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What is a credit card?
A credit card is a simple tool for borrowing money. Find out how they work and how to use one in this guide.
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Credit cards are issued by financial institutions (banks and lending companies) that allow you to borrow money when you want to make a purchase. This article will look into the features of credit cards, how they work, the benefits you can expect from having a credit card, and why it makes sense to compare credit cards before applying for one.
What is a credit card?
A credit card is a plastic card that is issued by financial institutions - usually a bank - to their clients. It allows holders to borrow pre-approved funds at the point of sale as a replacement to cash. A credit card has physical features such as a security chip, card number, magnetic stripe, ultraviolet features, and a three-digit CVV/CVC code. Here is a basic overview of each component.
Credit Card Breakdown
- Security chip. Almost all new credit cards in Australia today have in-built security chips. Chips provide you the ability to make payments on virtually any type merchant payment terminal around the world, and make it harder for criminals to get access to your details.
- Account holder name. Your name is important because it will be used by merchants to verify your identity, and is embossed on the front of your card.
- Card number. This is a unique identifier that is used to process all credit card transactions and is also embossed on the front of the card.
- Magnetic stripe. A credit card is swiped on the magnetic stripe to retrieve an account holder's information automatically.
- Ultraviolet feature. This is an anti-fraud feature that can be used by credit card holders and merchants to determine if a credit card is genuine.
- 3-Digit CVV/CVC Code. The three-digit code on the back of your credit card will be required by payment gateway companies if you want to pay a bill over the phone or online.
When you use a credit card to complete a purchase, you're authorising the credit card provider to send the payment to the merchant on your behalf. Merchants are required to verify that the person who is using the card is the rightful owner by asking for proper identification through a signature or their Personal Identification Number (PIN).
Credit cards have a credit limit - or a maximum amount - that any holder can borrow up to during a set month. The limit is determined by the card issuer based on the cardholder's ability to pay and their credit history.
What can you do with a credit card?
Credit cards let you borrow money at the time of purchase. This is useful when you don't have enough money or don't want to pay the entire cost of a product or service immediately. If you pay off your balance on time, the credit card is like an interest-free loan from the purchase date until the payment due date. Credit cards can now be used to make payments at a store, over the phone, or on the internet.
- At a store. Credit cards act as a sort of pre-approved loan by the credit card company so they can be used at the point of sale when you shop. The merchant swipes or inserts your credit card on their machines to receive the payment.
- Over the phone. For transactions that are done over the phone, you need to verify your name, account number, CVV/CVC code, and possibly your address to process the payment. The payment will be sent automatically upon verification.
- Online. Credit cards offer a very convenient way to shop online. Most e-commerce websites have payment gateways that process credit card transactions instantly. You will need to provide your name, address, credit card number, and three-digit code to make the payment.
It is important to differentiate a credit card from a debit card. Both credit cards and debit cards tend to be accepted at the same places. These cards also tend to have the same symbols of the major global payment networks. However, they have one major difference: where the money comes from.
Credit cards give you the ability to borrow money at the point of purchase, which you later pay off with your own funds. Debit cards offer the convenience of credit cards but are linked to a transaction account. For this reason, interest is charged on credit card transactions because money was borrowed from the credit card provider, but no interest is charged on a debit card because no money was borrowed.
How do credit card purchases work?
- Credit limit. The credit limit is the maximum amount you can borrow on the credit card. It is based on your credit history and profile. You have the option to state your preferred credit limit when applying for a card, although it's still up to the card provider's discretion. Take note that cards will have a minimum and maximum credit limit.
- Purchases. Credit cards let you make purchases in person, on the internet, or over the phone. There is an endless list of things you can buy with a credit card. They can be used to pay your monthly bills, travel tickets or everyday purchases.
- Cash advances. The cash advance option lets you withdraw cash from your credit card. Interest on cash advance will be charged from the first day so there is no grace period, and it usually has a higher interest rate than that for purchases. Remember too that transactions such as foreign exchange purchases and gambling transactions are counted as cash advances.
- Monthly repayment. Credit cardholders must make the minimum monthly repayment on their closing balance. This is calculated based on the balance owed and the interest rate, and is usually expressed as the greater of a dollar amount and percentage of the remaining balance. If you don't make this payment by the due date you'll receive a late payment fee.
- Interest. A credit card balance is essentially a loan that you haven't paid off. As with any type of loan, you will be charged interest as the cost of paying for purchases over an extended period. The interest is derived from the percentage rate specified by your credit card.
What types of credit cards are there?
At first glance, it's difficult to tell the difference between regular cards, gold/platinum credit cards, and black cards. However, take a closer look and you'll see that the differences can actually be quite significant.
The first feature you'll notice is that gold/platinum and black cards come with higher credit limits. For example, if the maximum credit limit of a standard card is $1000, it can get as high as $100,000 or more for some platinum cards. The limit is even higher for black card holders.
Credit card companies have stricter conditions for approving cards in the gold/platinum and black card tiers. Generally, you'll find that premium credit cards require you to have a high level of annual income as well as a clean credit history.
- Regular cards. These cards offer the standard features associated with credit cards. It lets you borrow a pre-determined amount of money and the bank will charge you an annual fee to keep the card.
- Gold and platinum cards. Gold and platinum cards offer more perks than regular cards. Generally, this comes in the form of higher credit limits, rewards programs, better promotions, and free insurance policies.
- Black cards. A number of banks have tried positioning black cards as being 'limitless'. However, nothing is without its limits especially when it comes to borrowing money. In reality, black credit cards feature the highest credit limits in the market and offer generous rewards to its holders in exchange for a much higher annual fee.
The general benefits of premium cards (gold, platinum, black) include the following:
- Higher credit limits
- Complimentary travel insurance, purchase protection and extended warranty policies
- Rewards programs with better earn rates
- Discounts on services
- Concierge services
These perks come at a cost. The annual fee for a standard card ranges from $50 to $75 depending on your provider. Premium card holders pay closer to $100-150 a year, with some exceptions costing anywhere from $400 to over $1,000. Even if you're eligible for a premium card from your bank, it doesn't automatically mean you should apply for one. It is important to check the specific perks and benefits that each card provides. Frequent travellers, for example, can rack up frequent flier points if they have a premium card.
Check out some credit card offers available now
What are the regular promotions offered on a credit card?
- Interest free promotions. Interest-free promotions can greatly benefit credit card holders who cannot pay back their balance in full. This means that you won't be charged interest for an introductory period of time, generally lasting between 6 and 12 months. Before you sign-up, it's important to check the standard rate and the revert rate of the provider to avoid nasty surprises.
- Balance transfer promotions. Balance transfer promotions let you transfer an existing balance to new credit card and repay it at a lower rate. A number of credit card companies even offer 0% interest for an introductory period to attract clients. However, take note that if you have a leftover balance after the promotion expires, the interest rate on the remaining balance will revert to the standard interest rate or even the cash advance rate.
- Bonus points promotions. Bonus points are attractive to cardholders who have frequent flyer accounts or enjoy earning rewards points. All you need to do is be approved for a card, and in some cases make a purchase or purchases equalling a certain amount of value, and you'll receive bonus rewards points. These perks are a way for credit card companies to provide incentives to get you to sign up.
Images: Shutterstock
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