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How does a credit card work?

How does a credit card work?

Elizabeth Thomas

10 Aug 2007

A credit card is a safer and more convenient alternative to cash. However, the simple act of paying for products and services with a credit card is supported by an elaborate behind-the-scenes system.

When you apply for a credit card, your application is carefully screened by the bank you apply to. A credit limit is worked out for you, based on your financial capability, educational qualifications, age etc. The bank that issues you the credit card is called the issuing bank.

At the heart of the credit card business is a mutually beneficial arrangement between the issuing bank and a host of businesses called merchant establishments through international networks such as Visa and MasterCard. Merchant establishments could be hotels, shops, travel agents or any place where transactions are made. Banks that enroll merchant establishments are called acquiring banks.

Your credit card is valid in any merchant establishment that accepts your network (MasterCard, Visa, et al) even if it has been enrolled by an issuing bank other than yours. Most Indian card issuing banks are part of either the MasterCard or Visa network, or both. There are other credit card networks like American Express and Diners Club too.

This network is at the heart of any credit card activity. When you use a card at an establishment to purchase a product or service, your card is swiped on a swipe-machine. The swipe machine is connected to a central computer belonging to the network, which in turn is connected to all issuing banks. The system verifies with your issuing bank whether you have sufficient credit to cover the purchase in a few seconds and approves or rejects the transaction. As soon as the approval comes through, you are asked to sign the charge slip. The merchant then verifies your signature with the one at the back of the card.

The charge slip is then forwarded to the acquiring bank, which then settles the transaction with the merchant. The issuing bank also proceeds to bill you for payment as per the cardholder agreement. The acquiring bank will settle the transaction with your issuing bank through the network.

From the merchant establishment's point of view too, the credit card is a safe and efficient payment mode and brings more business. The merchant establishment pays a fee to the bank that enrolled it for the service. From the bank's point of view, credit cards benefit in two ways: Banks make money through fees from merchant establishments and the higher-than-normal interest rate paid by card holders for the balance on their cards.

You can save on the interest cost if you are prompt in paying the balance by the due date. Credit card users get a free period of credit before they reimburse the credit card issuing bank. This may vary from 15 days to 40 days depending on the issuing banks. When you use a credit card, you have the option to pay just a part of the total amount spent and carry forward the balance. In such cases, you will have to pay interest on all your purchases without any free credit period.