How Do Credit Cards Work?

The Difference Between Credit and Debit Cards

Why use a credit card instead of a debit card? Although a credit card may physically look and feel like the debit card tied to your bank account, it functions more like a short-term loan. Credit cards can be used for all kinds of purposes: making purchases, paying bills, withdrawing cash, and more — all up to a certain limit imposed by the credit card provider. With a credit card, you don’t actually need immediate access to the funds you’re spending, because they aren’t immediately deducted from any sort of account. Instead, it is the user’s responsibility to make timely payments — often from their personal bank account — to pay off the balance that they’ve charged to their credit card. Some of the differences between credit and debit cards may be relatively obvious, but the actual inner workings of credit cards are far more complex.

How Do Credit Cards Work In Practice?

So if using a credit card is akin to receiving a small short-term loan, who is the issuer of the loan? Credit card companies are the ones responsible for issuing credit cards to individuals. Typically, these companies are banks and credit unions. When you apply for and subsequently receive a credit card, it’s the credit card company itself that’s responsible for servicing your account, billing you for your purchases, accepting your payments, distributing your rewards (like points, miles, or cash back), and performing other administrative tasks.

Credit card networks, however, are distinct from the credit card companies themselves. They provide the infrastructure atop which the credit card industry functions. The four main credit card networks are Visa, American Express, Discover, and Mastercard, and these networks are responsible for establishing where credit cards can be used as well as for facilitating payment processing at the place where you make a purchase — known as the point of sale (POS).

Credit card networks process transactions between merchants (i.e., sellers) and credit card issuers (e.g., Chase or Wells Fargo). However, it is possible for one entity to be both a payment network and a credit card issuer — such as Discover or American Express. Both are payment networks that issue their own credit cards.

Why Is a Credit Card Useful?

Simply put, credit cards exist for a few reasons:

• They can make spending convenient for individuals.

• They can make money for the companies that issue them.

• They can make money for the payment networks.

• They can facilitate extra spending with merchants, theoretically offsetting the fees they pay.

First, individuals tend to use credit cards because in many cases they’re a convenient, flexible payment method. They may help when an individual does not have an adequate cash flow to service their needs at a particular moment. Even for individuals who have no problem making purchases up front, credit cards may offer attractive rewards or benefits to incentivize their usage.

Second, credit card issuers are able to collect account fees — such as annual charges — and interest charges from their users. Users who fall behind on payments or don’t meet minimum payment thresholds will also likely be subject to additional fees and charges. When applying for a credit card, the issuing company’s team of underwriters must evaluate an individual’s credit history as well as the potential risk vs. possible profit they pose to the company when determining their eligibility for a line of credit.

Card issuers also receive something known as the “interchange fee” as reimbursement for being responsible for the debt an individual takes on as a credit card user. Payment networks collect the interchange fee, which is paid to the card issuer’s bank by the merchant’s bank. The interchange fee is typically represented by a percentage of the transaction plus a fixed amount (ex. 1.5% + $0.10). The payment processor is responsible for collecting these interchange fees from the merchant and delivering them to the issuer.

Third, payment networks make money by monetizing the use of their networks and serving as the intermediaries between issuers and merchants. For use of their networks and services, payment networks charge a “network fee” (which is typically around 0.05% on every transaction they process, amounting to billions of U.S. dollars annually). In financial industry jargon, 0.05% is equivalent to 5 “basis points,” with one basis point being equal to 0.01% or 1/100th of a percent. This is useful to know, as basis points have become helpful shorthand for industries that regularly deal with fractions of percentage points. Notably, these network fees are paid by the merchant, not the individual using the credit card.

Lastly: What’s in it for the merchant? Why would they swallow the cost of paying payment processing fees? In theory, many do so in the hope that the money they make by accepting credit card purchases offsets the amount they pay in fees in the long run. Ultimately, this relates back to the first point: Credit card usage is highly convenient for individuals, and nearly ubiquitous across society. Imagine you want to purchase an item, and one merchant accepts credit card payments while another does not. If you’re trying to stack up your rewards or you’re low on cash at the time you need to make the purchase, the merchant who doesn’t accept credit cards may lose your business.

Using a Credit Card

Now that we’ve laid out the system of aligned incentives that support the credit card industry, it’s time to explore what actually happens when you use one. Let’s say you’re checking out at the grocery store, and you swipe your credit card to make the purchase. When you pay for an item at the point of sale, a process begins to unfold. First, your card details are shared with the merchant’s bank. Then the merchant’s bank gets permission from the payment processor to actually process the transaction. Then, your card issuer is responsible for verifying your information and approving or declining your purchase based on how much available credit you have.

If the transaction is approved, the merchant receives payment from the issuing bank. They foot the bill up front, and users are expected to pay off their debts with the credit card company when they receive their billing statement, which is usually delivered monthly. More accurately, however, it is actually the merchant’s bank — known as the “acquiring bank,” or “acquirer” — that is responsible for settling credit card transactions for merchants directly into their accounts. That’s because credit card transactions entail the transferring of funds from the issuing bank (of the cardholder) to the acquiring bank (of the merchant). In the United States, it is standard for the merchant’s bank to receive payment from the issuing bank via the automated clearing house (ACH) system within one to three business days.

Branded and Co-Branded Credit Cards

You may have, for example, a credit card issued by Chase that operates on the Visa payment network. This is because payment processors like Visa license their brands to issuers.

There is another type of credit card that has also become increasingly popular: co-branded credit cards. These credit cards are the result of partnerships between credit card issuers and individual businesses. These branded credit cards will likely not only display the information of the issuer and the network, but an additional logo that relates to a particular store or business. For example, these might be Delta Airlines co-branded credit cards issued by American Express on the latter’s own payment network, or Best Buy co-branded credit cards issued by Citi on the Visa payment network. Some co-branded credit cards known as “store cards” may only be eligible for use in the retail or online stores of the partner, but others can be used anywhere that accepts credit cards.

From Starbucks to Apple to Uber, many businesses offer co-branded credit cards. But how do co-branded credit cards work? Co-branded credit cards rely on an agreement between an issuing bank and a business to offer rewards specific to the brand of that business. In the case of airline miles, for example, the issuing bank will often pay a premium (in some cases totalling billions of U.S. dollars) to purchase the rewards or miles in bulk from the airline directly, and then issue the rewards to credit card holders as they “earn” them via spending. Payment processors that make such moves are often hoping they recoup their investment on the interchange fees they’ll collect from individuals spending on branded credit cards trying to rack up miles.

The agreements between issuers and the businesses involved with co-branded credit cards can vary widely. For example, it’s not uncommon for the business to be made exempt from paying interchange fees on the payment network their co-branded credit card is hosted on.

The four major credit card payment processing networks are generally accepted by most retailers, although their availability and acceptance varies by geographic region. For example, Visa is accepted in over 200 countries and territories, but American Express is accepted in only 160. Individual merchants sometimes have exclusive contracts with payment networks to only accept specific credit card brands. With these considerations in mind, it’s not uncommon for individuals to own multiple credit cards from different issuers and networks in an effort to bypass usability constraints.

Crypto Credit Cards

With the remarkable rise of cryptocurrency and digital assets, more and more credit cards are hitting the market that incorporate rewards paid out in cryptocurrencies. The majority of these crypto rewards credit cards offer payouts in bitcoin (BTC) or other widely exchangeable digital assets. What’s notable about crypto rewards is that the crypto assets earned have the potential to appreciate in value, which is a feature not generally offered by airline miles or rewards points programs. Another growing sector in the crypto credit card market is cards that allow you to pay for goods and services using cryptocurrencies.