What are credit cards and how do they work?

Most people use credit cards, but few of us give them more than a passing thought. Are you curious about how they work? Read on for an explanation of what they are, how they enable you to buy things, and how to make sure they work for you when you need them.

What is a credit card?

Physically, it’s a piece of plastic (or in some cases metal) with a name, a number, an expiration date and a CVV (Card Verification Value) code. These bits of information allow the card-issuing bank to identify incoming transactions, approve them, and post them to your account.

Most cards also contain a magnetic stripe, a chip, and in many cases a thin metal loop or coil inside the plastic that allows you to use the card with NFC (Near Field Contact) point of sale terminals in stores. Each of these components has been added over time to help facilitate faster and more secure transactions; without them, every credit card purchase would have to be made by manually entering the account information at checkout, much like when you buy something for the first time on a website or online store, and none of your payment info is saved.

In practical terms, the main function of a credit card is to help people buy things quickly and securely, and these innovations help meet both of those objectives by speeding up the act of transmitting the relevant information and removing the possibility for user error.

How do credit cards work?

As mentioned above, most modern credit cards can be used in a number of ways, and these can be broken out into three categories:

In-Person Usage Methods:

Swiping the magnetic stripe
inserting the chip end of the card into a reader
“Tapping” or holding the card near an NFC terminal

Online Usage Methods:

Manually entering the card number, expiration date, and CVV code (this is also how you can complete transactions by phone, although that is less common these days)
Pre-filling these values using card info saved in a digital wallet

Smartphone/Device Usage Methods:

Using 1st party digital wallet apps such as Apple Pay or Google Pay
Using 3rd party payment apps like Paypal, Venmo, or Cash App

While the method of using the card may vary by merchant and purchase type, the goal is the same, which is to pass the card info through the merchant, via the network (most commonly VISA or Mastercard) and back to the bank that issued the card, so they can approve the purchase. This all happens in real-time and usually takes only a few seconds, which is one of the reasons lots of customers and merchants prefer to use cards for the majority of their transactions.

Extra Credit Fact: Contrary to popular belief, VISA and Mastercard do not actually issue credit cards or manage/service card accounts; both of these duties are handled by credit card issuers, usually banks. Instead, VISA and Mastercard own and provide access to the networks that send the payment information back and forth from the merchants to the issuers. These networks provide the rails between merchants and issuers, with transaction data moving back and forth on (extremely fast and highly secure) trains between the stations. And for the experts out there: Discover and AMEX operate their own networks separate from VISA and MC, but they are different because they also issue and service their own cards.

What happens when credit cards don’t work?

We’ve all had that experience, from time to time, when we go to buy something with a credit card and instead of the purchase going through as expected, the terminal flashes “declined.” This can be frustrating for both merchants and customers, because it slows down the checkout process and often results in a negative customer experience as the customer fishes around for an alternate way to pay while shoppers behind them in line look on impatiently.

However, these points of friction usually have nothing to do with either the customer or the merchant specifically. Rather, card issuers may decline certain transactions because they appear not to fit into the customer’s previous spending patterns. This could be because the purchase is larger than normal (e.g. buying a big screen TV on a card that is normally just used for coffee and gas), occurring in a different location (e.g. if you are on vacation or traveling for business), or happening with unusually high frequency (e.g. several rounds of drinks and appetizers purchased at happy hour within a 60-minute window).

They do this because they want to limit fraudulent purchases on your card. So when something looks off, they want to make sure it’s really you making the purchase, and not someone else who may have found your lost card or obtained your card information illegally. This helps protect them from having to eat the cost of fraudulent purchases, and also saves you the hassle of having to watch out for those purchases yourself.

It’s a good system and it mostly works as intended, allowing you to buy what you need and stopping the bad guys from buying things on your account. But it does hit the occasional snag, which can cause headaches if not resolved quickly. Luckily there’s a solution for this too: most card issuers either require or allow you to opt in to receiving fraud alerts by text and/or email.

Set up credit card alerts to make your life easier

We would recommend taking advantage of whatever fraud alert system your issuer offers, and configuring the alerts to be sent to your phone via text. In most cases, this will allow you to be notified and respond within seconds whenever a purchase is flagged as suspicious or fraudulent.

Here’s how it works. With fraud alerts enabled, if a card issuer flags an attempted purchase as potentially fraudulent and declines it, they will send you an automated text and/or email asking you to confirm that it’s valid, often within just a few seconds of the transaction being declined. All you have to do is follow the prompt in the text or email (usually by responding ‘yes’ or ‘1’ in the text thread, or by clicking the “approve” button in the email) and they will authorize the purchase to go through. This system has the dual benefit of notifying you immediately when a real fraudulent purchase is identified–you may have lost your card and not realized it, or someone may have stolen your card info–and making it easy for you to report the purchase as fraudulent and request a new card & account number.

Why should you use credit cards?

As a method of payment, credit cards are great because they eliminate the need to carry cash, they speed up the checkout process for customers and merchants, and if they are lost or stolen, they can be quickly canceled and replaced with no financial impact to you, the customer.

If you still have doubts about whether credit cards are the best way to pay, we’ve summarized many of the key benefits in a bit more detail below:

No need to carry cash, change, or checks around when you shop, and no need to worry about carrying different currencies when traveling
Faster to use than cash and in most cases debit, due to not requiring a PIN
Compatible with digital wallets and payment apps, enabling you to pay via smartphone and other devices, as well as from certain browsers, without re-entering your card info multiple times or having to carry your physical card
Rewards cards pay you back for your spending, and allow you to rack up significant value (or a nice discount, if you prefer to think about it that way) on purchases you were going to make anyway
Zero Fraud Liability is standard on all US-issued credit cards, and ensures that you’re not responsible for any purchases made without your permission
Credit card statements can be used to show proof of purchase and payment, in the event that you need to return something or there’s a dispute about whether a bill, fee, or fine was paid on time
Most card issuers allow you to set up alerts for just about anything, making it easy to track and control the activity on your card
Most credit cards have a bunch of little-known perks called “Complementary Benefits” that can be very handy in certain situations. These include things like Rental Car Insurance, Purchase Protection, Return Protection, and various others. To learn more about how these work and how to take advantage of them, check out our post on Credit Card Complementary Benefits