Credit Card

What It Means

A credit card is an electronic-payment card that enables the cardholder to make purchases against a line of credit. (A line of credit is a form of loan, according to which a bank or other financial institution grants a consumer permission to spend up to a preapproved limit of money, with the understanding that he or she will pay it back over time.) Other forms of electronic-payment cards include debit cards, which take the funds for a purchase directly from the cardholder’s checking account; and charge cards, which require the cardholder to pay off the entire balance of his or her purchases at the end of each billing cycle (usually monthly).

Unlike a debit card or a charge card, a credit card permits the cardholder to maintain a running balance (debt) from one billing cycle to the next, as long as he or she makes a small minimum payment each month. This form of credit is called “revolving credit” because it continues to roll over at the end of each billing cycle; there is no set number of installments for paying off the balance, as is the case with a home loan, or a car loan. The amount of credit available on the account (figured as the difference between the credit limit and the balance at any given time) is continually expanding and shrinking according to how much the cardholder spends using the card and how much he or she pays off each month. The balance that remains on the account from one month to the next is called revolving debt. This debt is subject to interest charges, which typically range from 5 percent to 25 percent a year.

The two biggest brands of credit card in the world are MasterCard and Visa. It is important to note, however, that Visa, MasterCard, and other brands (such as American Express and Discover) do not issue cards to people. Rather, they license their brand to individual member banks, and the banks issue the cards and extend credit to account holders. Further, each issuing bank is responsible for setting the specific terms of its customers’ credit card accounts (such as the interest rate), which means that not all Visa cards, for example, are alike.

When Did It Begin

Visa and MasterCard trace their origins to 1958 and 1966, respectively. Visa’s predecessor was BankAmericard, the product of California-based Bank of America. In 1966 Bank of America began to offer other U.S. banks licenses for the right to issue the BankAmericard, and in the early 1970s it started expanding internationally. MasterCard’s predecessor, introduced in 1966 to compete with BankAmericard, was “Master Charge: The Interbank Card.” It was created by the Interbank Card Association (ICA), an association of banks. Master Charge, too, expanded rapidly: two years after launching the card, the ICA had begun to partner with foreign banks.

In the early years of credit cards, merchants had to obtain authorization for each purchase their customers made by calling the issuing bank on the telephone. This process was revolutionized in the early 1970s, however, when issuing banks and merchants became linked through a centralized computer network, which enabled authorizations to be transmitted electronically. Another major technological advancement of this period was the introduction of the magnetic stripe on the back of the card, which increased the efficiency of authorization and helped to prevent fraud (such as illegal use of the card). The magnetic stripe contains encrypted data that, when swiped through a reading device at the point of sale (or cash register), identifies the account and the cardholder.

More Detailed Information

Each bank sets its own terms for the credit cards it issues. Further, a given bank may set different terms for different cardholders, according to their income and credit history (a financial report card of sorts that shows how much money a person owes to his various creditors and how reliable he is about paying his bills on time). If a person has a low income and a poor credit history, the bank must assume that extending credit to him is risky, and it will likely charge him a high interest rate in order to offset this risk (or it might deny his application altogether). On the other hand, if someone has a fairly high income and an exemplary credit history, the bank will rank him as a safe person to extend credit to and will likely offer a lower interest rate.

Annual Percentage Rate (APR)

Annual percentage rate (APR) is one of the most important variables to consider when using a credit card. The APR on the card is the amount of interest, such as 15 percent, the bank will charge the cardholder per year on her revolving account balance. The higher the credit card’s APR, the more it costs to carry a balance on that card.

Credit cards usually specify one APR for purchases and another, higher APR for cash advances. With a cash advance the cardholder withdraws money against his credit limit. To do so, he can make the transaction with a bank teller, or he can insert his credit card into an ATM (automated teller machine), enter his PIN (personal identification number), and withdraw cash. Usually only a portion of the card’s total credit limit is available for cash advances. In addition, many card-issuing banks charge a cash-advance fee, typically calculated as 2 to 3 percent of the total amount of the advance.

Minimum Payments

Credit card holders receive a monthly statement, or bill, which summarizes the activity (purchases and payments) on the card for that month. The statement also specifies the minimum payment the cardholder must make for that billing period in order to keep the account in good standing. The minimum payment tends to be just a tiny amount (such as 2 to 4 percent) of the total balance; often it is only slightly more than the interest charged on the balance for the same period. Thus, if the cardholder only pays the minimum each month while the balance continues to accrue interest, it can take him years, even decades, to pay off the debt.

Late Fees

A credit card statement stipulates the date by which the payment must be received by the issuing bank. If the payment is late, the issuing bank will charge the cardholder a late fee. Late payments can also result in other penalties, such as an increase in the card’s APR and a blemish on the cardholder’s credit rating.

Over-Limit Penalties

If the cardholder’s account balance exceeds his or her preset credit limit, the bank may charge an over-limit penalty for that billing cycle. In many cases, when someone tries to make a purchase that will put his or her account over the limit, the card will be denied at the point of sale; but if the purchase is only a few dollars over the limit, the transaction will sometimes go through. Also, sometimes it is interest charges that put the balance over the limit.

Recent Trends

In the 1990s many banks that issued credit cards launched aggressive marketing campaigns aimed at college students. Whereas it was once unheard of for someone without a steady income to receive a credit card, by 2004 about 75 percent of college students had a least one credit card, and 40 percent had at least four. Young, free from parental supervision, and financially inexperienced, students could fill out a credit card application in about five minutes and receive a card with a $2,000 spending limit within a couple of weeks. Over the course of four years of college, they could rack up debt that would burden them for years to come. According to Nellie Mae, a student-loan provider, in 2004 college seniors carried an average of nearly $3,000 in credit card debt.