Credit cards play a vital role in building credit scores and creditworthiness. In addition, it earns you redeemable points, cashback, or miles. We all know how to swipe, tab, or dip the plastic money to pay for daily purchases, but how do credit cards work?
Knowing the credit card types and how they function help you become a responsible consumer. It'll help you understand their purpose, maximize benefits and avoid debts and financial ruin.
What Is a Credit Card?
A credit card is the purchasing power of an individual, stored in plastic, metal, or digital card. It offers a revolving line of credit for making purchases. The issuer requires at least a minimum, if not total, payment on the card balance in each billing cycle. You'll pay a fee based on the Annual Percentage Rate (APR) for carrying the balance to the next month.
Credit cards come with a ceiling on the line of credit, which limits your total purchasing power; hence are called a credit limit. Your monthly statement shows expense details and the balance you owe. As you pay off your balance, it releases your available credit.
In addition to providing a monthly interest-free loan, credit cards also offer rewards and benefits for you and your family. You can redeem points to cash or check or use it to buy gift cards. You'll earn points as you utilize the card for payments.
You can use a credit card to make purchases, balance transfers, and cash advances. However, it would be best to refrain from withdrawing cash from a credit card. Any money taken out of the credit card as cash advances will start accruing hefty interest immediately.
How Do Credit Cards Work?
What seems like a simple purchase decision when you pay using a credit card undergoes a complex process. It involves a customer, his/ her issuing bank, Merchant, and the acquiring bank, along with a payment processor and payment network.
So, how do credit cards work exactly?
Regardless of whether you slide the magnetic strip against the card reader, insert a chip-enabled card or go contactless, the card reader receives your information and sends it to the Merchant's bank. Merchant's bank then requests payment authorization from the credit card issuer. Once authorized, the issuing bank sends the money through the payment network to the Merchant's bank. The multi-step process happens seamlessly at lightning speed in the background.
How Different Types of Credit Cards Work
Besides big banks like Bank of America, Capital One, Citi, and Wells Fargo, many other banks and credit unions issue credit cards. Various products are available based on consumer types, credit history, reward structure, card network, and many other features. And hence, they function slightly differently, although they are generally the same.
How Do Secured Credit Cards Work?
Secured credit cards work like debit cards, where your credit limit depends on your security deposit. The security deposit acts as collateral for the credit. The card issuer will keep the security deposit if you stop paying your monthly balance.
You apply for secured credit cards just like any traditional credit card. Once approved, you must deposit cash as a security to use the card for purchases. And your credit limit is usually equal to the security deposit amount.
Secured credit cards are best for people that are building or improving their credit history. Banks and credit unions base their credit approval decision on the applicant's income, credit risk, and history.
How Do Cashback Credit Cards Work?
Cashback credit cards provide cash back on every qualifying purchase. The credit card issuer determines the amount of cashback and qualifying purchases. Depending on the card, a general cashback ranges from 1% to 2%.
Credit cards may also offer bonus cash back at a higher rate in specific purchase categories with or without activation requirements. The final Cashbacks show up in your account at the end of every billing cycle.
Cashback credit cards usually have a higher Annual Percentage Rate (APR) and a potential annual cap on bonus cash back. Most bonus cashback requires enrollment requirements.
How Do Co-Branded Credit Cards Work?
Co-branded credit cards work similarly to traditional credit cards that banks or financial institutions offer. Besides regular cashback, miles, or points, they'll have additional perks on purchases at the co-branded merchants. The co-branded card can be a hotel, an airline, or a store credit card.
Businesses offer co-branded credit cards to customers to maintain loyalty, grow, and save on interchange fees. The credit card issuing company has an opportunity to expand its customer base. And consumers unlock additional savings by being loyal to the brand. It's a win-win for everyone.
How Do Travel Credit Cards Work?
Unlike cashback credit cards, travel credit cards offer points or miles for all eligible purchases. The accumulated miles or points can offset travel-related expenses through a statement credit. They can also pay directly for travel arrangements like flight tickets, hotels, or car rentals through the credit card website. The points/ miles are also redeemable as cash or gift cards but with less value.
Travel credit cards can be co-branded cards like Delta SkyMiles credit cards, Hilton Honor credit cards, or unsecured cards offering travel benefits. Banks and financial institutions like Chase, CapitalOne, and American Express offer travel credit cards.
If you are a frequent traveler, premium travel credit cards offer the most benefits. They come with an annual fee, but the credit card benefits and savings are worth more than the fee. Some of the premium travel card benefits are:
No Foreign Transaction
Most premium credit cards don't have a foreign transaction fee, meaning you don't pay any costs if you swipe out of the United States. If you frequently travel internationally and use credit cards for payment, the foreign transaction fee alone can add up. Not having to worry about transaction fees saves money and headache.
Huge Signup Bonus
Premium credit cards have a high signup bonus. You only have to meet their minimum expenses requirements within the set time frame, usually two to three months. For example, the Capital one Venture card offers 75k if you spend 4k in 3 months. It is equivalent to $750 in points. It's a sweet deal for a card with a $95 annual fee.
Everybody gets excited about their favorite travel plans and their joyous arrangements. Something going wrong on a trip is the last thing on our checklist. That's where a credit card with travel insurance benefits can protect you against any unexpected events.
When you use a premium travel credit card to pay for your eligible travel expenses, they provide travel accident insurance, trip cancellation and interruption protection, delay reimbursement, rental car coverage, and many other benefits.
Lounge access is one of the best premium travel credit cards. Most people dream of getting inside this private area which is accessible either through membership or buying your way in.
Some premium travel credit cards offer a free priority pass select membership that gives you free access to the airport lounge. A few of the selected premium cards also offer multiple guests entry along with the cardholder.
TSA Precheck/ Global Entry Credit
TSA Precheck and global entry help you skip the busy airport lines and enter the terminal hassle free. It requires a detailed background check and an interview with the U.S. Customs and Border Protection(CBP) officer but once approved, you can skip the processing lines and paperwork.
You can say goodbye to removing your belts, shoes, and electronic devices and quickly pass through security.
Transferable Reward Points
Most premium credit cards offer transferable reward points to hotels and airline loyalty programs. These cards have partner programs, and you can find the complete list on the card issuer's website. The point transfer may not be 1:1, but sometimes, it's cheaper to use points than booking through cash or card directly.
The Bottom Line
If you use credit cards responsibly, they work in your favor. The cards are slightly over 3 inches by 2 inches in size and can fit into your pocket. With virtual cards, you don't even need to carry them. You can store them in your phone's digital wallet. They are very convenient compared to carrying large sums of dollar bills.
Credit cards work as a revolving line of credit. You can make a purchase even though you don't have the money upfront. And you'll also earn rewards for using it. You just have to make sure to pay it off by the due date.
This article originally appeared on Savoteur.
Ram is an Engineer by day and a personal finance blogger by night. He shares his tips and tricks on earning, saving, and growing money through his blog, Dollar for Cent. He uses his analytical and problem-solving skills to tackle money problems, find deals, and increase wealth. He loves his day job but believes our lives should not be location-bound and time-constrained. He documents his financial journey and hopes to reach financial freedom.