How do credit cards work?

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  • When you use a credit card to make a purchase, several things happen behind the scenes.
  • Your payment is sent both to the credit card network (such as Visa or Mastercard) and to your bank for authorization. From there, your bank will send money to the payment network, and the payment network will take a small reduction before sending the money to the retailer.
  • Credit card issuers make money by charging interchange fees to merchants who accept credit card payments. They also earn money from late fees and interest charges.
  • Many credit cards offer rewards such as points or cash back, but the key to getting value from these cards is to only charge what you can afford to pay each month.
  • Check out the Business Insider list of the best rewards credit cards »

Over the past 50 years or so, credit cards have moved from a niche payment method to something completely ubiquitous.

While most people know very well how to pay with a credit card, the background details of how credit cards work are not widely known to the public.

How do credit cards work?

From the consumer’s point of view, using a credit card is very simple; you drag (or tap) it to any merchant that accepts it, and then you leave with your goods. Your credit card company pays the merchant, and you pay the credit card company when the charges appear on your statement.

Since the credit card company only pays the money on your promise to pay back, they want to get an idea of ​​how likely they are to pay off your bonds. Most credit card companies use your credit score to determine this probability and decide whether or not to approve you for a new account. This is one of the reasons why a good credit score is important for your financial health. Your credit score can also determine the interest rates assigned to you for any new type of loan.

Processing credit card payments

Suppose you use your Visa Chase card to make a purchase of $ 100 from a retailer. When you swipe your credit card, the retailer sends your card information to the credit card network (Visa) and to your card issuer (Chase) for authorization. If you have enough credit available, Chase will block your account for $ 100 and notify the retailer that your purchase is authorized.

Then, every evening, the retailer’s bank will send all of the day’s transactions to Visa and other payment networks for processing. Chase will send Visa $ 100 less a small amount for the fee, and Visa will also take its fee and return the rest to the retailer.

The various fees charged by credit card companies and processors are called interchange fees. Interchange fees on credit cards generally consist of a small fixed amount and a percentage of the total sale (for example, $ 0.20 + 2.1% of the sale). Debit card processing fees are usually much lower (usually less than 0.5% of the sale)

Why do banks offer credit card rewards?

Banks make money from interchange fees every time you use one of their credit cards to make a purchase. Banks therefore have every incentive to encourage consumers to get one of their credit cards and, most importantly, to use their credit cards.

One of the ways that banks encourage the use of credit cards is by rewarding credit cards. By offering a sign-up bonus for new cardholders as well as rewards for each purchase you make, banks hope to keep their cards at the top of your wallet.

Other Ways for Credit Card Companies

Besides the interchange fees that banks charge for each purchase, there are several other ways for credit card companies to make money.

Many rewards credit cards have annual fees, and these annual fees help to offset the cost of the rewards they give. In addition, many credit card companies make money from late fees and the interest they charge people who don’t pay their bills in full and on time.

The best way to use credit cards

Finding the best credit card for you involves matching your spending habits with the benefits and points, miles, or cash back offered by different cards. There are many types of credit cards, and chances are you can find one that matches your spending habits and gives you the rewards you want /

You should only use credit cards if you are able to do so without interest or late fees. To this end, you need to remember some things:

Pay your bill in full each month: Again, the interest rates charged by the credit card companies are quite high.

Avoid cash advances: While most credit cards can work for getting money from an ATM, you will usually be charged a fairly high fee.

Always pay on time: If you are unable to pay the balance on your statement in full, you want to at least make sure you pay at least the minimum amount by the due date. Otherwise, you will likely be charged late fees ranging from $ 29 to $ 39 or more.

Make sure you need this card with annual fees: There are many cards with annual rewards that more than offset their costs, but if you really want to minimize your costs, choose a rewards card with no annual fees.

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