The Different Types of Payment Cards
There are four main ways that people make payments, which are by cash, by debit card, by gift card, and by credit card. What distinguishes credit cards from the other two types of cards is that credit card transactions are purchased with borrowed money, which the cardholder agrees to pay at some point in the future, according to their cardholder agreement.
Some people get confused about this, and may think that a debit card that carries a Visa or MasterCard logo, which are credit card processing companies, are some sort of credit/debit. These cards are debit cards though, and all purchases or other transactions made with them will be debited from the bank account that it is associated with.
There is also a card that is called a prepaid credit card, which also bears the logo of a credit card processor, but these are actually gift cards, there is no money loaned with them. They are preloaded from another funding source, often to be used for making purchases on the internet.
These cards can either be for a single use, or they may be reloadable, but in no case is there ever credit extended, so using the word credit in any sense to describe them is a misnomer.
With an actual credit card, credit is always extended, although in almost all cases, one does not have to pay interest on the money borrowed provided that the credit used is paid back during what is considered the grace period.
How this works generally is that a credit card client is billed for the purchase at the end of the billing period, and then is extended a period of time to pay off that balance in full, usually 21 days. A lot of people think that the grace period starts from the time the purchase is made, but this is usually not the case. It is always wise though to consult your cardholder agreement though to prevent any surprises.
Types of Credit Cards
The first type of credit card are ones issued by financial institutions for general use, called major credit cards. Contrary to what some think, the cards are always issued and owned by the financial institution, not the payment processor, such as Visa or MasterCard. So if you have a credit card issued by a certain bank, the fact that it is a Visa or MasterCard only denotes the company that processes the transactions, as well as where they may be accepted.
Almost all merchants take both Visa and MasterCard, although with some other cards, merchants may or may not take them, although there are several other types that have wide acceptability, such as American Express.
Many merchants may offer their own branded credit card, called a store card, and these cards can only be used with the specific merchant that owns them. They are usually administered by a financial institution on behalf of the issuer, usually by a bank or credit card company.
Not all credit card companies are banks, and there are financial institutions that solely issue and manage credit cards, although most are administered with banks in addition to the other financial services they provide.
There’s also what’s known as a secured credit card, and in this case it is a real credit card, even though cardholders are required to deposit funds to be held in case of default. The credit card company will issue a real credit card to them, which is identical to non secured credit cards other than involving the security deposit.
After the card is kept in good standing for a certain amount of time, a year or so typically, the cardholder may be deemed to have proven their creditworthiness such that the deposit will be returned to them. Secured cards are usually sought and offered to those whose credit history is insufficient to qualify for a regular credit card, and the secured card can serve to build or repair their credit.
How Credit Cards Work
While credit cards to allow people to obtain credit, this doesn’t mean that they will necessarily pay any interest. A lot of the money that is made by credit card issuers don’t involve interest at all, as processing fees add up to quite a bit of profit for them, and they are often willing to share these profits with cardholders as rewards and incentives for using their cards more often.
When you make a purchase with a credit card, the credit card issuer will charge the merchant a certain percentage of the transaction, usually around 2-3%, for processing. If the merchant wishes to accept the certain type of credit card, for instance Visa or MasterCard or Amex, they have to pay these fees.
So these transaction fees are common to the particular credit card processor, and these are negotiated at that level, for instance between Visa and the merchant. So the particular financial institution that owns the card doesn’t matter in this case, and the payment processor will keep some of the transaction fees and give some to the financial institution.
There are two separate benefits that become available to credit card users out of this arrangement. First, there may be rewards offered, although not all major credit cards offer them, and consumers should shop around to find the best deals.
Some cards that offer rewards will also require that an annual fee be paid, and this annual fee also may reduce the standard rate of interest charged, so you always want to consider these fees when calculating the relative benefits and desirability of a given credit card.
The other benefit is the grace period, and the reason why credit cards can extend this is that they make a profit from the transaction itself, if it is a purchase that is. Cash advances and certain purchases are treated differently, ones where there is no transaction fee involved, and in these cases interest will be charged from the day of the advance or purchase. Almost all purchases do involve transaction fees though and are exempt from this.
Some cards offer an introductory rate or a balance transfer offer, which involve reduced interest rates for a given time. If one does have credit card debt or expects to hold credit card debt in the near future, these options can be worth considering.
Using Credit Cards Wisely
Ideally, one would use credit cards as short term cash management tools, and to benefit from rewards. It is actually smart to use credit cards whenever possible, to earn the rewards they offer, things like cash back for instance, or free merchandise or air travel. Given the choice between using cash or debit and using a credit card, provided one is using a rewards card, which are pretty common, the credit card is clearly the better choice.
This does require one use sound management however, and if one gets a percentage or two of their purchases back but it costs them a lot more in interest, that’s only a good deal if they were planning on borrowing anyway and planning on using this means to borrow anyway.
A lot of people do use credit cards to borrow, and given the fact that credit on credit cards is usually issued more liberally than other credit facilities, there is a lot of potential to over borrow and get in financial trouble with these cards.
Normally, a financial institution will look at your ability to repay credit pretty closely before extending credit to you, for instance with a personal line of credit or a loan through a regular bank. With credit cards though, they don’t look at such things anywhere near as closely, and often they will extend your borrowing limit just on the basis of your repayment history, without even looking at capacity very much.
So if you qualified for a certain credit limit initially, based upon your income and your debt load, if you fulfill your obligations, your credit card limit will often be extended even though your capacity to bear debt has not increased. Should someone be tempted to overextend themselves with this, this can indeed lead to trouble.
Whenever you borrow on a credit card, beyond the grace period, you always want to look first at lower interest options. Credit cards typically have interest rates of around 20%, and this is why they can afford to be more lax with issuing credit, but there are people who could receive rates considerably lower that don’t pursue this, and just pay the higher credit card rates.
In any case, it is important to calculate the cost of borrowing whenever you borrow money, and the higher cost of borrowing that credit cards often involve needs to be particularly paid close attention to.
Very often, people will use these cards with impulse buying, either desiring to buy something now rather than waiting until they have the money, or perhaps even buying things they cannot afford. This is the case with credit in general, but without the normal restraints on credit that credit cards have, one can get into more debt than they can handle much easier.
The desire to purchase things can be a strong one though, but the more one takes time to reflect upon whether using credit in a given situation is wise or not, the less likely they are to get in trouble with credit. As a guideline, you don’t want to buy things on credit you would not buy if you had the cash, and would not buy for the price that the cost of borrowing brings it up to.
Credit cards can be a great tool, but only if used wisely and with proper reflection.