What is a credit card? How do credit cards work?

Did you know that one of the very first references to credit cards came from the 1887 novel “Looking Backward” by Edward Bellamy? He mentions the phrase 11 times and although he doesn’t refer to the cards we have today, but something more similar to debit cards. 

Today, there are billions of credit cards used all around the world. But how much do you really know about that rectangular piece of plastic in your wallet? In this blog post, we take a closer look at what is a credit card and what are the ins and outs of it to make their world more understandable. 

What is a credit card?

A credit card is a card used to pay for products and services. In simple terms, it’s a plastic card that conforms to global ISO standards and has the following characteristics on its front side: 

• EMV chip
• The cardholder’s name and account number
• Card expiration date
• Issuer logo
• Card scheme logo

Meanwhile, these features appear on the back of the credit card: 

• Magnetic strip
• Customer service number
• Signature box
• CVV number

How does it work?

While these are the physical characteristics of a credit card, you might also wonder how does a credit card work? Now it gets interesting because a bank, financial institution, or building society issues a credit card and it extends a line of credit to you which you can use at various merchants to make purchases.

This line of credit needs to be paid back in installments over time with, in most cases, some type of interest rate. You can also do a cash advance which is withdrawing funds from your credit card, but be aware that the charges for this can be quite high. 

Next, let’s take a closer look at what types of credit cards you can get.

Types of credit cards

Balance Transfer

This type of credit card has an introductory interest rate and, most times, it offers “a lower fee on balance credit card transfers.”

Rewards

These types of credit cards offer you credits for goods or services. These can range anything from airline travel, hotel stays, and even cashback. The rewards you receive will depend on how much you spend with the corollary that the more you spend, the higher the rewards you earn.

Premium

Although these types of cards usually come with a higher annual fee, they offer perks that don’t really come with regular credit cards. With such cards, you could enjoy special events, concierge services, access to airport lounges, additional insurance coverage, and even retail.

Retail

A large retailer or store usually issues this type of card. It is usually specifically limited to making purchases at that retailer and it often gives the cardholder a discount on the first purchase.

Secured

Secured cards are usually issued in the US and are mainly used by people with lower credit scores. In order to use your card, you need to prove that you have the funds first. This means that you’ll need to put down a cash deposit before you can use this type of card at retailers or stores.

Credit builder

Ideal for individuals with a low credit score. This type of card helps them build a stronger credit rating, as it helps them use the credit allocated responsibly. Typically, these cards have borrowing limits that are lower than usual and charge interest rates that are higher than most, acting as an incentive in a way of responsible borrowing.

Overseas / Travel

Perfect for overseas travel because they rarely incur overseas fees. They are great for managing your holiday expenses as well as avoiding reliance on cash when you’re abroad.  

Advantages and disadvantages

There are many benefits of credit cards and some drawbacks. So, if you’re thinking of applying for a card, keep the following in mind:

Advantages of credit cards

Below, you’ll find some of the primary advantages of using a credit card:

Make emergency buys

Accidents happen all the time and more often than not, they’re unexpected. If you don’t have a large savings fund, credit cards can be really useful if your car breaks down and you need an emergency fix or another type of emergency crops up that you have to deal with.

You can rest assured that your unexpected situation will be addressed while paying the amount off in installments at a later date. 

Spreading the costs around

Some credit cards also offer you deals with zero or small interest rates for the first couple of months. This means that you can buy something expensive when you get your card and pay it off interest-free for the first few months while this offer is still available. However, make sure you pay off the amount during this period, as after that, interest will be charged. 

Debt consolidation

If you have a lot of debt and you’re looking for ways to manage it, a credit card can come in handy.

For example, if you get a credit card that offers lower interest rates than the debt you’re carrying, you can pay off the debts with your credit card and have one lump sum to pay off over a period with lower interest rates.

Payment protection

Some credit cards also offer you protection on your payments if you make a purchase and the merchant you buy from goes under and cannot deliver. However, you need to check that your provider offers this option and the minimum and maximum amounts covered. 

Earn rewards

You can also accumulate rewards or the so-called “loyalty points” when you make purchases, which can add up to more benefits for you as these can include cashback or even discounts at selected retailers.

Strengthen your credit rating

A strong credit score means you’re more likely to be approved for a credit request such as a loan for a home. However, if you don’t yet have a credit history, or you’ve defaulted on loans in the past, this may be a bit more difficult to get.

Therefore, credit builder credit cards come in handy, as they help you use the credit responsibly while you build a responsible reputation for yourself in terms of how you manage your money.

Track your spending

Your bank, financial institution, or building society that issued you with your credit card should send you a credit card statement each month. This statement, as well as the online portal of your issuing institution, will help you keep track of your expenses.

Fraud protection

Typically, credit cards come with more fraud protection when compared to a general debit card account. This means your liability declines if you’re the victim of fraud. 

Convenience

Technology these days is just marvelous! You can now add your credit card to your digital or mobile wallet and spend that way instead of having to carry and pay with cash. All you need for this is your smartphone!

Zero to low interest

Do your homework right and you may even find a credit card that offers you zero percent interest on purchases or balance transfers for periods between 12 and 18 months.

Disadvantages

There are also downsides to using credit cards, however, and you should weigh up the advantages and disadvantages and the overall credit card cost to you.

The inevitable fees

Yes, there are fees with credit cards. These credit card fees can range from annual, balance transfer, foreign transaction fees, late payment fees, and fees for when you reach above your credit limit. 

There are interest rates, too

Credit card companies charge interest rates on using their services, and these are considered “some of the highest interest rate debts consumers can access.”

You can run up debt

Because money isn’t automatically deducted from your bank account, you run into the situation of spending more than you have. This can increase your overall debt and it’s a growing concern in many countries around the world. 

Bankruptcy

Credit card providers often offer attractive interest rates in the first few months. However, these rates jump up rather steeply after this period, which can cause many people who do not budget effectively to be driven to bankruptcy. 

Spending more than you have

According to researchers, the use of credit cards leads to a sort of “abstract” pain of payment, causing people to spend more than they have. 

Merchants who pass the buck onto consumers

Every merchant that signs up to offer card acceptance services essentially pays a transaction rate to their card acceptance services provider.

However, to make up for this transaction rate, some merchants can hike up their costs, passing them down to consumers. This can ultimately lead to inflated pricing for consumers.

How do credit card payments work

Now that we’ve covered the pros and cons of credit cards, let’s look at how credit card payments work as well as how does credit card interest works.

In brief, say you make a payment for 200 GBP this month and this amount appears on your statement. Even if you’ve paid almost all of this amount on your credit card, your credit card provider will still charge you interest on the full amount rather than on the balance of the 150 GBP which you already paid towards your credit card.

In addition, there are fees for cash advances you need to be aware of, and the interest on these can be even higher than those mentioned above, going into double digits. You are also likely to encounter ATM withdrawal fees, which can cost you somewhere around 3 GBP or even more. 

So, you need to always make your minimum monthly repayments on time. Try to cover your credit card debt as quickly as possible as well as avoid withdrawing cash from your card. 

How to get a credit card

If you’ve decided that getting a credit card is the right step for you, you need to apply for one at your local bank, building society, or financial institution.

In most cases, your credit score will be a determining factor for whether your credit card is approved or not. Your credit score refers to your ability to make timely, consistent, and accurate repayments on your loans.

Other factors you should consider when you apply for a credit card are whether you have existing debt and whether you can manage this; whether you have existing open accounts with outstanding balances that you might close; the accuracy of information provided on your application form; as well as your previous credit history and whether you’re considered a responsible borrower.

How do credit cards differ from debit cards

Debit and credit cards look practically indistinguishable, but there are some major operational contrasts between them. For example, you can use both types of cards for cash withdrawals or traditional and online payments.

However, credit cards come with interest fees because your bank lends you a certain sum, which you must pay later. On the other hand, a debit card gives you the chance to pay or withdraw using the financial reserves that you really have.

Conclusion

Having a credit card can be a lifesaver most times as you can pay for unexpected events without having to worry about where the money will come from.

However, there are some drawbacks such as high-interest rates and fees and this is why it’s wise to consider both sides of the equation before you start filling out your application form. 

Disclaimer: Please be aware that the contents of this article and the myPOS Blog, in general, should not be interpreted as legal, monetary, tax, or any other kind of professional advice. You should always seek to consult with a professional before taking action, since the particulars of your situation may materially differ from other cases.