In this post, we’ll talk about the parties involved in making credit cards work, what their role is, and what we can do to maximize the benefits we receive while avoiding fees and interest charges.
Credit Cards can be our best friend. It’s convenient to insert our card at the register, or to enter our info online. Most come with perks that get us cash back, miles or hotel stays. They’re safe to use. Payment networks have implemented chip technology to secure our payments, and they proactively monitor for fraud.
I’ve had several fraudulent transactions that the payment companies have spotted and refunded to my account without my involvement. That said, it’s important to understand how credit cards work so you can take advantage of the benefits while minimizing the potential additional charges that come with them (e.g. interest payments and late fees).
So how do credit cards work?
Aside from us (the credit card holder) and the merchant (the person or business we are paying), there are 2-3 key parties behind the scenes involved in making credit cards work.
Payment Networks
First is the transaction processor or payment network. These guys provide the infrastructure that allows the vendor to accept our card and process the payment. You probably have heard of Visa and MasterCard. They are 2 of the bigger payment networks. They earn money by charging a fee to the vendor on every transaction processed. The fee is usually around 2% of the purchase price. Cool for us, we get the convenience of paying by card and the vendor pays the fee. Even cooler for the payment processors, because there were over $40 trillion in payment card volume worldwide in 2022. And while there are more payment processors than just Visa and MasterCard, that’s a pretty nice pie that they get a slice of.
Issuer
Next up is the financial institution that issues the card. If we look at the back of our card, we should see the issuing bank – some common ones are Chase, Citi, and Capital One. The bank is the party that is putting up the money. Think of a credit card as a loan that is always open and available to us. That’s called “revolving credit”. When we complete a credit card application, the bank assesses our credit worthiness, and offers us a card with a pre-set limit. This is the amount that they think we can safely pay back. So, let’s say for example, we apply and receive a card with a $1,000 credit limit. We can charge up to $1,000 at any given time. Once we hit $1,000, we will be shut off until we pay off some of the principal (More to come on principal and interest).
So revolving credit is quite convenient. The issuing bank doesn’t care what we buy, they just won’t let us exceed our limit. And we just need to slap down our card when we hit the drive-thru. We don’t need to apply for a loan to get that cheeseburger. As long as we’re under our limit, the issuing bank will approve the transaction.
What’s going on behind the scenes?
Let’s pause for a sec and dig a little deeper into what’s going on between us, the payment network (remember them?) and the issuing bank.
We pull up to the drive through window, order our burger and insert our card. The payment network notifies the issuing bank of our request to pay the vendor. Providing we are under our limit, the issuing bank then transfers their (the bank’s) money to the vendor to pay for our tasty burger.
The issuing bank nicely paid for our burger. The bank will put the charge on our next statement and we will have until the payment due date to pay the issuing bank for our burger, and anything else we charged during that statement period.
You may notice that the bank is taking all the risk here. The bank puts up the money to pay for our purchases. The payment network is processing the transactions, but takes no financial risk.
This brings us to the risky side of credit cards. We’ve established that the bank is the only party taking a risk. They paid for the burger but haven’t been paid back until the statement is sent and we send in our payment. If we don’t pay at all, the bank loses money.
To compensate them for the risk they are taking (i.e the risk that we don’t pay them back), the bank charges interest (yuck!).
Credit Card Interest
I took a quick look at some credit card offers and the interest rates range from 17% to 29.99%. So what does that mean? For simplicity, let’s say our rate is 25%. The interest rate is referred to as 25% APR (Annual Percentage Rate). This means that you will pay the issuing bank 25% of what you owe them per year in interest. This is pretty frightening. Considering that the average consumer has roughly $6,000 in credit card debt. The average consumer is paying $1,500 every year to the issuing bank in interest payments. Read more here.
Let’s take a look at how credit card interest works. We hit the drive thru several times this month and spend a total of $100. We’re being careful and we have no other credit card charges this month. At the end of the month, the credit card issuer (the bank or other financial institution who made the initial payment on our behalf) will send us a bill. They’ll tell us 3 key pieces of info.
- We owe $100
- It’s due on xx/xx/xxxx (usually 1-3 weeks in the future)
- Our minimum payment is $25.
Credit Card Payments
If we pay $100 (Yay!!) we essentially got a free loan for about a month to cover our purchases. We used the issuer’s money every time we used our card and we paid it all off before the payment due date.
If we pay the minimum $25, we’ve shown the issuer that we are making progress towards paying them back, which is important, but we still owe them $75. On our next statement, they will charge us 1 month’s worth of interest on that $75 that is outstanding. They will calculate 25% (our credit card APR) interest on the $75, divide that amount by 12 because the 25% is an Annual Percentage Rate, and our statement will show a charge of 1 month’s worth of that APR, or $1.56.
Be cautious. You’re probably thinking that paying $1.56 is no big deal, especially given the convenience of swiping, and the credit card perks we’ll accrue on the purchases. It’s easy to overlook the small numbers and lose sight of the bigger number. The $1.56 is one month’s interest on the $75 outstanding from the prior month. Remember that the average card-holder has $6,000 in credit card debt (charges that they’ve not been able to pay back) so the annual cost is $1,500 in interest payments to service that $6,000 in debt.
We can see that paying in full is ideal, but this is not always practical. It’s important that we understand what our credit card’s APR is, and how that is applied to our outstanding balance so that we can make the best decisions as to where to put our money.
Late or Missed Credit Card Payments
As a card holder, we also need to understand how our card handles late payments. Almost all cards have a late payment penalty. If we pay after the due date specified on our statement, or we miss a payment, we will be charged a late fee. Many cards I looked at charged around $25 for a late fee. However, some will charge us a larger late fee, some as much as $38, if we miss another payment within a specified number of months.
Check your contract. Setting up auto-pay on our card’s website can help avoid late payment fees.
Credit Card Partners
So for those keeping score, I mentioned there were up to 3 key parties involved and we’ve only talked about 2 – the payment network, and the issuing bank. Somewhere along the line, other merchants discovered the bonanza that was created by the sky-high credit card interest rates and decided they wanted to get in on this. One such group was the airlines, which is why you can get a Delta American Express Card.
But other businesses have caught on as well. Essentially what happens is that the partner – say the airline, offers miles, checked bags, upgraded seating and other perks to the card holder to encourage us to get the card and to spend more money.
Credit Card Reward Trade-offs
We typically get more perks for spending more money. We feel good because we’re buying ourselves nice stuff and rewarding ourselves with miles so we can take our new stuff on a nice trip.
The payment network feels good because it takes a fee every time we use the card.
And the issuing bank and the partner feel great because every time we fail to pay off our card in full, they are sharing a huge interest payment.
It’s easy to let the perks, convenience and buy-now-pay-later habit encourage us to over-spend. Effectively using credit cards, or any form of debt, is important to prevent us from digging a hole we can’t get out of.
Credit Card Fraud
We should talk a bit about fraud. These days it is more and more pervasive. Be sure to check statements, or better yet, create an online account with the card issuer where we can set up alerts (emails or text messages) to warn us of risks (transaction over a certain $ amount, purchase where the card is not present, etc.).
If we see a charge we don’t recognize, report it immediately. Most card companies will credit us immediately, investigate, and then contact us with the results of their investigation.
Card companies are also getting pretty good at denying suspicious payments. This is a double-edged sword. I was traveling out of the US and forgot to let my card company know. They denied a legitimate restaurant charge – pretty embarrassing.
Card Skimming
Updated 3/30/24: There have been a rash of stories in the news about card skimming. Criminals go to a legitimate business and replace or modify the credit card reader to allow them to read and steal our credit card info. Watch out for readers that look like they have been tampered with. Be wary if the card cannot be inserted and you are asked to swipe your card.
Keeping Safe
A couple tips for keeping safe with credit cards.
- Be careful of swiping. Just about all credit cards now have chip and pin technology which allows you to insert your card into a reader, or tap the card on the reader. This technology is very secure. Swiping is less secure.
- Be careful about giving your credit card info to anyone. You may be asked to give your credit card info over the phone when making a purchase. The person on the other end is probably writing this down so they can enter it into a billing system at some point. You don’t want your card info written down. Anyone who has this info can set up an account on amazon, add your credit card details and start charging away. Most people are honest, some are not.
- Don’t enter card info online unless you are confident of the validity of the website. Never enter card info after clicking a link from an email. Open your browser and navigate to the site on your own instead. Once on the website, make sure the website address begins with https://. The s means the website is using a higher level of security and encryption.
- Bonus tip: Scratch off the 3 digit code on the back of your card so it is unreadable. The card is still usable for insert, tap or swipe. But, if you hand your card to someone to pay a bill, they won’t be able to steal your card info. Think about how easy it is for waitstaff to take your card, snap a quick pic of both sides, and then return it. Again, most people are honest, but some are not.
- Set up card alerts for transactions over a certain dollar amount, international purchases and card not present so you can review these immediately. Check monthly statements carefully and report any unknown purchases, report these to your card issuer.
Annual Fees
Some cards charge an annual fee. Often this is waived for the first year and then applied to your billing statement every year going forward. Cards with annual fees typically provide you with higher levels of perks. Be sure you are aware of what you pay and what you get. Some may be worth it to you. Check back at the end of each year. Did you receive enough perks to offset the fee? And remember, if you did not pay off the fee right away, you also need to factor in the interest you paid.
Let’s recap
- I love my credit cards. I pay them in full every month and enjoy the convenience, along with 2% cash back that is deposited directly into my savings account.
- I set up auto-pay on my card’s website so that I never miss a payment
- Cards offer perks to get you to sign up and to spend. Make sure you know what your card offers and shop for the best perks. Mine has rental car insurance coverage which I used once – saved me a bundle. Some offer to extend the dealer warranty when you buy electronics. One of mine offers free credit monitoring. And beware of incentives that require you to spend more.
- Payment networks (like Mastercard and Visa), card issuers (typically banks like Chase or Citi) and sometimes partners like an airline, Costco or other retailer, work together to provide a seamless experience. Each provide value, but they get paid for their role in the process. It’s your job to understand the cost associated with the convenience of paying by credit card.
Thanks for reading and please post comments or questions. I’m happy to answer any follow-ups you may have.
Up next debit cards. Debit cards are similar to credit cards but different in some important ways. We’ll explore this next. Read here.