How Credit Cards Work

Using Plastic To Buy and Borrow

Credit cards consist of standardized plastic cards that are used both as a means of payment and as a means of borrowing. All true credit card purchases involve the use of a revolving line of credit, which is extended to cardholders with the promise to pay the funds back at a future time.

How Credit Cards WorkA lot of credit card use involves the use of very short term credit though, although many cardholders do take advantage of longer term financing that credit cards offer. The interest rates offered by credit cards tends to be higher than more traditional lines of credit offered by banks though, typically in the 20% range, although some credit cards do offer lower rates.

There are two major players involved in delivering the services that credit cards offer, which are the payment processing end of things and the underwriter of the debt. So for instance you may be using a Visa or a MasterCard credit card, and many think that it is these companies who own the card, but instead they only provide third party payment processing services, and the actual owner of the card will be the underlying institution, the bank or the merchant who issued and manages the account that the card represents.

If the card issuer is a merchant, they will assign the management of their credit card lines to a financial institution, although if they are big enough they may do so by way of a subsidary set up to manage their credit facilities. This is a financial product and therefore needs to be managed by a financial company of some sort, although this part of the business can often be hidden from the consumer, and they often times may not be aware of who is managing a card of theirs.

To qualify for a credit card, one must meet the normal requirements that getting approved for credit entails, for instance having enough of an income to make payments on it, and having an acceptable credit rating. Credit cards will sometimes be issued to those who have no established credit though, and are the entry point to the world of borrowing.

In contrast with normal lines of credit, credit cards aren’t just used when one seeks to borrow money, in other words when one does not have the access to funds immediately and instead plans on funding the purchase at a later date. A lot of credit card use involves situations where the cardholder does have the funds but chooses to use a credit card anyway, as a convenient method of payment, as a way to easily track and manage their finances, and as a means to earn rewards.

How Credit Cards Started

Credit cards got their start as a way of managing the accounts that individuals had with specific merchants. These merchants sought to extend credit to select customers as a means of increasing sales, and that concept has been around far longer than credit cards.

All of this was at one time kept on paper, which might be fine for small merchants, but larger ones found this to be cumbersome and inefficient, and sought better means to track the accounts of their credit worthy clientele.

At one time merchants used to use credit coins to track purchases, which could be imprinted onto sales slips as a way of identifying the purchaser and tracking their purchases. This was at least superior to having to write out the information long hand. This also reduced the amount of clerical errors that were made.

These coins would have the customer’s account number on it as well as the logo of the merchant to distinguish it from other coins issued by other merchants. Since the customer’s name was not on the coin though, this led to anyone in possession of the coin being able to use it, and therefore security could become an issue.

Charga-plate was another predecessor of today’s cards, which was a small piece of sheet metal similar to a military dog tag, which would have the customer’s information printed on it, and unlike charge coins, this version did have the customer’s name and address on it for identification purposes.

Charga-plate also had a piece of paper affixed to the back which contained the customer’s signature, which could be used for verification purposes, a feature that still exists with today’s credit cards. These plates were retained by the merchant, who would retrieve them when usage was requested by the customer.

The first charge cards, as they were known then, emerged from the airline industry, who started issuing cards as far back as 1934. Buying now and paying later ended up being a big hit with flyers, and by 1941 half of the revenues of major airlines were being charged to these accounts and these cards.

Around this time we started seeing installment plans being offered with accounts, where you could purchase airline tickets and pay for them over time, and today installment plans play a big role in the use of credit cards, taking these cards from buy now pay later to buy now and pay much later if you wish.

During the 1940’s, we saw the emergence of the gas card, in concert with the growing automobile market. Gas cards really helped drive the growth and acceptance of charge cards, and in the 1950’s we seeing the first general purpose charge cards, which could be used at a variety of merchants.

To make this work, what was needed was central organization, and this is where banks stepped in. Several major banks started issuing their own cards, and once this was married to third party processors that dealt across banks, by way of banks merging their cards, the major players of today emerged, most notably Visa, MasterCard, and American Express, who control most of the major credit card market today.

The Impact of Credit Cards

It’s no secret that credit drives spending, and this was the idea with the credit card, as a means of driving sales. This is why the merchants offered it prior to the credit card, and it’s also why merchants are willing to pay a premium to credit card processors to allow customers to use these cards with them.

Even in their earliest time, credit cards have been met with criticism, and perhaps especially then, when credit card issuers were faster and looser with their cards than they are today. Unlike today, where credit card issuers will mail out invitations to apply, in earlier times actual cards were mass mailed, loaded and ready to go, with about 100 million cards being mailed out in the U.S. prior to this practice being outlawed in 1970.

While in many cases these cards fell into the hands of those who wouldn’t have qualified for them, this did serve to elevate the use of credit cards to an epic status that surely benefited the credit card issuers in the long run.

Back then, the only real competitor to credit cards was cash, so credit cards offered a unique convenience. Nowadays, debit cards are widely used as well, but even so, about a third of all point of sale purchases today are made with credit cards, and this is expected to grow further.

Credit card companies charge significantly higher processing fees than debit cards do, and very often will share this income with their cardholders by way of a rewards program. This includes both merchandise and cash, and consumers will shop around for the best deals here often times.

There’s no question though that credit cards drive sales in a way that is beyond what cash and debit cards do, and this is due to the nature of credit being offered with the credit cards. Often times people will use credit cards as cash equivalents as they do with debit cards, where they actually have the money at the time of purchase but choose credit card payments out of convenience or to earn rewards, but people do use these cards as a means of credit as well, and that’s how the cards generate higher sales.

This widespread use of credit does benefit the economy as a whole as well, by the same mechanism as credit does generally, and if some people do overextend themselves, as people often tend to do, a certain amount of this certainly isn’t unhealthy for the economy, as the benefits do outweigh the costs by a good margin, although it certainly can become a burden at the individual level if it gets out of hand.

There are many people who carry too much credit card debt to the point where this can become a real burden, especially given the typically high interest rates that credit cards offer, although in many cases this can be managed through lower interest consolidation.

Many do not properly advantage themselves of these options, although one can indeed get into a bind where their creditworthiness becomes negatively affected by the debt and they may not be in a position to qualify for better rates.

Like all cases of credit difficulty, this may be a result of unfortunate circumstances, as well as through lack of proper restraint on spending, but in all cases one must be aware of the risk exposure that credit cards may involve, especially when they create situations where one’s buying power may exceed one’s ability to service the debt.

This is very often the case with credit cards, and is a distinguishing feature of them in fact compared to other credit facilities, which normally look to stay within reasonable limits of one’s debt capacity. This often isn’t the case with credit cards though, and therefore one must be particularly diligent when using them or even accepting credit line increases beyond what one would be comfortable with.

Overall though, credit cards can be a marvelous thing for the cardholders, merchants, the card issuers, and the economy as a whole as well, when used properly, but that’s the real key here.

Ken Stephens

Chief Editor,

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.

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