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How do credit cards work?

May 08, 2009 08:47 IST
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Today, credit cards have found widespread usage due to the conveniences they offer. Unlike the olden days, you do not have to carry large sums of money when you go shopping.

All you need to do is take your card with you while shopping, select whatever you want to buy, hand over your card to the cashier to make the payment and walk out with your purchase. So simple, isn't it?

Besides, the card issuing banks offer many types of benefits like cash backs, reward points, interest free credit and discount offers on purchases made at select stores.

All this makes it attractive to use a credit card in lieu of cash for your purchases. If you are wondering, "What happens after I hand over my card to the cashier?" Read on to know more...

When you hand over your card to the cashier to pay for your purchases he takes it and swipes it in the merchant's point of sale (POS) system.

This system is connected to the merchant's bank via a communication link. This POS system helps in verifying your data by using an electronic verification system.

The details verified include the validity of your card and the availability of sufficient balance on your card to pay for the purchases. This data is available on the magnetic strip, present at the back of the card.

Once your details are transmitted to the merchant's bank, they are sent to your bank which then authorises the payment if all the details are in order. This authorisation is then sent to the merchant's bank, which then blocks the amount from your credit limit so as to reimburse it to the merchant later on.

The authorisation generates an approval code and is transmitted to the merchant. This code has to be keyed in by the cashier, after which two copies of charge slip is generated. This charge slip is your agreement to pay your issuing bank the amount of purchase. You then sign one copy of the charge slip and take the other one with you, along with your purchase.

Just like you, there are many others who use credit cards for their purchases. They also generate their own charge slips. All these charge slips are stored in batches and submitted by the merchant to his bank, at the end of the working day.

But remember the nature of relationship of the merchant with his bank is far different from your relation with your bank. It is more of a contract, called as merchant account and is actually a line of credit than a regular account.

As per this contract, the bank agrees to undertake collection of payments on behalf of the merchant from his customers' banks.  These payments are credited to the merchant's bank accounts after deducting the fees for all the services involved.

When the merchant deposits these batches in his bank, they are sent by the merchant's bank for clearing and settlement through the credit card association. This association charges your purchase amount to your bank and pays the amount to the merchant's bank. The merchant's bank then reimburses this amount to the merchant.

Your bank now charges your purchase amount to your credit card account. On the specific date, your bank will generate an account statement, listing all the credit and debit transactions in your account. If the debits are higher than credits, you have to pay the difference to your bank.

You will also be given a due date, which is the last date by which you have to repay your bank. The failure to pay off this amount by due date will mean paying late fees as well as interest charges to the bank. These fees and charges can be very high, so be very careful.

Credit card is a powerful credit tool to help you tide over short term financial requirements. However, they must be used judiciously, as any misuse of the card can attract stiff charges and make you fall into the debt trap, besides destroying your credit rating.

So the watch word is, 'BE CAREFUL' while using the credit card.

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