How Credit Cards Work

There are a great many people who will have very little idea of how credit cards work. They may frequently use a credit card or credit cards and know that they are presented with a bill at a certain point each month which has to be paid, yet have little or no knowledge of what goes on behind the scenes every time they make a purchase with their credit card, or indeed of the various ways in which credit card companies make money out of their activities.

It is very much an over-simplification to say that credit cards work by allowing people to defer payment on a financial transaction until a later date. If this were simply the case and everyone cleared their balance in full each month, credit card companies would make no profit from their activities and thus fail to survive in business. The reality is that each and every time we make a transaction with our credit cards, the company will be making at least something out of our doing so.

When we use our credit card in a retail outlet, for example, it is normally the case that we will not be charged for doing so, though certain exceptions can occur. Although we are not charged for this benefit, however, the credit card company will effectively be charging the retail outlet for accepting their card in payment and making some small profit from our activity in this fashion. This is why in some instances, companies or retail outlets will charge a payment fee for paying by credit card. They are simply passing on the user fee – or at least some of it – to the consumer.

The second way in which credit card companies can potentially make money from the consumer is by charging interest. Every month, the credit card user will receive a statement, informing them of the balance outstanding on their card. They are then told by which date payment in full has to be received in order to avoid incurring interest charges, or alternatively, when a minimum payment – representing a percentage of the outstanding balance – has to be received, after which date interest will be charged on the balance outstanding.

If we do not clear the balance on a credit card in full, interest will be charged to the account and added to the outstanding balance at the time of the next statement. The minimum payment advised at that time will again be a percentage of the total but will be used in the first instance to offset accrued interest, not the outstanding balance. In this way, by making only the minimum payment each month, even moderate credit card debt can take many years to repay, with the interest paid in this time proving to be considerable.

If we use a credit card to obtain cash from an ATM, we will be charged for making the transaction in the form of a one-off fee and will likely find that interest starts being charged from the date of the transaction, not from the date of the next statement as is normally the case with purchases. The interest rate charged for this service is also likely to be higher than that charged for normal, routine transactions.

Credit cards are a useful or even indispensable tool in the modern world in which we find ourselves living but they can therefore be seen also to be an extremely lucrative business to those banks and other bodies which issue them. It is the individual responsibility therefore for each individual consumer to use theirs in the most cost effective fashion possible and minimise the level of charges which they can and will incur in the process.