How Credit Cards Work
Do you ever have those moments where your son or daughter asks you a question and you can’t give a good answer? There’s no shame in getting stumped on “Mommy, why is the sky blue?” (umm…atmospheric gases?) or “How does TV work?” (umm…satellites and radio waves?). But the other day, I took my son to the store and after I paid for my groceries with my Visa, he asked me “Mom, how do credit cards work?” I mean, I know how they work. Or, I think I know how they work. But I couldn’t explain it. Can you help me out? Thanks,
As a father of three myself, I’ve been peppered with more questions than you could believe. Sometimes it feels like I’m being interrogated by a grizzled detective even though it’s just my eleven year old son. I remember when he asked me, “Why is it windy?” I thought and thought about it but I couldn’t come up with a good answer….and I still can’t!
So, your question about credit cards is a very good one and I’ll try to do my best to explain.
A credit card is basically a way for people to pay for something instead of using cash. There’s a famous story about a man who went to a restaurant, ate his meal and then realized he had left his wallet and his money at home. This got him to thinking that there should be a way to pay for things without money and so he came up with The Diners Club card. Now, that’s a great story but he wasn’t the first person to think of using something other than cash to purchase something. Before him, there were other systems in place like ‘charge cards’ and even ‘charge coins’. And before that, there were entire economies based on trade and bartering (which still exist in school lunch rooms to this day!) But, the philosophy was the same – the ability to purchase something without actually having to pay for it at that exact moment. Our system is much more complicated today but the basic foundation is still the same.
So, let’s get down to the nuts and bolts of what is actually happening when you go to the supermarket and buy your groceries.
Although to your eyes, the transaction only involves you and the store, there are actually four parties involved: the store, the bank that the store uses to process transactions, the bank that issued your credit card, and you.
So, when you swipe your card, the bank that issued your credit card pays the bank that processed the transaction which, in turn, pays the store. This process boils down to the simple fact that your credit card issuer is lending you money that needs to be paid back.
And this is where we get to the way credit card companies make money. If you don’t pay off the full balance within the allotted grace period (generally a month or so), they will start charging interest. That interest will add up and you’ll end up paying more than the initial price of the item you took home from the store in the first page.
Now, that’s a pretty grown up explanation so, I’ll try to put it in a way that a child could understand.
A credit card is a promise between an individual and the credit card company. The company promises to lend money and the individual promises to pay it back. But, if the borrower doesn’t pay it back, the credit card company will charge them some extra money until the debt is paid off.
I hope that helps you, and your son, understand a little bit more exactly how credit cards work.
Jeffrey Schwartz is the Executive Director of Consolidated Credit Counseling Services of Canada and President of the Credit Association of Greater Toronto (CAGT).
If you have a question about a debt management program or just about finance in general, Jeff is here to help. Send us an email with your question to [email protected]. You’ll get the expert advice you need and your question may be featured here on our website.