How Credit Cards Work
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Have you ever considered how credit cards work and why they can be such an expensive line of credit? We have put this short article together to answer these and some other questions. |
A credit card is the only form of payment card that offers a revolving line of credit in addition to its function as a means of electronic payment. In contrast, charge cards such as that offered by American Express must be paid off monthly.
How does a credit card work in practice?
Suppose you buy a TV and present a Visa card, bearing the logo of the issuer, say Barclays, in payment. You place your card in a card reader, which reads the data in the microchip and adds information that identifies the merchant and the monetary value of the purchase; you then enter a four digit PIN (Personal Identification Number). This electronic message automatically goes via telephone line to a computer maintained by the merchant’s acquirer, also a member of the Visa association. That computer reads the message and determines that you used a Visa card. It calls up Visa’s computer, which checks with Barclay’s computer to verify that you have a credit balance sufficient to cover the purchase.
If you have enough credit, the Barclays computer will send back a message to the Visa computer authorising the transaction. Visa relays the message back to the terminal at the store. The entire process takes just seconds, and finishes by printing out the credit charge receipt that is given to you by the store. Since the transaction is captured and stored electronically, the receipt is used only to settle disputes that might arise for example due to a stolen card.
The merchant submits a request for payment to its acquirer, which in turn sends it to Visa’s computer. The Visa computer passes on the request to Barclay’s computer, which posts the transaction to your account with Barclay’s. Visa’s computer consolidates this transaction with all other Visa transactions that day and settles the accounts among banks.
The merchant receives about 2 percent less than the amount you paid for the TV. That 2 percent is called the merchant discount, and is paid to the acquirer. The acquirer keeps a portion for his services, and pays about 1.4 percent of the purchase amount to the issuer, in this case Barclay’s. That 1.4 percent is called the interchange fee which is set by Visa. American Express does not have an interchange fee because it is both the issuer and acquirer, and keeps the entire merchant discount.
Credit Card Associations
Visa and MasterCard are by far the largest payment card systems. Visa accounts for more than half of global purchases, with MasterCard ranking second and American Express third.
Surprisingly, neither Visa nor MasterCard earn profits. Both are for-profit corporations, yet they are operated on a break-even basis. They cover their costs with fees levied on their membership, which totals many thousands of banks. The associations have their own management and employees, but they are owned by the banks that issue their cards, and are supervised by boards of directors composed of representatives of those banks.
A bank can be a member of both associations, but may serve on the board of directors of only one or the other. The daily operations of the two associations are run by separate managements. The following rules apply to the Visa association, but the MasterCard association has similar rules.
The board of directors of an association is elected by the member banks, which are allocated votes based on the volume of various products they offer. The board appoints the management which hires the staff and is responsible for the following:
- Developing operating regulations
- Processing transactions and interchange payments between members.
- Developing system-wide innovations such as interchange technologies.
- Promoting the association brand through advertising.
- Coordinating other system wide matters, such as fraud control.
Individual members, besides being responsible for their own financial commitments, set card interest rates, fees, special features, and sign up card holders (as issuers) and merchants (as acquirers).
Issuers
Card issuers receive revenues from two sources: merchants who accept their cards and consumers who use their cards. Finance charges on credit card loans comprise over three-quarters of the revenues. By comparison, merchant discount fees comprise over half of the revenues on American Express charge cards.
Issuers must properly manage a number of expenses, of which the cost of funds and bad debt charge-offs are the largest. Other expenses include labour, data processing, system development and maintenance, and new card solicitations.
Computerised credit scoring has increased issuers’ ability to weed out potential poor payers, but it remains hard to predict which cardholders will default. The default rate on bankcard loans remains well above that on mortgages, car loans, and personal loans. However, since the global financial crisis hit in 2008 issuers have become much more careful about who they issue cards to and more restrictive on the line of credit they are prepared to issue to individuals.
Acquirers
Only members of the association can enter into contracts with merchants, although member banks can work with third-party firms to do so. Acquirers perform the following functions:
- Signing up merchants and managing the relationship
- Installing terminal equipment
- Providing authorization services when customers present their cards
- Keeping track of transactions and reporting the data to merchants
- Transferring funds to the merchant on a daily basis to cover card purchases, i.e. clearing and settlement
- Responding to merchant problems with card processing
Some acquiring banks conduct all aspects of merchant acquiring, from signing up the merchant to transaction processing and customer service. Other banks serve as the customer’s point of contact but outsource the processing functions to third parties. Still others serve only as the depository institution where clearing and settlement occurs, leaving the third party as the active member of the merchant relationship.
Visa Membership
Any financial institution eligible for government insurance is eligible for Visa membership. This now includes financial institutions owned by or affiliated with non banks such as retailers, investment firms, insurance companies, and car makers.
To become a member of the Visa association, an institution must pay an initial service fee that depends on the type of membership applied for, the type of cards to be issued, and the number of accounts. However the membership fee is trivial relative to the typical revenues from bankcard operations.
Credit Card Loans
Credit card loans have higher interest rates than most other consumer loan rates, due mainly to loan defaults, overheads, and the cost of financing the loans. Unlike most other consumer loans, credit card loans are not secured by assets that could be seized if the consumer defaulted. In addition a card holder is more inclined to use the full line of credit when his financial situation worsens – precisely the riskiest time for a creditor.
Credit card loans usually include other costly benefits such as frequent flier miles, purchase guarantees, and insurance. About 40 percent of credit card holders use them only as payment devices and pay off their short-term loans before the issuer charges interest. In spite of these expenses, credit cards are an important profit centre for most issuers.
Credit cards have been the driving force behind the credit revolution of recent years. However, the down side has been the ease at which credit became available with millions of people being able to access money form a multitude of sources. I suppose it was inevitable that the brakes had to come on at some point and the days of cheap and easy credit may be gone forever.
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