Background
Arguably the biggest financial innovation of the past 100 years, credit cards are familiar pieces of metal or plastic that allow cardholders to borrow funds to pay for goods and services.
Unlike debit cards, which draw money from the cardholder’s checking account, credit cards allow the cardholder to borrow a certain amount of money (called a credit line) from the card issuer (typically a bank or other financial institution) based on their creditworthiness (how credit limits are determined).
Credit cards are also the fourth-highest source of US consumer debt. Americans had roughly $1.2T in credit card debt as of Q3 2024—almost as much as they had in auto loans at the time ($1.6T), and significantly more than home equity loan debt.
History
On a 1958 morning in Fresno, California, 65,000 people woke up to find a strange rectangular piece of plastic on their doorstep without explanation.
Most of them hadn’t heard of credit cards, but that was all about to change. (Some companies, like Diner’s Club, had previously experimented with “charge cards”—see the difference.)
Those chosen for the “Fresno Drop” didn’t know it yet, but Bank of America was behind the stunt. Before that morning, whenever someone wanted to buy a pricey item like a dishwasher but didn’t have the money, they typically went to a bank and attempted to take out a loan, which could take days.
But the Fresno Drop wasn’t an instant success. Some cards were stolen, and delinquency rates were six times higher than they were with the previous bank loan system.
Many merchants, however, loved the cards. Customers also liked skipping the trip to the bank. In Bank of America’s first year offering credit cards, 20,000 merchants and 2 million cardholders signed up.
Bank of America later started a network (now called Visa) that allowed consumers’ and merchants’ banks to communicate each time someone made a purchase using a credit card. Today, many other banks (as well as institutional investors) help govern and profit from Visa, with Bank of America owning roughly a 1.5% share.
How Credit Card Purchases Work
When someone buys something using a credit card, the merchant’s point-of-sale system captures the card’s information (think: who the card belongs to, its expiration date, and more).
The information is then sent to the merchant’s bank, which sends the data to the network (such as Visa or Mastercard). The network determines who the customer’s card issuer is (often a bank, like Wells Fargo), and the card issuer approves or denies the charge after checking for fraud risks, the customer’s available credit limit, and more.
If everything is good to go, the purchase is authorized, and the customer’s card issuer places a hold on the card that temporarily reduces the customer’s available balance by the purchase amount and tells the merchant’s point-of-sale system that it can go ahead and make the sale.
The process continues overnight, when the merchant’s bank sends a batch of transactions from the day to the payment network (this is called “clearing”). The network then calculates fees for both the customer and the merchant (learn more about merchant transaction fees).
Finally, the network instructs the customer’s bank to go ahead and deposit the cost of the purchase minus the transaction fees into the merchant’s bank.
How Credit Card Payments Work
Think of the money the customer’s bank paid the merchant as a small loan from the bank to the credit card holder. After the bank pays the merchant, it’s time for the credit card holder to pay the bank back.
The credit card holder will see the transaction, and any others made that month, on their monthly statement.
The credit card holder can either choose to pay the statement balance in full (any time during the “grace period”—more on that here) to avoid any interest charges, or pay the minimum balance. If the cardholder only pays the minimum balance, they will rack up interest on the remaining statement balance.
Interest rates for credit cards are notoriously high, with APRs (or annual percentage rates) typically ranging from 15% to 30%. Credit card companies not only make money off interest, but also from yearly fees for certain rewards cards and much more (learn about how credit card companies make money here).
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