How Credit Cards Work

 

Credit cards work like any other type of loan or line of credit.  The cardholder enjoys the freedom of making purchases at will as well as the ability to finance purchases over time.   The card itself is an instrument in an industry based on networks that connect 5 different groups consumer, issuers, associations, merchant and acquirers.

 

Consumers Consumers are those who purchase or "consume" goods and services and they are the "end-users" of credit cards. Customer transactions using credit cards exceeds $1 trillion annually. Credit cards can finance food, gas, clothing, travel, entertainment, phone calls, and even rent. Any U.S. resident over the age of 18 can apply for a credit card available through "issuers".

Back to Top       Issuers In the simplest terms, the credit card issuer lends money and manages the customer relationship. Issuers usually invite consumers to apply for a specific credit card product. In other cases, a potential customer may find an application and send it to the issuer. Often the applicant is given incentives for transferring his or her existing credit card balances onto the new card as well as for using the card for daily purchases. The issuers manage the entire customer relationship from application through to customer service. Since a credit card company is lending money, issuers must be backed in some capacity by a financial institution, usually a bank. It is the issuer who literally lends the consumer the credit to make a purchase. The issuer takes on risk when granting credit, and is compensated with interest payments. Therefore issuers look for creditworthy individuals.   Credit card products offered by issuers may have a variety of features and services including the annual percentage rate (APR) on transactions, the rewards programs, related insurance, travel benefits, and so forth. On each credit card is an association symbol that lets a customer know which merchants will accept the card. Back to Top       Associations There are several associations in the U.S., two of which are VISA and MasterCard. Both were founded over 30 years ago, have global networks, and have affiliations with millions of merchants who accept credit cards. The larger the network of merchants the association has, the more consumers will want to apply for a card that uses that association's network. These associations have electronic infrastructures that enable the payment system to work from the point of sale to the customer's account. When a consumer decides to make a purchase, the card is presented to the merchant's salesperson. The salesperson first checks to see if the establishment accepts the association on the card. He or she then swipes the card through the reader or calls a central number to see if the purchaser is allowed to make a transaction. Within 5 seconds, the transaction is either approved or denied, and the consumer signs a receipt for the purchase. Behind the scenes, the terminal at the point of sale involves technology that allows information on the sale to be transmitted to VISA or MasterCard's network. From there, the issuing bank is determined, and the purchaser's account record is accessed and updated. Back to Top       Merchants Merchants accept credit cards because many customers prefer them over cash or checks. Buyers are more likely to purchase when they don't have to worry about whether they are carrying enough cash with them that day, or whether their last paycheck cleared. Carrying a credit card removes those concerns. At the point of sale, merchants must either have a terminal to swipe the card, or a telephone to call and verify that the card is valid. The salesperson is responsible for validating that the purchaser actually owns the card by checking the signature on the back of the card, against the signature on the receipt. Online, it is especially important for merchants to offer credit card payment, since 95% of all online transactions are made with credit cards. It is far more efficient in a virtual world to pay digitally. However, online transactions pose the most risk to merchants. Committing fraud online is easier since it's more difficult to confirm that the person entering the card actually owns the card. MasterCard and VISA cardholders are not liable for fraudulent purchases made on their cards. Rather, it's the merchant who usually has to bear the brunt of fraudulent activity. The good news is that new technology in payment systems is rapidly emerging which will significantly reduce exposure. Back to Top       Acquirers The acquirers are financial institutions that establish relationships with merchants who agree to accept electronic payment instead of cash or checks. The acquirers need to convince merchants that it's worth their while to join the network and install the necessary hardware. The motivating reason is that more consumers will patronize the merchant and spend more money if offered the convenience of paying with a credit card. Acquirers provide card authorization capabilities by linking to the association networks. They also provide actual funds to the merchants' checking accounts representing the value of the credit card transaction.