How Credit Cards Work: Knowing Different Parts of a Credit Card

Is it too good to be true to get a loan so easily? 

• Credit cards are a form of short-term borrowing that enables you to borrow up to the credit limit. The lender (usually a bank) sets a credit limit. Credit cards can be an easy way to get interest-free loans, valuable rewards, travel perks and shopping benefits. If used correctly, they can also help you build your credit score.
• But the costs far outweigh the benefits if you don't pay off your whole balance each month. Any interest owed will quickly compound and credit card companies usually charge very high interest in the first place! 
• A credit card works in 5 steps: the handover, the validation, the debit, the bill, and the credit history.

The Different Parts of a Credit Card

1. A card number is an identification number embossed on the card itself and stored on the chip or magnetic strip of the card. It is used to make transactions when the card is tapped or swiped.
2. The expiry date defines when it’s time to get a new card! Also used when buying online as a security measure.
3. CVV is a 3- or 4-digit code usually located on the back of your card. It serves as a fraud-prevention tool when making purchases that don’t involve a physical card, such as with online shopping. Nowadays, of course, many use 2-factor authentication as well, using alerts sent to your phone.

How Credit Cards Work

You can apply for a credit card from any credit card issuer or bank. The credit card issuer or bank will then assess your income and repayment ability by, among other things, reviewing your credit report. If your application is accepted, you'll receive a card with a fixed credit limit.

Here’s the general step-by-step process of how credit cards work:

1. Handover

You hand over your card to make payment, though increasingly, they will bring the electronic terminal to you.

2. Validation

 The merchant then sends your information out over a secure internet connection to validate your account and confirm with the issuing financial institution (FI) or bank whether to let the purchase go through. 

3. Debit 

Assuming your credit card isn’t declined, the purchase price is debited from your account. You get your stuff, and the merchant gets paid (minus some processing fees. See "How credit card companies make money" below)

Every time you repeat Steps 1 through Step 3, your additional purchase amounts are added to your account. At the end of the month, you’ll have to pay up via Step 4.

4. Bill 

Every month, the FI or bank that issued your credit card will send you a bill that includes every purchase made during that month. The credit card issuer will show your balance due and the monthly minimum amount owed. For example, a bank may calculate the minimum sum at 3% of the outstanding amount or $50, whichever is higher. Be sure to check what these terms are before you sign up.

Say, for example, your credit limit is $5,000. If you spend $1,000, your minimum amount due would be $50 and not 3% ($30).

If you just pay $50, you will incur interest charges on the remaining balance of $950.

If you just pay the minimum amount (or anything other than the full amount), you will incur a financing charge for the remaining balance. Interest for the balance is calculated starting from the statement due date and will be reflected in your next monthly statement.

If you keep on paying only the minimum amount due every month, your financing charge (i.e. the interest) is compounded. This can turn out to be very, very bad news as the interest rate tends to be very high -- far higher than anything a bank would pay you for your deposits in a savings account.

Example: Paying the Minimum Balance Each Month on Your Credit Card

• You recently obtained a credit card with a credit limit of $5,000

• The monthly spend on the card is roughly $1,000

• The interest rate is 25% per annum

• The minimum balance that has to be paid monthly is $50

The graph below shows that by only paying the minimum balance, you’ll end up incurring $2,398 worth of interest on the credit card in just two years! 

Chart for illustration only - actual charges and credit card company behaviour will vary

However, paying off your statement balance in full each month means you can completely avoid paying any interest. That’s because most credit card companies don’t charge any interest until after your statement’s due date. So if you pay the bill in full, you won’t pay a penny in interest. This “grace period” is one of the best things about responsible credit card use.

5. Credit History

This is an underappreciated but very important part of using credit cards. Every time you pay your credit card bill on time, maintain a low credit card balance or (preferably) pay your balance in full each month, you’re building up your credit rating. Having a good credit history shows banks and other financial institutions that you’re financially responsible, which will make it easier (and cheaper!) for you to borrow money for major purchases (such as property or a car) in the future.

Most Credit Card Companies Check Eligibility Based On:

1. Age
2. Residency
3. Employment and income
4. Credit history

Singapore requires credit card candidates to have surpassed the minimum age of 21 years, have an annual income of a minimum of S$30,000 or more (depending on the card type), have a stable income source, and a specific number of years’ good credit history.

HOW CREDIT CARDS WORK. COMPLETED ✅.

SOURCES

1. https://www.investopedia.com/articles/pf/10/credit-card-debit-card.asp
2. https://learn.moneysmart.sg/credit-cards/credit-card-basics/how-do-credit-cards-work/
3. https://www.moneysense.gov.sg/articles/2018/10/understanding-credit-cards
4. https://www.creditcardinsider.com/blog/how-does-a-credit-card-work/#are-credit-cards-a-good-idea
5. https://www.moneysmart.sg/credit-cards/credit-card-bank-application-basics-ms
6.  https://www.singsaver.com.sg/blog/what-happens-when-you-cant-pay-your-credit-card
7. https://gendal.me/2014/08/09/
8. Cover photo from picjumbo