How do credit cards work?

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• When you use a credit card to make a purchase, several things happen behind the scenes.
• Your payment is sent to the credit card network (such as Visa or Mastercard) and to your bank for authorization. From there, your bank will send money to the payment network, and the payment network will take a small cut before sending the money to the retailer.
• Credit card issuers earn money by charging exchange fees to merchants who accept credit card payments. They also earn money through surcharges and interest charges.
• Many credit cards offer rewards like points or cash back, but the key to getting value from these cards is just to collect what you can pay each month.
• See Business Insider’s list of the best rewards credit cards »

In the last 50 or so years that they’ve been around, credit cards have morphed from a niche form of payment to something completely ubiquitous.

While most people are quite familiar with how to pay with a credit card, the behind-the-scenes details of how credit cards work are not public knowledge.

How do credit cards work?

From the consumer’s perspective, using a credit card is very simple; He slides it (or touches it) to any merchant who accepts it, and then leaves with his merchandise. Your credit card company pays the merchant, and you pay the credit card company when the charge appears on your statement.

Because the credit card company presents the money solely with its promise to return it, you want to get an idea of ​​how likely you are to pay your obligations. Most credit card companies use your credit score to determine this probability and decide whether or not to approve it for a new account. That is one reason why having a good credit score is important to your financial health. Your credit score can also determine the interest rates assigned to you for any new type of loan.

How credit card payments are processed

Let’s say you use your Chase Visa card to make a purchase of $ 100 from a retailer. When you swipe your credit card, the retailer sends your card information to the credit card network (Visa) and to your card issuer (Chase) for authorization. If you have enough available credit, Chase will hold your account for $ 100 and inform the retailer that your purchase is authorized.

Then every night, the retailer’s bank will send all of the day’s transactions to Visa and the other payment networks for processing. Chase will send Visa $ 100 less a small fee, and Visa will also collect your fee and send the rest to the retailer.

The various fees charged by credit card companies and processors are called exchange fees. Credit card exchange fees generally consist of a small fixed amount and a percentage of the total sale (for example, $ 0.20 + 2.1% of the sale). The fees to process debit cards are generally much lower (generally less than 0.5% of the sale)

Why do banks offer credit card rewards?

Banks make money from exchange fees every time you use one of your credit cards to make a purchase. Therefore, banks have a vested interest in encouraging consumers to obtain one of their credit cards and, more importantly, to use their credit cards.

One of the ways that banks encourage credit card use is through credit card rewards. By offering a sign-up bonus to new cardholders along with rewards for every purchase they make, banks hope to keep their card on top of their wallet.

Other ways credit card companies make money

In addition to the exchange fees banks get for every purchase, there are a few other ways that credit card companies make money.

Many rewards credit cards have annual fees, and these annual fees help offset the cost of the rewards they grant. In addition, many credit card companies earn money on late fees and interest charged to people who do not pay their bills in full and on time.

The best way to use credit cards.

Finding the best rewards credit card for you is a matter of matching your spending habits to the benefits and points, miles or cash back offered by different cards. There are many different types of credit cards, and you can probably find one that fits your spending patterns and gives you the rewards you want /

You should only use credit cards if you can do so without interest or late fees. To that end, there are a few things you will want to remember:

Pay your bill in full each month: Again, the interest rates charged by credit card companies are quite high.

Avoid cash advances: While most credit cards can work to get cash from an ATM, you will generally be charged excessive fees for doing so.

Always pay on time: If you can’t pay the full balance on your statement, you should at least make sure you pay at least the minimum amount by your due date. Otherwise, you are likely to be charged a late fee that can be $ 29 to $ 39 or more.

Make sure you need that card with an annual fee: There are many cards with annual rewards that more than offset your fee, but if you really want to minimize your out-of-pocket costs, go for a rewards card with no annual fee.

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