Plastic money – as they term it, is one of the fastest growing mechanism to carry money with you. You no longer need to stash your wallet with notes to meet any financial obligations created while walking into the shopping mall or while surfing the digital shopping mall (Internet). How easy it has now become to pay ! Isn’t it ?
There are broadly two types of plastic money – Debit Cards & Credit Cards. Debit cards are backed by your bank balance. Credit Cards are backed by your credit worthiness and shall be the topic of this discussion.
How Credit Cards Work
Credit cards literally means cards with “Credit”. You can equate it with a loan being sanctioned to you by a bank which can be withdrawn as and when you want and you have to pay it back on due date. Considering it is a type of loan, only people with good credit history or having the ability to pay back the loan are sanctioned a credit card – just similar to a bank loan. The amount upto which you can extract / spend from your credit card is called a ‘Credit Card Limit’.
A credit card has two sides. The front side has the card holder’s name and a sixteen digit credit card number. It also mentions the expiry date of the credit card. The reverse side of the credit card has a magnetic strip which is used to swipe in a merchant’s Point of Sale unit to pay funds. The reverse side also has a 3 digit CVV (Card Verification Number) which is used for online shopping purposes and verifying a credit card holder over the phone. You must keep these numbers safe and secret. Any one who knows your credit card numbers can make any payment over the internet / phone.
By virtue of carrying a credit card, you don’t need to carry a cheque book to use a credit card. Just like a debit card you swipe the card in any of the merchant’s Point of Sale (POS) device and the payment shall be made to the respective merchant.
On a monthly basis, the credit card company issues a bill to the credit card holder detailing the list of payments made via the credit card and the due date by which the payment needs to be made to the credit card company. If you make the payment before the due date, you are not charged interest (unlike a loan whereby you are charged interest from the date you withdraw the funds from the loan account). However, if you do not make the payment before the due date, you are charged an interest rate which may range between 24-48%…phew….
This is one of the most important and yet the most unknown effect of Credit Card’s usage. As you would be aware by now that a credit card is provided to people with credit worthiness. In other words you would have to prove that you don’t need credit in order to get credit. How would you break this chicken or the egg situation ? The answer lies within the usage history of a credit card. Generally if you have maintained a banking relationship with a Bank, they are likely to provide you a credit card facility with a standard limit. Irrespective of how low this credit limit, you must try to make the most out of this limit. Try to route all your monthly purchases such as mobile bills, grocery, utility payments, fuel costs, etc. through the credit card. Make sure that you pay the credit card bill before the due date. Try doing this for a couple of month / years.
Every month you pay the credit card bill on time, your credit history gets a tick mark. Credit History is a record of your financial transactions maintained by a central agency. In India, this agency is called CIBIL. All financial institutions generally share the financial history of their customers with CIBIL. To know more details about Credit History and how it plays a vital role in your financial well being, please refer to our article Improve your Credit History – Timeline of your Current & Future Financial Image !
This is one of hidden secrets of a credit card. First let me explain what a balance transfer is. For example you have a bill of Rs. 50,000 to pay on a credit card. You have two options – either to pay the bill or transfer the balance to another credit card. Generally credit card companies offers promotional offers to new customers whereby customers can transfer their existing credit card debts / balances to the new credit card at the time of account opening at low / no charges. Combined with this the credit card companies throw in a further no interest period which may range upto 1 year. This means that if you transfer your credit card balance from your existing card to the new card, then you would not have to pay the credit card balance for next 6 months. You would only have to pay monthly a minimum x% of your balance to the credit card company (generally 1-5%). Also, most credit card companies charge balance transfer fee to provide this offer. It can range from a fixed fee to a rate between 3-5%. Hence for example if you transferred Rs. 50K to a new card on a 6 months 0% balance transfer offer, you would have to pay around Rs. 1500 (3% of balance) to the credit card company. This Rs. 1500 is added to your 50K balance, making the total dues to Rs. 51.5K. Every month for the next 6 months, you would have to pay the credit card company minimum payable amount of 2%(assumed rate) which is reduced from your balance outstanding.
After 6 months, you would have to clear the entire balance. The biggest catch lies here. Many times people either forget or they tend to avoid paying the credit card due to lack of liquid funds. Hence after the end of the promotional period, they have to pay hefty interest charges range any where from 20 to 40% to the credit card company…. And you wondered how credit card companies make money !
Generally credit cards offer the flexibility of withdrawing cash from an ATM machine just like a debit / ATM card. You may be wondering that where does that cash come from considering that the credit card is not linked to a bank account. Credit card companies allow users to generally withdraw a specific percentage (75% to 95%) of the credit card’s limit as cash from any ATM. These cash withdrawals are subject to a high interest rate from the date of cash withdrawal – generally 30% p.a. plus rate of interest. While this may be a handy option in case of an emergency, but you must not use it except in case of an emergency. And if you withdraw, make sure that you repay your credit card account at the earliest possible opportunity to prevent being billed with high interest charges.
Most of the credit card companies try to incorporate some or the other kind of reward points structure in their credit card schemes. For example, if you purchase anything for Rs. 10o, you would get 1 reward point in your credit card account. Over a period of time you tend to gather a lot of such reward points which can be used towards buying gift vouchers, holiday discounts, flight tickets, etc. I found an interesting article published by my fellow blogger Mr. Shabbir Bhimani (http://shabbir.in/manage-credit-cards/). Please refer to “The Benefits” section of his article for details on how reward points practically work and show up in credit card statement. However, you must avoid a catch of overspending to get more reward points.
You may have now noticed that a credit card is more than a plastic card. It offers many features and if used carefully, it can become your important companion without which you may not want to leave your home every morning. In metro cities where credit cards are widely accepted by most of the retail shops, you would find that you may not need to withdraw any cash for most / all of your daily expenses.
Watch out for this space for further articles on how to make the best out of your credit card.
9 Replies to “How Credit Cards Work”
[…] How to Make Best out of Credit Cards By Banyan Financial Advisors On March 23, 2012 · Leave a Comment Number of View: 1Credit cards are one of the most powerful financial tools available in the market which touches a person’s daily life. If you are aware of the pros and cons of this tool, you can probably make the best out of your credit cards which may just be used for making day to day purchases. After reading through this article you may start using your card which is lying in your drawer or if you don’t have one, you may even want to apply for one. Before going ahead, you may want to have a read at our article How Credit Cards Work. […]
Credit card companies provide us with a lot of benefits of extended credit and reward points. How does they actually make profit??? Does hefty intt rates on default there only sourse of income, or some of the amount also recovered from the merchant …….
Generally credit card companies have the following sources of Income :
1. They collect 1%-3% of the transaction value from the merchant. American Express are even nastier – they take over 4% charges. I hope this would explain why some vendors in the market either don’t accept credit card payments or would want a minimum X amount of goods to be purchased in order to use credit card.
2. Interest rates – this is their biggest revenue earners. It may sound strange to a careful credit card user that if he can make the payment on time, he would never end up paying interest. However, there is a large % of people out in the market who don’t end up making payments on time.
3. Credit card annual fees;
4. EMI facilities offered by credit cards.
This is a Good informative Article. Many credit card companies try to loot public by the way of interest charges and processing fee.
thanks for the article.
Thanks Mr. Babu. I would not blame it entirely on the Credit Card Companies. The consumers have to be more blamed than them. They are charging interest on an unsecured loan. If the consumers spend irresponsibly and don’t repay their debts on time, the credit card companies are not be blamed. What would be your view point ?
credit card is a very dangerous financial tool,if it is not handed carefully.if one has credit card,he should also have the required discipline to handle it.
You have brilliantly summed the article. It is true with any tool. However if used properly, it is a very useful tool.
Yes I do agree, Credit Cards are very useful, when you use it very diligently.
Yes Mallikarjun. You summed it all brilliantly.