Personal Finance 101: How Does a Credit Card Work

by AJTrenkle on Tuesday, November 13th, 2012 | No Comments

Nearly every American owns at least one credit card, and many of us (myself included) use so many different cards for different purposes that there is probably not a wallet around that would hold all of them. But how, exactly, do credit cards work? This is an important question as it allows you to better understand how credit cards can be useful for you, how you can benefit from using them them instead of cash; but also how they even more greatly benefit both the merchant and the bank and can therefore hurt your financial well-being if not used with wisdom. Essentially, credit cards are key components of the financial system, a network of banks and intermediaries that help buyers and sellers come together while also connecting savers with borrowers. In this way, credit cards are not much different than larger and more serious kinds of loans (like mortgages and car loans), and play a similar role to stocks and bonds as well. Let’s look at how this all works.

Above is a basic graphical outline I did not make that shows how a credit card transaction works. This is useful because it helps you to better understand all of the parties involved. This diagram is written from the perspective of a business charging your credit card, so keep that in mind when reading. The “acquirer” is the bank for the merchant. What is not shown are the steps between the issuer and acquirer where payment processing takes place between these banks. This is where companies like Visa and Mastercard come in, as they help quickly and accurately speed the transaction between the two big banks.

Let’s provide a case study. Say Susan with her Chase Freedom Credit Card goes to buy a $3.00 latte at Starbucks. Susan is represented in her purchase by her bank, Chase, who has approved her for a line of credit to go and buy things on based on her history and credit score. The “Freedom” Card is just a type of credit card product issued by Chase, similar to how a single car company like Ford might have multiple styles of cars (Mustang, Taurus, F-150, etc.). Starbucks then will have an account with a bank of their own. This bank will instantly reimburse the merchant for the value of the latte, minus a transaction fee of 3% or so. Starbucks bank will then go and request $3 from Susan’s bank, Chase, via the payment processing system known as Visa or Mastercard. These companies take a cut of the action on processing the payment. Susan’s bank then sends the $3 to the merchant bank and marks her account up for $3. When Susan’s credit statement closes she will owe payment on that $3. If she does not pay it off, she will have quite high interest charges plus penalty fees to pay.

Along the way rebates are given to the customer (Susan) in order to entice her to use the card more.

So how does this benefit all parties? Let me explain via the following diagram which I have drawn.

This shows the interests that each actor has in the process. You can clearly see that Susan and the merchant Starbucks gain substantially from their use if credit cards. Susan, however, does also take on risk, but mostly controllable risk in that she can control her own spending habits.

In fact the largest uncontrollable risk you could say is clearly from Susan’s bank even though I have drawn this as though everyone is paying off what they owe. The bank has no way of being completely assured Susan will pay off her debts even if it runs her credit score and fully knows her payment history.

However the bank probably is little concerned by this as they can run up fees and interest charges on Susan’s account, revoke or lower her credit line, and close her account. In fact they probably want a lot of these things to happen as most customers will (eventually) pay off these fees and charges and the bank is maximizing its returns by being aggressive in giving credit to more risky customers who will incur these fees while writing off losses to the few that are complete deadbeats. This is akin to an aggressive poker player losing some hands big but winning many more they otherwise would have folded.

Therefore it is really in the bank’s interest to get a lot of customers of different kinds and entice them to use a lot of their products for most transactions. They will make a small steady profit in the churn and percent transaction fees from good customers with 800+ credit scores while potentially also charging the real premium products a yearly fee. They will make easy money from the middle class who may carry some balances and incur some fees but generally pay their balances eventually. And they will lose big on very risky customers but hit even bigger on many others in the high risk category as discussed above. Banks get a lot of customers by aggressively promoting new products and offering various rebate and point schemes. This benefits them enormously in the aggregate macro environment.

But it can benefit you the individual customer as well as points, rebates, and sign up bonuses can add real value. It is this system we will discuss more in our next article.

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