Do you know exactly how credit cards work?

found at http://www.moneycontrol.com/ 

Have you entered the cashless age, using plastic money or using your credit to the best effect? Yes, I am referring to ‘credit cards’. Believe me, there is nothing better than a credit card for all those cautious buyers. Shopping has become so easy with credit cards, that we enjoy the freedom to move out even without cash.

In early 1990’s, very few people had credit cards since it was quite costly. Now, the scenario is different. Credit cards are available for free and many customers are opting for it because of its convenience.

Some people are still skeptical about a credit card’s usefulness. The first question they would think of is, ‘Why do the banks give 30 days interest-free credit?’ They futher think that there must be some hidden cost attached to it. But do you know how a credit card exactly works? Let me explain this to you with a simple example.

Mr. X pays holds a SBI credit card and wishes to purchase a home theatre system costing Rs 45,000. He has three options. 

1. Purchase by cash
2. Purchase by taking a loan
3. Purchase by credit card

In case of the first option, there is nothing to worry about. It is a straight transaction. In case of the second option, Mr. X will end up paying Rs. 450 interest @ 12% per month. In case of the third option, he will enjoy a credit of more than 30 days, which is without interest. With this, he will also get the benefit of a reward points scheme, run by SBI credit card. 

Again, the question remains the same, how SBI card would give an interest free credit for Rs 45,000, when they can earn Rs. 450?

Mr. X has paid some amount for the home theatre system with his SBI credit card (a VISA / Mastercard affiliated card). The merchant swipes the SBI card on a machine provided by another bank, let us assume it's an ICICI Bank swiping machine.

When the merchant swipes a SBI card in a ICICI Bank machine for authorization request, ICICI Bank contacts SBI Card through VISA / Mastercard network. It asks for validity of credit card and the credit limit. SBI card checks the validity of the credit card first. In case of a valid card, it also checks the transaction amount with the available credit limit.

On that basis, SBI Card approves or rejects the transaction received from the merchant through ICICI Bank.

Let’s assume the transaction is validated by SBI Card and Mr X signs a credit card transaction receipt printed by the ICICI Bank machine. The signed receipt works like a promissory note, which carries an obligation on Mr X to pay the money to the SBI Card.

The merchant periodically submits all such receipts to ICICI Bank. ICICI Bank pays sum of all receipts including the Rs 45,000 of Mr X. For this facility, the merchant has to pay ICICI Bank (provider of swiping machine) ‘Merchant Discount Fees’. Let’s assume, it is 2%. So, ICICI Bank will pay just Rs 44,100 after deducting 2% merchant discount fees. ICICI bank will send this transaction details to SBI through VISA / Master Card. SBI will pay the amount to ICICI bank after deducting interchange transaction fees. Interchange transaction fee is a fee paid by an acquirer (ICICI Bank) to issuer of the credit card (SBI Card).

Interchange transaction fees is decided as per rules of VISA / Master Card for different transaction. Let’s assume it is 1%. So, SBI will pay ICICI Bank Rs. 44,550. After completion of bill period (30 days), SBI Card will get money back from Mr. X ie. Rs. 45,000. Thus, SBI Card earned Rs 450 in this transaction, which is almost equivalent to interest on a loan. Cost is borne by the merchant in this case for interest free credit to Mr X.

Now the question is ‘Why does the merchant pay interest on credit given to a customer?’ The merchants enjoy several benefits because of credit cards. This is a safer transaction medium than a cheque. For bigger purchases, customers are not willing to carry cash and merchants are not willing to accept a cheque. Hence, credit card is an amicable solution. Because of its convenience and acceptability, customers prefer to use a credit card. Customers tend to purchase more when the transactions are made through plastic money. It ignites an impulse to purchase in many customers’ case.

Similarly, merchants tend to sell more in case of credit card usage hence they earn their profit in a different way, by allowing credit card transactions to take place.

To promote the usage of their bank's card, all banks offers certain reward points and cash-back schemes. This is an additional benefit to all customers for using a credit card.

The author, Ketul Shah, is a Chartered Accountant specializing in Indian and US mortgage.