How Do Credit Cards Work? Demystifying Credit Art & Science

Credit cards offer unparalleled convenience, and credit card transactions can be made in seconds – with no need to count cash, make change, or even have the funds on hand.

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.

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 “billing statement” or “statement balance.” You’ll have until your statement due date to make at least a minimum payment, and any remaining balance will “revolve,” and 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 financing, or in some cases, for carrying a balance.

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 eligible purchase made with a rewards card, you can earn points, miles, or a percentage of your spending back in the form of cash back in the form of a statement credit depending on your particular card. How much you earn is based on a few different factors, including how much you spend and in some cases, what you’re spending on. Points and miles can be redeemed for things like airfare or hotel stays, while cash back rewards could 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.

Your credit card can have a variety of different APRs, each for a different purpose, and all tuned to you – your credit score, credit risk profile, and other factors. 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 or have a returned payment.

Many credit cards use the average daily balance method of accruing interest on purchases, but this will vary, depending on the card provider.¹ Credit card issuers are required to disclose the interest compound method they are using, so make sure you read your card’s terms and conditions if you are unsure. If your card issuer is using the average daily balance method, here’s how it works 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, or in some cases, 360, depending on your credit card issuer. Then, they multiply that result by the number of days in the billing cycle to get the amount of interest you owe.²

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.³
• 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 an encrypted code that’s unique to the specific transaction.⁴
• 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.⁵
• 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, the following steps take place:⁶

1. The merchant sends a request for payment authorization to their payment processor.


2. The payment processor sends the transaction to the card association before it reaches the issuing bank.


3. Authorization requests are made to the bank.


4. The bank either approves or declines the transaction.


5. The bank sends the approval status back.

Meanwhile, your card issuer deducts the purchase from your credit limit and adds the transaction to your next monthly statement.