how does credit card work
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A credit card system is a type of retail transaction settlement and credit system, named after the small plastic card issued to users of the system. A credit card is different from a debit card in that the credit card issuer lends the consumer money rather than having the money removed from an account. It is also different from a charge card (though this name is often used to describe credit cards by the public) in that charge cards do not extend the user credit -- the charges must be paid each month in full. In contrast, a credit card allows the consumer to 'revolve' their balance, at the cost of having interest charged. Most credit cards are the same shape and size, as specified by the ISO 7810 standard.
How they work
A user is issued a credit card after an account has been approved by the credit provider (often a general bank, but sometimes a captive bank created to issue a particular brand of credit card, such as American Express Centurion Bank), with which they will be able to make purchases from merchants accepting that credit card up to a preestablished credit limit.
When a purchase is made, the credit card user agrees to pay the card issuer. Originally the user would indicate his/her consent to pay, by signing a receipt with a record of the card details and indicating the amount to be paid, but many merchants now accept verbal authorizations via telephone and electronic authorization using the internet.
Electronic verification systems allow merchants (using a strip of magnetized material on the card holding information in a similar manner to magnetic tape or a floppy disk) to verify that the card is valid and the credit card customer has sufficient credit to cover the purchase in a few seconds, allowing the verification to happen at time of purchase. 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.
Each month, the credit card user is sent a statement indicating the purchases undertaken with the card, and the total amount owed. The cardholder must then pay a minimum proportion of the bill by a due date, and may choose to pay more or indeed pay the entire amount owed. The credit provider charges interest on the amount owed (typically at a much higher rate than most other forms of debt).
Credit card issuers usually waive interest charges if the balance is paid in full each month, but typically will charge full interest on the entire outstanding balance from the date of each purchase if the total balance is not paid.
For example, if a user had a $1,000. outstanding balance for purchases and pays the entire $1,000. there would be no interest charged. If, however, even $1.00 of the total balance remained unpaid, interest would be charged on the full $1,000 from the date of purchase until the payment is received. The precise manner in which interest is charged is usually detailed in a cardholder agreement which may be summarized on the back of the monthly statement. (See The TD Gold Travel Visa Cardholder Agreement Retrieved January 3, 2006)
The credit card may serve as a form of revolving credit, or the user may choose to apply any payments toward recent rather than previous debt. 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. 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 (see external links for some on-line services).
Because profit margins in the credit card industry can be quite high, credit providers often offer incentives such as frequent flier miles, gift certificates, or cash back (typically 1 percent) to try attract customers to their program.
Low interest credit cards or even 0% interest credit cards are available. The only downside to consumers is that the period of low interest credit cards is limited to a fixed term, usually between 6 and 12 months. However, services are available which alert credit card holders when their low interest period is due to expire. Most such services charge a monthly or annual fee.
The Merchant's side
From the merchant's view point, the transaction, if it is made using a bank credit card, is often much more secure than receiving payment with a check or carrying an unpaid balance because the issuing bank commits to pay the merchant the moment the trasaction is verified. The bank charges a commission to the merchant for this service and there may be a certain delay before the agreed payment is received by the merchant. In addition, a merchant may be penalized or have their ability to receive payment using that credit card restricted if there are too many cancellations or reversals of charges.
Secured credit cards
A secured credit card is a type of credit card secured by a deposit account owned by the cardholder. Typically, the cardholder must deposit between 100% and 200% of the total amount of credit desired. Thus if the cardholder puts down $1000, he or she will be given credit in the range of $500-$1000. This deposit is held in a special savings account.
The cardholder of a secured credit card is still expected to make regular payments, as he or she would with a regular credit card, but should he or she default on a payment, the card issuer has the option of recovering the cost of the purchases paid to the merchants out of the deposit.
Often, though, if the cardholder does not make the required payment, many issuers of secured credit cards consider that the account must be paid before the security is released instead of using the security to pay the balance due. The card is not cancelled, the balance is not set off the deposit, and interest continues to accumulateon the unpaid balance for considerable periods of time. In some cases the total charges may far exceed the original deposit and the cardholder not only loses their deposit but is left with an additional debt.
Most of these conditions are usually described in a cardholder agreement which the cardholder signs when their account is opened.
Secured credit cards are an option to allow a person with a poor credit history or no credit history to have a credit card which might not otherwise be available. They are often offered as a means of rebuilding one's credit. Secured credit cards are available with both Visa and MasterCard logos on them. Fees and service charges for secured credit cards often exceed those charged for ordinary non-secured credit cards.
Features
As well as convenient, accessible credit, the cards offer consumers an easy way to track expenses, which is necessary both for monitoring personal expenditures and the tracking of work-related expenses for taxation and reimbursement purposes. They have now spread worldwide, and are offered in a huge variety of permutations with differing credit limits, repayment arrangements (some cards offer interest-free periods, while others do not but compensate with much lower interest rates), and other perks (such as rewards schemes in which points "earned" for purchasing goods with the card can be reclaimed for further goods and services).
Some countries such as the United States limit the amount that a consumer can be held liable for due to fraudulent transactions as a result of a consumer's credit card being lost or stolen.
Security
The low security of the credit card system presents countless opportunities for fraud. This opportunity has created a huge black market in stolen credit card numbers, which are generally used quickly before the cards are reported stolen.
The goal of the credit card companies, as they say, is not to eliminate fraud, but to "reduce it to manageable levels", such that the total cost of both fraud and fraud prevention is minimized. This implies that high-cost low-return fraud prevention measures will not be used if their cost exceeds the potential gains from fraud reduction.
Most Internet fraud is done through the use of stolen credit card information which is obtained in many ways, the simplest being copying information from retailers, either online or offline. There have been many cases of hackers obtaining huge quantities of credit card information from company databases. Not unusual are cases of employees of companies that deal with millions of customers in which they were selling the credit card information to criminals.
Despite efforts to improve security for remote purchases using credit cards, systems with security holes are usually the result of poor implementations of card acquisition by merchants. For example, a website that uses SSL to encrypt card numbers from a client may simply email the number from the webserver to someone who manually processes the card details at a card terminal. Naturally, anywhere card details become human-readable before being processed at the acquiring bank is a security risk. However, many banks offer systems such as ClearCommerce, where encrypted card details captured on a merchant's webserver can be sent directly to the payment processor.
The Federal Bureau of Investigation is the agency responsible for prosecuting criminals who engage in credit card fraud in the United States, but they do not have the resources to pursue all criminals. In general, they only prosecute in cases exceeding $5,000 in value. Even though the FBI usually does not investigate, most common credit card networks have not implemented procedures to prevent credit card fraud. Three improvements to card security have been introduced to the more common credit card networks but none has proven to help reduce credit card fraud so far. First, the on-line verification system used by merchants is being enhanced to require a 4 digit Personal Identification Number (PIN) known only to the card holder. Second, the cards themselves are being replaced with similar-looking tamper-resistant smart cards which are intended to make forgery more difficult. The majority of smartcard (IC card) based credit cards comply with the EMV (Europay MasterCard Visa) standard. Third, an additional 3 or 4 digit code is now present on the back of most cards, for use in "card not present" transactions. See CVV2 for more information.
Profits and losses
Credit card issuers (banks) cover their costs (including the interest costs for the money that is paid to merchants prior to the bank being paid by customers), and earn profits, by:
- Interchange fees. Interchange fees are charged by the merchant's acquirer to a card-accepting merchant as component of the so-called merchant discount fee. The merchant pays a merchant discount fee that is typically 2 to 3 percent (this is negotiated), which is why some merchants prefer cash, debit cards, or even checks. The majority of this fee, called the interchange fee, goes to the issuing bank, but parts of it go to the processing network, the card brand (Visa, MasterCard, etc.), and the merchant's acquirer. The interchange fee that applies to a particular merchant is a function of many variables including the type of merchant, the merchant's average ticket dollar amount, whether the cards are physically present, if the card's magnetic stripe is read or if the transaction is hand-keyed, the specific type of card, when the transaction is settled, the authorized and settled transaction amounts, etc. For a typical credit card issuer, interchange fee revenues may represent about fifteen percent of total revenues.
- Charging interest on outstanding balances. Customers who do not pay in full the amount owed on their monthly statement (the "balance") by the due date (that is, at the end of the "grace period") owe interest ("finance charges"). These customers are known in the industry as "revolvers". Those who pay in full (pay the entire balance) do not. These customers are known in the industry as "transactors" or "deadbeats". Interest charges vary widely from card issuer to card issuer. Often, there are "teaser" rates in effect for initial periods of time (as low as zero percent for, say, six months), whereas rates for those with poor credit can be as much as 29.74 percent (annualized). In the U.S. rules governing interest rates are set at the state level; some banks have chosen to establish their credit card operations in states such as South Dakota that have less restrictive limits on interest rates.
- Fees charged to customers. The major fees are for (1) payments received late (past the "grace period"); (2) charges that result in exceeding the credit limit on the card (whether done deliberately or by mistake); (3) cash advances and convenience checks (often 3 percent of the amount); (4) transactions in a foreign currency (as much as 3 percent of the amount; a few financial institutions charge no fee for this); and (5) an annual payment.
Credit card companies generally do provide a guarantee the merchant will be paid on legitimate transactions regardless of whether the consumer pays their credit card bill. However, credit card companies generally will not pay a merchant if the consumer challenges the legitimacy of the transaction and will fine merchants who have a large number of chargebacks.
In recent times, credit card portfolios have been exceedingly profitable to banks, largely due to the booming economy of the late nineties. However in the case of credit cards, such high returns go hand in hand with risk, since the business is essentially one of making unsecured (uncollateralized) loans, and thus dependent on borrowers to not default in large numbers.
In some areas, such as Ireland, governments profit from credit cards through the imposition of a stamp duty or credit card tax. This is usually done where a cheque tax previously existed. This tax is taken automatically from the account, just like a purchase, by the bank on behalf of the government annually. This tax - unlike its cheque counterpart - is payable in arrears so no refund is possible.
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