All About Credit Cards (Part 1) Personal Finance Topics

All About Credit Cards (Part 1)

Ah the credit card.  When you think about it ideas of platinum and gold cards and the high life may come to mind. This is part of the story. The other part of the story is that using a credit card irresponsibly can burden a person with an enormous amount of debt and keep him up late at night. So what is a credit card and how does it function?

Key Points

  • A credit card can be thought of as a mini loan.
  • Your credit score and credit report greatly impact credit cards.
  • A debit card is fundamentally different from a credit card by taking funds directly from your checking account.

An Introduction to Credit Cards

A credit card in essence represents a mini loan complete with terms and conditions and a time window to repay the loan. Credit cards do this by providing a line of revolving credit. A revolving line works by providing a max balance from which the user can draw from and pay down as long as the max balance is not exceeded.  For example I can have a credit card with a credit limit of $5,000 meaning that I can charge up to $5,000 onto the card without paying any of this debt down and at this point my card is “maxed out” and I can charge no more to my card.

More on Credit Card Functionality

When you apply for a credit card the issuer of the card will gather information on you (mainly through your credit report) to make a decision whether to issue the card and at what interest rate. This is why a credit score matters, a better credit score results in lower interest rates and approval for a credit card.  Aesthetically a credit card is a small plastic card that includes the customer’s name, the credit card number, expiration date, and issuer.  Common issuers are banks, credit unions, and other financial institutions.  VISA and MasterCard are the most well-known companies that process the payments between companies and the banks; they do not issue cards.  Discover and American Express are payment processing companies, but these two companies also credit cards. To put it differently there exists no “VISA card” only through the VISA company, however there are Discovery and American express cards in which these companies actually lend the money.

So what happens when you swipe the card as payment for your groceries, gas, tasteful underwear?  Once it is swiped an electronic request is sent to your bank or your card payment processor (VISA, MasterCard) essentially saying “Hey is there enough credit available for this payment?” The approval or declination is sent back and you either will end up with your purchase or suffer from a slightly embarrassing moment as your card is denied.

The Difference between Debit and Credit Cards

A debit card resembles a credit card in looks, but that is where the similarities end. The fundamental difference between the two is when a credit card is used you are using borrowed funds whereas when you use a debit card the charge is automatically deducted from the checking or other account the card is linked to. Thus a debit card combines the convenience of writing a swift check without having the temptation of spending money you may not have (and avoiding interest costs).  Most major banks offer a debit card when you open a checking account with the respective bank.  If you’re bank doesn’t offer one, shop around at the local major banks to see what is offered.  An important note is that debit card transactions will not affect your credit score or credit report as it does not represent a credit (debt) transaction.

Definitions

  1. Credit cards: a card used for payment which is essentially a mini loan in which a max balance exists and is usually paid back on a monthly basis and accumulates interest on the outstanding balance.
  2. Debit cards: a card used for payment which funds are immediately deducted from the linked account when used

Further Reading

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