A credit card is a type of unsecured borrowing under which a bank or NBFC agrees to offer you a predefined credit limit. You can make transactions up to the said limit and pay it back on the due date or convert the transaction into EMI and pay over a period of a few months. Unlike personal loans or car loans which are installment loans accounts, credit cards have a revolving credit account. This means you can borrow money on the same account again and again as you keep paying the dues.
How does a Credit Card Work?
As said above, a credit card lets you borrow money (up to the given credit limit) and pay it back as and when due. When you make a purchase, the amount will be deducted from your credit limit and when you pay it back, the payment will be added back to your credit limit. This gives regular access to credit as long as you do not max out your limit.
Let us understand this with an example.
|You have an HDFC Credit Card with a total credit limit of Rs. 1 Lakh. You purchase a TV for Rs. 30,000 and convert it into EMIs of 6 months and you also spend Rs. 5,000 on miscellaneous expenses. After these two transactions, your credit limit will be Rs. 65,000. Now, once your bill is generated for the cycle, it will include the EMI of Rs. 5,000 and other Rs. 5,000 spent (apart from other fees and charges). Once you pay Rs. 10,000 towards the bill, the same amount will be added to your credit limit and you will now have an available limit of Rs. 75,000. This cycle continues as you make purchases and pay bills.|
However, if you do not pay your credit card bills in full, the bank will charge interest or finance charges on the unpaid amount. This amount will keep accruing until you pay your bills completely.
Common terms related to Credit Card
Below we have listed some of the terminologies that will help you understand how credit cards work-
|Things related to the usage of a Credit Card|
|Interest||If the credit card bill is not paid in full, the outstanding balance will start attracting interest (also known as finance charge or APR), compounded daily. Credit card is among the costliest forms of borrowing if not used wisely|
|Credit Limit||Every Credit Card has an upper limit beyond which you cannot spend. If you try to use the card after you have reached the upper limit, the transaction may be rejected by the credit card issuer|
|Billing Cycle||Credit cards have a one month billing cycle which ranges from one statement date to another. All the debits and credits during that period will be included in the credit card statement|
|Minimum Payment||If you are not able to pay the total amount due, the bank gives you the option to pay a minimum amount which usually consists of the EMIs due for the period and other additional charges and a percentage of the new purchases|
|Balance||Balance is the sum you have spent using your credit card, but haven’t paid back yet.|
|Credit Utilisation Ratio||It is the ratio of your credit card balances to the available credit limit. A higher credit limit translates to a low credit score. You should ideally keep this ratio below 30%|
|Interest-Free Period||This is the time period during which you do not have to pay any interest on the purchases. Free credit period of 20-50 days is offered by all card issuers|
How Credit Cards Transactions Work?
Now that you understand the basic functioning of a credit card, you should also know what happens when you swipe a card at a POS machine. For this, you first need to know about the parties involved in the process.
1. Merchant- The merchant or shopkeeper is the one from whose place the purchase is made
2. Acquirer Bank- The merchant’s bank is the acquirer bank
3. Network- This network helps in facilitating the transaction. The common ones are Visa or Mastercard
4. Issuer Bank- It is the bank that will provide you with the credit card
Let’s look at what happens when you swipe the card at the retail store. We have divided the whole process into 4 important parts-
|The shopkeeper will swipe your card or insert it into a POS machine. You will be asked to enter a PIN. The network will check whether there is sufficient balance in your account and if yes, the transaction will be authorised||All the receipts collected by the merchant in the day are sent to the acquirer bank for receiving the payment||The acquirer bank via the network sends a request to the respective issuer bank. The issuer bank upon deducting the interchange fees pays the balance amount to the acquirer bank.||After receiving the payment the acquirer bank will deduct the merchant fees and pay to the merchant.|
How does a Credit Card Work Online?
When you are using your credit card to purchase something online, the e-commerce merchant will ask for the following information-
- The credit card number
- Expiry date and CVV
- Your name
- Billing information
When you click on the ‘Pay’ option, the information is sent to your bank via a payment gateway. The banks will send an OTP to your registered mobile number or email id for authentication. On providing the correct OTP, the transaction will be completed.
Frequently Asked Questions (FAQs)
How do payments on a credit card work?
A credit card lets you spend money on credit – it’s like having a loan for the amount you spend using the card. If you pay off the bill in full each month, you won’t pay interest on what you’ve borrowed.
How is interest charged on a credit card?
Credit cards charge interest when you don’t pay off your full balance by the due date each month. When you carry, or revolve, a credit card balance from month to month, interest is charged on a daily basis, and it affects both your existing balance and any new purchases that post to your account.
What happens if I don’t use my credit card?
If you don’t use your card, you won’t earn any interest. Non-use also means credit card companies can’t charge merchant processing fees when you use your card.
What is 24% APR on a credit card?
If you have a credit card with a 24% APR, that’s the rate you’re charged over 12 months, which comes out to 2% per month. Since months vary in length, credit cards break down APR even further into a daily periodic rate (DPR). It’s the APR divided by 365, which would be 0.065% per day for a card with 24% APR.
How do credit cards work technically?
A cardholder begins a credit card transaction by presenting his or her card to a merchant as payment for goods or services. The acquiring bank (or its processor) captures the transaction information and routes it through the appropriate card network to the cardholder’s issuing bank for approval.
How many times a month can I pay my credit card?
The number of payments you make each month doesn’t matter as long as you make at least the one minimum payment. However, one point to keep in mind if you pay your card often is that multiple payments don’t carry forward.