the way a credit card works is actually part of a fairly complex system. From the terms and conditions of your account to the technology that makes a credit card purchase possible, understanding how credit cards work can help you use them to your financial advantage.

 

The Basics of How Credit Cards Work

Credit cards are small plastic or metal cards encoded with personal information that’s linked to a line of credit provided by your card issuer. They essentially work as short-term reusable loans that allow you to pay for almost anything – as long as you keep within your credit limit and repay your card issuer each month. 

 

Swiping your credit card might be as easy as waving a magic wand, but there’s a lot that goes on behind the scenes, the details of which are established in your card member agreement. Here’s the gist of how all credit cards work. 

 

Each time you use your credit card to pay for something, your card issuer pays the merchant for you. But you’re not off the hook: your card issuer will then send you a monthly statement or bill that lists all purchases made in your billing cycle, the sum of which is called your “statement balance.” You’ll have until your statement due date to make at least a minimum payment, but any remaining balance will “revolve,” and begin to accrue interest. That interest charge, calculated based on one or more of your card’s annual percentage rates (APRs), is essentially the cost you pay for carrying a balance – and it can add up. To avoid credit card debt, it’s always best to try to pay your statement balance in full each month. 

 

But eliminating debt isn’t the only reason to pay your balance in full each month. As long as you make your payments on time and keep your credit utilization ratio low, your credit card can help to build your credit history and boost your credit score.

 

How Different Types of Credit Cards Work

Unlike debit cards which simply connect to the funds currently available in your checking account, there are many types of credit cards, all with their own pros and cons. Rewards credit cards, for example, offer financial incentives like points, miles, or cash back bonuses. Here’s how they work: for every purchase made with a rewards card, you earn points, miles, or a percentage of your spending. How much you earn is based on how much you spend. Points and miles can be redeemed for things like airfare or hotel stays, while cash back rewards can usually be redeemed for a statement credit. 

 

Beyond reward cards are many other categories. Some cards offer no foreign transaction fees, others may offer low APRs. Some might be designed for students or those with little-to-no credit history, while others are meant for businesses. How each type of credit card works depends on the card issuer, the card itself, and the terms and conditions – so be sure to do your research before choosing a credit card.

 

How Your Credit Card’s Interest Works

Your credit card can have a variety of different APRs, each for a different purpose, and all tuned to you – your credit score and credit risk profile. Each APR is used to calculate an interest charge for a different card use, so there are separate APRs for purchases, cash advances, and balance transfers, for example. In addition, higher APRs may kick in if you’re late with a payment.

 

Here’s how credit cards calculate interest on purchases: If you carry a balance from month-to-month, the card company takes the average of all your daily balances for that billing cycle and multiplies it by your “daily periodic rate,” which is simply your APR divided by 365. Then, they multiply that result times the number of days in the billing cycle to get the amount of interest you owe.

 

The Technology Behind How Credit Cards Work

Now let’s go a little deeper. Each credit card is encoded with personal information that’s connected to your credit card account. Some of that information – like your name, card number, expiration date, and signature – is visible to the naked eye. But wait, there’s more!

  • Magnetic strip. Your card’s magnetic strip – or magstripe – is made of magnetic particles that allow a magstripe reader to understand the information embedded within the card. The direction of the magnetic charges “write” the code within the card, which is then read when the card is swiped.1
  • EMV Chip. A credit card’s chip is essentially an updated, more secure alternative to the magstripe. For each transaction, the chip and card reader create a unique encrypted code that’s used to verify the transaction against your personal account information.2
  • Card number. You might think of your card number as something like an account number, but credit card numbers also signify things like card issuer, card type, and currency. All credit card numbers also end with a mathematically derived “check digit” that’s used to assess the card’s authenticity, especially when typing in your card number online.3
  • Card identification number (CID). Your CID (also known as CSC or CVV) adds another layer of security. Each card’s CID is unique and is required to authorize online and other “card-not-present” transactions. 

 

Every time you make a purchase with your credit card, either your magstripe, EMV chip, or card number and CID are used to authorize the transaction. To break it down as simply as possible, when you use your card:4

  1. The payment information embedded within your card is read and then transmitted to a payment processor in real-time.
  2. Next, the payment processor communicates with your card issuer and the retailer to authorize the transaction.
  3. If approved, the payment processor then makes sure the appropriate amount of money is sent from your card issuer to the retailer.
  4. Meanwhile, your card issuer deducts the purchase from your credit limit and adds the transaction to your next monthly statement.

 

But it Wasn’t Always That Easy

Credit cards are a relatively recent phenomenon. Credit has been used by merchants for thousands of years, but it wasn’t until the early 20th century that the credit card as we know it began to take shape. Early predecessors included metal “charge coins” that were individually imprinted with customer information.5 Charge coins allowed customers to make purchases on credit at specific corresponding places of business. 

 

The first general purpose, universal charge card was introduced in 1950.6 Customers could then make credit purchases at a variety of locations but they were required to pay each statement in full. American Express debuted its first charge card in 1958. Shortly after, banks began to develop revolving credit systems and credit cards blossomed into what we know today.

 

The Takeaway

From the terms and conditions laid out in your card member agreement to the intricate technology that makes credit cards a possibility, understanding how credit cards work can help you use your card wisely.

Megan Doyle

Megan Doyle is a business technology writer and researcher whose work focuses on financial services and cross-cultural diversity and inclusion.

 

All Credit Intel content is written by freelance authors and commissioned and paid for by American Express. 

The material made available for you on this website, Credit Intel, is for informational purposes only and is not intended to provide legal, tax or financial advice. If you have questions, please consult your own professional legal, tax and financial advisors.