Finance

How the Heck Do Credit Cards Work Anyway?

Credit cards can be mystifying to a lot of adults, even those who have had them for several years. You might be wondering when the right time is to apply for your first credit card or how credit cards make money. Read on for a breakdown of all the credit card basics you should know.

Credit Card Basics

A credit card is similar to a loan in that a person is given access to a certain amount of money that has to be paid back over time. There are two types of credit cards to know about: secured and unsecured. 

A secured card is usually what most first-time users apply for. With no credit history, it’s difficult to be approved for cards that offer large sums of money with low interest rates. Interest, by the way, is a percentage of what a user spends that’s added to the amount he or she must repay the credit card company.

With secured cards, a user provides his or her own money to a lending company. The amount a user deposits sets his or her card’s limit. Unsecured cards, on the other hand, have pre approved amounts that are determined by a number of factors based on your credit repayment history and the current amount of outstanding debt. 

How Do Banks Make a Profit?

Now that you know how a credit card works on the user’s end, it’s time to take a look at what goes on behind the scenes. Credit card companies need banks to provide them with money for their clients. The bank earns money back through fees and interest rates. 

There are several different ways a bank can make money through credit cards, which are called “profit models.” A common source of revenue comes from merchant fees, which are processing costs that businesses must pay whenever someone purchases something at its store. This is often why most restaurants and stores have a minimum amount required before you can buy anything with a credit card. 

Credit card contracts also impact bank profit. The contract length has a lot to do with expected credit loss. Someone who has a card that he or she doesn’t pay off for two years will create a much larger loss than someone who only held his or her card for, say, six months. 

The Benefits of Having a Credit Card 

There are many benefits to having a credit card—even a secured one with a low limit. Using credit cards to pay back school loans, monthly bills and general living expenses help raise your overall credit score, which is important when it comes to buying a house, renting an apartment and acquiring insurance. Many credit cards also offer rewards to members who spend responsibly and pay back their debt on time, such as cashback, travel rewards, sign-up bonuses and more. 

Now that you know a little bit more about credit cards and how they work, you can use them responsibly. 

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