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?
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