09/08/2021
How do Credit Cards work? Should I own a Credit Card?
What are credit cards? How do they work? How do credit card companies make money? And most importantly, should you be using a credit card? What are the pros and cons? Come, let’s find out. Let’s use an example to understand. Suppose you are a university student and suddenly there’s a pandemic and all your classes are now online. But to attend these online classes, you would need a laptop and you do not have one. You need to buy a laptop urgently but there’s insufficient money in your bank account for buying it. So you ask your parents to transfer some money to your bank account. But it will take 2-3 days to transfer the money and you need to buy the laptop before your class the next day. What other options are there? In such situations, you can use credit cards to make the purchase immediately and pay for it later.
So essentially, a credit card is a card that helps you in purchasing things instantly but you can pay for them later, at the end of the month. Generally, if there’s enough money in your bank, you withdraw cash and use it to make payments. The second option is to use a debit card that is directly linked to your account. When you make a payment through your debit card, then the money is deducted directly from your bank account and transferred to the other party. But with a credit card, the bank makes the payment on your behalf. And at the end of the month, you repay all the expenses of that month to the bank. You can take more than a month in repaying the bank’s money but then the bank will charge high interest, similar to a loan. So you can think of the credit card as a type of a ‘mini loan.’
How is the payment being processed? There are some payment processing companies. Like Visa, MasterCard, and American Express. But Visa and MasterCard are the most popular companies. They basically provide the back-end infrastructure to facilitate credit transactions. The bank issuing you the credit cards are distinct from the Visa and Mastercard. These two are only involved in the payment processing.
Every Credit card has a credit limit. The amount of money that you can spend with a credit card without first paying the bank. The credit limit varies from bank to bank and the type of card you have bought. And the bank checks your salary, your credit score and then decides on your credit limit. If the bank is assured that your salary is adequate that you can afford to pay back the bank then the bank will trust you more. Now, Credit Score is also an interesting concept. If you do not make the credit card payments and loan repayments on time, then the bank will think that it will be quite risky to give you money on credits. To judge this risk the banking sector has created its grading system. The score ranges from 300 to 900 and it is known as your Credit Score. If your credit score is between 750 and 900, then it is an excellent credit score. So your credit score is calculated based on your previous track record and on that basis, the bank judges if your credit limit should be high or low. In fact, whether or not to issue a credit card to you at all.
How will you benefit from using a credit card? #1 I already mentioned one advantage at the very first beginning. If you want to buy something immediately, but you want to pay for it later at the end of the month, you can. #2 The second major advantage is that using a credit card is less risky than using a debit card. If you are a victim of fraud then in the case of a debit card, the money will be directly deducted from your bank account. But in the case of a credit card, your bank or the credit card issuer will pay on your behalf. And if there is a fraud, they can investigate it. If there is actually a fraud, then they will get your money back. #3 The third major advantage is the rewards that you get for using a credit card. The reward systems vary depending on the bank and the type of credit card. In some you can get cashback, in others, you may get heavy discounts and you may even get insurance in some.
Which credit card is right for you? To decide, you need to remember three main things:
Which bank or issuer? (Rewards points system and Hidden Charges)
Which level of credit card?
Which payment network?
How do these banks profit from credit cards? The most simple way for banks to earn money is by charging annual fees. To use some credit cards, you have to make yearly payments. Apart from this, there are many different types of fees charged by the banks. If you are not making timely payments, then a late fee will be charged. If you want to withdraw cash from the credit card, then there is often an extra fee @ 2% - 5%. But you would be surprised to know that a large portion of these banks’ income actually is a result of people’s lagardness. Many people do not pay their credit card bills at the end of the month. Because of this, the banks charge a high-interest rate on it. And this interest rate can be as high as 30% compounded annually. That’s twice or thrice the interest rate on loans.
The main disadvantages of credit cards are:
High-interest rates
Hidden Charges
So the question arises: should you use a credit card? Or should you not? #1 The answer to it is very simple. If you make timely payments of the credit card bills, then you can use it. #2 On the other hand, if you use credit cards to buy things that you can not afford, if you think that now I may not have the money, I will use the credit card to buy it, and I will arrange the money from somewhere within 30 days, then please do not use a credit card. You may fall into a debt trap. #3 Third, if you want to get a credit card because of the rewards, then evaluate the situation a bit. The various fees that you will pay to use that credit card, often the processing fee is around 2% - 3%, and the reward that you would get in exchange, would they actually be worth it? Or are you still losing money? So you will have to calculate it a bit. #4 Fourth, if you are worried about paying online or anywhere else about falling for a fraud, then use credit cards in such situations to be safe.
- Manjur Rahman
- https://manjurrahman.website/?p=118
