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How do Credit Cards Work?

By: Edward Mellett - Updated: 11 Sep 2012 | comments*Discuss
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Purchasing on Plastic

When purchases are made on plastic, the credit card user is making a contractual agreement to pay the card issuer at some point in the future. The cardholder confirms their consent to pay, by signing a receipt with a record of the card details indicating the amount to be paid or by entering a personal identification number (PIN). For purchases where the card cannot be present, merchants may accept verbal authorisations, known as card not present (CNP) transactions.

In just a few seconds, electronic verification systems allow merchants to verify that the card is valid and that the credit card customer has sufficient credit to cover the purchase. This facility allows the verification to happen immediately, at the time of purchase. The verification is performed using a credit card payment terminal or Point of Sale (POS) system with a communications link to the merchant's acquiring bank. Data from the card is obtained from a magnetic stripe or chip on the card; commonly known as Chip and PIN in the UK.

Other variations of verification systems are used by eCommerce merchants to determine if the user's account is valid and able to accept the charge. These will typically involve the cardholder providing additional information, such as the security code printed on the back of the card, or the address of the cardholder.

Monthly Statements

Each month credit card users are sent a statement detailing the purchases that have been made with the customer's card, any outstanding fees, and the total amount owed. After receiving the statement, the cardholder has an opportunity to dispute any charges considered incorrect, or otherwise pay a defined minimum proportion of the bill by a due date. A higher amount, up to the entire amount owed, can also be paid. The credit provider charges interest on the amount owed (typically at a much higher rate than most other forms of debt) generating huge revenues for credit card companies. Some financial institutions can arrange for automatic payments to be deducted from the user's bank accounts by direct debit, thus offering a facility to avoid late payments altogether (and associated charges to customers).

Credit card issuers usually waive interest charges if the balance is paid in full each month, but will typically charge full interest on the entire outstanding balance from the date of each purchase if the total balance is not paid.

Calculating Interest

The general calculation formula most financial institutions use to determine the amount of interest to be charged is APR/100 x ADB/365 x number of days revolved. Take the annual percentage rate (APR) and divide by 100 then multiply to the amount of the average daily balance (ADB) divided by 365 and then take this total and multiply by the total number of days the amount revolved before payment was made on the account. Financial institutions refer to interest charged back to the original time of the transaction and up to the time a payment was made, if not in full, as RRFC or residual retail finance charge. Thus after an amount has revolved and a payment has been made that the user of the card will still receive interest charges on their statement after paying the next statement in full.

A customer's credit card may simply serve as a form of revolving credit, but has the potential to become much more complicated, with multiple balance segments each at a different interest rate, possibly with a single umbrella credit limit, or with separate credit limits applicable to the various balance segments. Usually this compartmentalisation is the result of special incentive offers from the issuing bank, either to encourage balance transfers from cards of other issuers, or to encourage more spending on the part of the customer.

In the event that several interest rates apply to various balance segments, payment allocation is generally at the discretion of the issuing bank, and payments will therefore usually be allocated towards the lowest rate balances until paid in full before any money is paid towards higher rate balances. Interest rates can vary considerably from card to card, and the interest rate on a particular card may jump dramatically if the card user is late with a payment on that card or any other credit instrument, or even if the issuing bank decides to raise its revenue. As the rates and terms vary, services have been set up allowing users to calculate savings available by switching cards, which can be considerable if there is a large outstanding balance.

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