If you’ve ever asked yourself “How do credit cards work?” then today’s post is for you…
Recently, I was standing in line at WalMart, waiting for their POS terminal to process credit card transaction. The checker looked confused and asked me to swipe my card again. I did and still the problem persisted.
Then it happened – the checker turned on the dreaded “blinking light” button calling for a manager to come and help us. I sighed, reached into my wallet and asked if I could just pay by cash instead. The checker flipped off the switch, took my money and I left WalMart (thankfully) with my purchases.
As I left, I thought about all the ways that I take credit cards for granted. They are a modern convenience that I have come to expect to work flawlessly – without interruption or delay. I wondered what happened to cause the delay at WalMart that day and that got me asking “how do credit cards work?”
I realized that I really didn’t understand how credit cards work. I know how credit card companies make money, how interest rates work and how to find the best credit cards.
As I’ve discussed before, I’ve learned from experience how devastating credit card debt can be and how to make good ones work to my advantage. This post isn’t about any of that. Today I want to explore the mechanics of credit cards – a little about their history, who assumes the risk, how they actually work, what’s on the horizon for credit cards, and what place credit cards could or perhaps, should have in your future.
A Little History
The idea of a credit card can be traced back to the 1920s in the United States when it was used to sell gas to new car owners. However, back then a credit card was only good at the store that issued it. It was nearly 1960 when Bank of America Corp. introduced its “BankAmericard” – the precursor of modern credit cards.
That card was the first to be issued by a third-party bank and be accepted by a large number of merchants. In 1966, a group of banks issued the “Master Charge” card to compete with BankAmericard, which would itself evolve into the Visa brand that many of us carry in our wallets today.
How Do Credit Cards Work – An Answer
Swiping a credit card, is so simple, that it’s easy to be ignorant about the complex series of processes that occur between you swiping your credit card and the merchant whose goods you purchased getting paid. Here’s what that process entails:
- You swipe your credit card, giving a merchant your personal data, which gets entered into the merchant’s payment system (POS terminal or e-Commerce website).
- Your data is sent to an acquirer/payment processor who routes your data through the payments system for processing.
- The acquirer/processor sends the data to the payment brand (i.e. Visa, MasterCard, American Express, etc.) who then forwards it to the issuing bank.
- The issuing bank verifies that the card is legitimate, is not lost or stolen, and that the account has the appropriate amount of funds to cover the purchase.
- The issuer generates an authorization number and routes that number back to the card brand, agreeing to pay for the purchase on the cardholder’s behalf.
- The card brand forwards the authorization code back to the acquirer/processor.
- The acquirer/processor sends the authorization code to the merchant.
- The merchant completes the sale, gives you a receipt and lets you walk out of the store with his goods.
So, as you can see, it is complex. It still amazes me that all of these steps happen so fast and most of the time, without a hiccup. Interestingly, if my card is stolen and I haven’t reported it as such yet, and a thief is able to use it to make illicit purchases, I am not on the hook for those purchases. Neither is the card brand or the issuing bank. Credit card debt is unsecured debt and thus has nothing tied to it.
The risk for extending credit to cardholders is borne by the banks that use the brands on the cards they issue. However, merchants assume the liability for theft and fraud. It’s like a game of musical chairs and the merchants are the ones left standing.
Obviously, it’s in issuing banks’ and card brands’ best interest to do all they can to prevent fraud so that merchants will continue to pay for and use the convenience that is then passed on to you and me.
The Future of Credit Cards
When credit cards were introduced to the market, cash and checks were the dominant payment method. Even in the 1990s, credit cards were primarily used for discretionary purchases such as entertainment and travel.
That’s all changing now. In 2010, cash transactions represented only 26 percent of a customer’s in-store purchases, according to a study by Hitachi Consulting and BAI. Credit and debit cards make up 74 percent of all online purchases. It seems likely that both trends will continue into the future.
As mobile wallet and contactless payments grow in popularity and acceptance, I imagine a few more wrinkles will get added to the already complex, yet highly efficient credit system that’s currently in place. It’s interesting to me that even as we move farther away from tangible transactions, we’ve managed to keep the experience simple, at least for us shoppers.
Is There a Place for Credit Cards in Your life?
I’ve mentioned this before but it bears repeating – if you are wise with credit, you can make it work to your advantage. They’re not tools that should be avoided just because many choose to abuse them. Many of the best credit cards out there offer rewards like free cash, gift cards and travel points that you can redeem for airplane tickets, hotel rooms and even cruises. Mr. Frugal Rules has written numerous times about how we use credit card rewards to travel for free.
When someone wants to give us something for free that also makes our life easier, why should we turn them down? If using a card for everyday purchases that I’ve already budgeted for can fund my family vacation, why wouldn’t I make room in my future for them? This is not to say that you have to or should use them in this fashion, but credit cards do provide a justifiable way to stretch your budget…assuming you’re not using it to overextend your lifestyle.
How do you use credit cards to your advantage? Did you know all that goes in to how credit cards work?
Photo courtesy of: ©Depositphotos.com/pressmaster
Free Money Minute says
I use my one credit card as a convenience, for protection and for the rewards. Ultimately, I pay it off each month. It does pay me a little back each month, but I would probably be better off not using it anymore as I tend to spend a little more than a typically would. I would be careful if you are going to play this game with the credit card companies.
I agree. You have to be very disciplined to try to use credit cards solely for their rewards. If you are though, you really can make them work to your advantage.
Jon @ MoneySmartGuides says
It will be interesting to see how credit cards progress in the future. When I was in Europe last year, all of their credit cards have a chip in them for security features. When I would hand them my card without the chip,many would look lost, not knowing what to do. Many times, the cashier had to call for help and was shown how to swipe my credit card. Others refused to accept the card.
It is crazy to think about all of the steps involved in authorizing a charge and how quickly it happens. It boggles my mind when I think about how did someone come up with this idea to get it to work?
Jon – thanks for sharing your experience in Europe. I’ve read about contactless payment and how the big credit card brands and companies that make and process credit cards want to move to swipeless cards like the ones you described. Many think it’s just an inbetween step before we get to cardless payment where we are just using our smartphones (i.e. mobile wallet) to pay for everything we buy. Mr. Frugal Rules says cash will never completely go away but it will be interesting to see what place it holds in another 20 years.
DC @ Young Adult Money says
I’m also amazed at the sheer complexity of the process and how quickly it goes when you are in the store. Seems to happen simultaneously! I think credit cards are one of those things that can be really beneficial for the rewards, if used properly.
I agree DC. I was surprised to find out how complex the process is. I suppose it’s a good thing otherwise I am not sure how they would guard against total and instant fraud.
Chris @ Stumble Forward says
Great post. I’ve never really known how credit cards work and process their transactions the way that they do. What I also find so amazing is how credit cards manage to spot fraudulent activity so fast. Back last year I bought around $4300 in new appliances with my card and shortly after that I received a call from my credit card company to confirm it was a legit transaction. It’s amazing how fast they can determine and figure that stuff out.
Thanks Chris. I agree, it is amazing how quickly cards can spot fraud. I think they know they have to do that to protect the merchants who accept their cards otherwise the whole system will come to a screeching halt. I once saw a map that one of the world’s largest credit card processors had on its wall. This digital map showed trends on a regional level – where instances of fraudulant activity were cropping up. It allowed them to identify regions and spot trends quickly. It also showed them how to help authorities identify and stop crime rings around the world. It was pretty cool.
Matt Becker says
Like other commenters, I had never really thought much about what actually went into a credit card transaction. Really interesting how many middle-men there are. It seems like there’s room for a higher level of efficiency.
We use credit cards for pretty much all of our purchases, both for the rewards, the protection, and largely for the ease of tracking expenses. It’s just so much easier to pull everything into something like mint than to have to keep track of a bunch of cash transactions.
Thanks, Matt. It does seem like there should be room to streamline it some. We’ll see if that ever happens. I recently worked on some direct mail copy for a plastics company and was equally amazed at how many middle men are involved in the process of making a bottle of ketchup. There are about the same number of steps involved in putting a bottle of ketchup on the shelves as there are in processing a credit card transaction!
Credit cards are definitely a gift to the financially wise. They build credit and pay you back a percentage with no downside (assuming you pay your bill each month). I wonder how they’ll evolve in the future!
Awesome little lesson here Mrs. FR!
Thanks, Jacob. I have to admit that I have an irrational fear of using credit cards for their rewards but Mr. Frugal Rules is helping me overcome that and take advantage of the free gifts card companies are willing to give us (heck, they don’t realize I guess that we are self-controlled and have learned the hard way not to spend more than we have with our cards).
Canadian Budget Binder says
Clearly there is a lot of back and forth transmissions to clear credit card usage but for good reason. Thanks for explaining that. cCredit cards for me are a means to gain free stuff through rewards and of course convenience of not having to carry around a load of cash or writing cheques. When my wife and I first started dating her credit card didn’t have the chip and pin where mine did many years ahead of Canada. We now have it here. I find that we rely on our credit cards for everything but mainly the convenience of them. We pay them in full every month which can easily get out of hand if someone is not disciplined to do so.
Yes, I agree Mr. CBB. It can get out of hand if you don’t watch your expenses carefully but they are incredibly convenient and offer much more protection than cash or checks.
We use credit cards for rewards only. It’s pretty lucrative if you are disciplined about it!!!
I am just discovering that myself Holly. I think Mr. Frugal Rules and I will fund his birthday celebration next year off of credit card rewards.
Wow very interesting to learn about! We mainly use our cards for the rewards.
Thanks Michelle. I am glad you enjoyed it. We’ll have to do a follow up post on the best credit card reward programs out there to share the love!
It is amazing how quickly it all happens, and how things get flagged. We drove to Las Vegas once for a business trip, bought gas in two different states and then checked in in Vegas to find my business card denied. It was red flagged for being used in multiple states in the same day, so they cut it off. While it was a bit embarrassing when checking in, I’m glad they notice stuff like that. I make it a point to call first when I’m going on a multi-state trip now.
Good point, Kim. I used to think it was so strange to have to call ahead and tell my credit card company where I was going but like you, I am thankful that they watch for that kind of activity – to protect us but more so the merchants who accept their cards.
Jake Erickson says
Wow, who would’ve thought all of these steps are done simultaneously every transaction. Credit cards are extremely convenient and I love the perks of using them. That being said, they need to be used and managed properly or else they can cause some major issues.
Definitely Jake. Playing the credit card rewards game is NOT for everyone.
Grayson @ Debt RoundUp says
It is cool that you laid this all out as many don’t understand how many hands actually touch your data. Since owning an online business, I had to deal with this and knew the steps. I guess we shouldn’t be surprised that data gets lost or hacked because of all of the touch points.
Thanks Grayson. I bet you learned quite a bit about credit cards firsthand with a unique perspective as an online business owner. I hope that you feel protected by the credit card companies. I’m curious if you’ve had to deal with fraud personally in terms of people fraudulantly using cards to make purchases on your site.
Interesting post! It`s amazing to think about how fast that whole process happens. I don`t really use credit cards because we`re in a DMP but we will start using one soon for the rewards available,
I know Catherine. It is amazing how quickly it all happens. Can you imagine if all the computers went down everywhere all at once? Commerce would come to a screeching halt!
It would be really complicated to have a credit card for each store! I have the same problem as Kim, card getting flagged all the time for international travel, I always forget and think now they know the pattern, but Guatemala is on their black list and understandably so.
Wow. I didn’t know card companies have blacklisted countries but I suppose that makes sense. What do you do instead for payment? Are you just limited to local currency?
Debt Blag says
Super-interesting post. Thanks! It looks like we got smacked with the early adopter penalty so we’re stuck with old equipment everywhere, while other companies that started using credit later get credit cards with chips and phones for paying.
I’m not sure exactly what has the US lagging behind Europe and Canada when it comes to contactless payment, but I think part of what keeps us from adopting mobile wallet is our complete and total adoption of the credit card system. It’s so entrenched and is executed so flawlessly (relatively) that its convenience and familiarity make it difficult to abandon, even if what’s out there could be even more convenient.
Midlife Finance says
As long as it works quickly, I ‘m not too interested in the back end. I’d rather concentrate on not using the card when not necessary. 🙂
I guess the smart wallet is the future, but I need to get a smart phone first…
Smartphones aren’t just the future. They are the present. I knew it was time for me to upgrade when my retired mother-in-law had a smartphone and an iPad before I did. 🙂
Shannon @ The Heavy Purse says
It is amazing how so much happens in those few seconds after we swipe our credit cards. And I have to laugh, because we do get impatient when it takes more than a nanosecond. 🙂 I certainly appreciate the convenience and reward points my credit card offers, but we are also very careful to pay the bill off in full and tell our girls that too. They know when Mom or Dad swipes that plastic card that we still pay for all of our purchases. 🙂
So glad you mentioned that Shannon. It is so important to teach our children not to abuse credit or be afraid of it but rather, to find balance by using it to their advantage, not charging more than they have budgeted to spend and never letting a balance carry over from one month to the next. We are trying to instill those values in our kids as well although with them all under age 6 right now, they are still a little young 🙂
Edward Antrobus says
I’ve heard that contact-less is big in Europe, but I don’t see it catching on over here. just too few places accept it. So far, or of all the places I’ve every been in, most McDonalds and some 7-Eleven’s have the technology. meanwhile, sole didn’t even bother putting in an nfc transmitter in the iPhone 5 because it was a feature that too few users were using.
I know, Edward. We are going to have a tough time transitioning to another form of payment. Even if it’s more convenient and secure than what we have now, we like what we know, what we know works and the credit card system is so deeply entrenched in all of commerce. Maybe that’s why even square is essentially a swiper.
The fact that all that processing occurs within seconds is amazing! I think there will always be some form of credit card although it may not be a physical card. I think there will always be a fear over fraudulent charges or stealing information.
Great post Nicole. I was completely unaware that the merchants were on the hook for theft, although I suppose that makes some sense since they could theoretically do some shady things if they were not.
When I was a server and worked the day after Thanksgiving, the credit card servers were always overloaded and it took two to three times longer for transactions to occur. It really was the only time that it behaved that way, which shows just how much plastic is used on that day.
Q: “why wouldn’t i make room for them (i.e. credit cards) in my future? A: ’cause it’s a slipperly slope! You get into the habit of using them ’cause you’ll always pay them off in full at the end of each month and you have outsmarted the cc companies and taken advantage of their “perks”. Oh shit – then some big ass ER happens and out of habit you pay for it with your cc. Pretty soon you can’t make that payment in full by the end of the month and interest (at usury rates) compounds and pretty soon you’re screwed – but all along you thought you were outsmarting the cc companies – ha! best of luck with that one.
Roger @ The Chicago Financial Planner says
Interesting background info. Most of us, including yours truly, take this all for granted.