What are credit cards?

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A credit card is a financing instrument issued by a creditor that allows the authorized cardholder to finance the purchase of products or services or, in some cases, a cash advance.The credit card is actually the physical representation of the line of credit made available to the cardholder.

Most credit cards in circulation today are revolving accounts. With revolving debt, the outstanding balance can increase or decrease, based on items purchased with the card and payments made by the borrower toward the credit card balance. Additionally, the required payments on credit cards are will also fluctuate based on the account’s balance. In contrast, installment loans have set payments structured to consistently and gradually decrease the loan amount.

Types of credit cards

Consumers and businesses have a wide array of options when it comes to credit cards. However, not all of credit cards function the same way. The following are the three basic types of cards used by credit users today:

  • Charge cards. Sometimes also called department store or retail cards, charge cards emerged during the 1920s when hotels and oil companies started issuing them to trusted customers. Soon after, department stores and other retailers started doing the same. Prior to charge cards, many merchants would often offer credit lines to customers they trusted. The credit or charge card was a physical representation of that relationship. However, these “limited purpose” charge cards could only be used with the merchant or vendor that issued the card; and the balance would normally be paid off in full shortly after.
  • Debit cards. Although debit cards first emerged in the U.S. during the mid-1960s, they really didn’t take off until automated teller machines (ATMs) became popular and widespread during the 1980s and 1990s. Unlike standard credit cards and charge cards, debit cards don’t extend a line of credit. Instead, they withdraw funds from the user’s savings or checking account whenever the debit card is used to purchase items or withdraw funds through an ATM. Today’s debit cards, particularly for checking accounts, can often work in the same merchant networks established by standard credit cards (Visa and MasterCard).
  • Standard credit cards. The standard credit card first emerged after World War II as an expansion of the charge card, when a Brooklyn bank issued a charge card honored by participating merchants in its area. In 1950, Diners’ Club started doing the same with participating restaurants around the nation (and eventually the world). In 1958, Bank of America launched what would become the Visa Card. A group of California banks banded together in 1966 to do something similar with the launch of MasterCard. Today’s standard credit cards can be used with merchant or vendor participating in that credit card company’s network.

As the use of standard credit cards have proliferated, several new variations of the standard type of credit cards have entered the market:

  • Secured credit card – designed for individuals with less-than-perfect or bad credit, secured credit cards required a security deposit as collateral. The credit limit is usually tied to the security deposit amount.
  • Rewards cards – to encourage greater use of credit cards, which garnered more fees for the credit card company (from merchants), creditors started offering various rewards for credit card users, such as points, gifts and cash.
  • Airline cards – this variation of the rewards card offered airline miles or points that can be redeemed for travel with the participating airline.
  • Gift cards – many credit card companies have joined the gift card trend by providing gift cards that can be used with any merchant participating in that credit card’s network, until the gifted balance is completely used.
  • >Prepaid cards – similar to debit and gift cards, prepaid cards can be used throughout the credit card company’s network up to the deposit balance maintained in the account. However, prepaid cards can usually be replenished.

Obtaining a credit card

Just as with most loans, a credit card is issued to an individual or company only after the creditor has reviewed, underwritten and approved the credit card application.

Each creditor or financing company establishes its own underwriting criteria and lending guidelines. Although many credit card companies do look for good to excellent credit, some credit card programs (such as secured credit cards) do accept applicants with damage credit or low FICO credit scores.

Using the credit card

When a consumer makes a purchase with a credit card, the credit card company electronically transfers or directly deposits the amount of the purchase to the merchant’s account, less a processing fee paid to the credit card issuer (by the merchant). This “merchant fee” is one reason why many vendors and merchants prefer cash or debit cards.

When the consumer signs the receipt for the purchase, he or she is making a promise to repay the credit card company based on the terms of the original credit agreement that the borrower signed with the creditor. The credit agreement will identify the interest rate, the due date, and the minimum payment due with each statement.

The creditor can adjust the credit limit as well as other terms of the loan agreement over time, and with notice, based on the consumer’s payment history to the creditor and overall credit profile. For example, say a new credit card customer has a credit limit of $500.After a period of charging goods and services and making timely payments, the credit card issuer may increase the credit line to $1,000.With continued timely payments and a good credit history with other creditors, the credit limit may be increased further still.The consumer can also request an increase in credit limit at any time, though the creditor always has the prerogative to accept or decline that request.Once the request is made, the credit issuer will evaluate recent payment patterns to determine whether a new credit limit can be offered.

Late payments on credit cards have the reverse effect. If the consumer begins to make payments past the due date, the credit issuer can raise the interest rate on the card or lower the credit limit.If the consumer misses payments or defaults on the credit card agreement entirely, the card issuer may cancel the credit card completely and proceed to collect the outstanding balance due from the consumer.

Credit cards are a staple in the modern world of consumer finance, providing a convenient way to purchase goods and services from merchants across town or around the world. Used responsibly, credit cards can also be one of the most effective ways to establish good credit.

Disclaimer: NetCredit is a direct personal loan provider and does not provide financial advice, nor does it vouch for any vendor or service mentioned on our NetCredit personal finance blog or online consumer loan glossary. Always research and perform due diligence on any service provider or vendor before deciding to use them, and we recommend that you speak with a financial advisor regarding all decisions that will affect your finances.

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