How Do Credit Cards Work Actually?

As you present your plastic cards as payment, do you ever wonder how they actually work in practice? We know the card represents money but there is much more to the process than you might realize. Your credit card is a product that is a cash alternative. It’s designed to be easy for consumers to use as ease of use is why credit cards have become so popular.

If you make a purchase with cash you are paying your own money to the item. When you buy with a credit card you are using the money of the financial institution that provides the card to you.

Every purchase you make with a credit card is basically a small loan from the credit card lender. The lender has given you a spending limit that regulates how many purchases you can make with your credit card and has told you how much those little loans will cost you (APR).

The Lender’s Role in How Credit Cards Work

Each month your credit card lender sends an itemized statement to you. This provides a full record of charges you’ve made to the account, any cash advances you’ve taken and also lists the charges for use of the convenient credit card.

The monthly statement shows the total debt due and also provides a minimum payment for those who want to spread out payment over time. New credit lending laws require the lender to provide information on each bill that tells you how much you must pay monthly to fully pay off your debt in three years.

The simple answer of how credit cards work is that they are revolving loans. You can add to the balance, pay down the balance or pay only the minimal amount required each month. Because using a credit card is basically a loan, you also are charged interest and fees.

Annual Fee

There may be an annual fee involved and this is increasingly common in today’s economy. The annual fee is often waived for frequent credit card users. For years, consumers were urged to apply for and carry many different credit cards. If you didn’t use a card, you were not charged.

When the economy took a sudden downward turn and unemployment became a crisis over the whole world, lenders discovered the problem of consumers with large lines of open credit available on multiple credit cards.

Today, there may be fee associated with credit card accounts that are meant to discourage consumers from having cards active but seldom used.

Thus, accounts may carry an annual fee or may be closed after an extended period of no activity on the account. This is done to reduce the risk of the lending bank.

Lenders Need to Take a Profit

Lenders need to make a profit so they offer special programs, rewards and benefits to lure new accounts. They also assess fees to make the accounts more profitable.

The APR is the prime source of income for credit card lenders. As interest rates on mortgages, car loans and personal loans have declined in the past two years, credit card APR has risen dramatically.

Adding to the profit for lenders are fees charged for balance transfers and international transactions and higher rates for cash advances.

If you are late on a payment or have allowed charges above the spending limit to be processed, the fees for those activities are a source of income for the credit card lender.

Knowing how credit cards work means understanding the balance between benefits and costs and making decisions as to when the cost/benefit ratio suits your needs and lifestyle.