The credit card system is one of the most successful creations in the history of finance. Using a simple yet ingenious tool, it allows anyone with an account to borrow money up to a certain limit and repay it over time at a relatively low interest rate.
The idea behind this arrangement is that borrowing against your future income will allow you to obtain goods and services today. This increases the overall demand for goods and services, also known as economic activity, therefore benefiting everyone (including people who borrow money).
However, if this system is left unregulated it can lead to debt traps (where debtors are unable to repay their debts) and limiting credit access to those who actually need it.
This has led to the creation of a complex and interconnected system in which an incredible amount of information is processed every second.
We will start with how credit cards work , then we’ll explain what happens when you swipe your card at the till, finally we’ll discuss how transactions are actually verified. So how does a credit card work? The easiest way to understand this process is to compare it to an old fashioned shop. In this system, the customer walks into a store and picks out some items they want to buy. The total cost of all their purchases is calculated and they are required to pay that exact amount in cash.
In a credit card transaction, you give your credit card (a physical object) to a merchant who will record the details of the purchase and send them over to a financial institution (the issuer).
The issuer then decides whether or not the transaction is valid based on the available information. If it’s all good, they will credit your account with some money and debit their own account accordingly.
Any outstanding balance you have will be due in full when your monthly bill arrives.
A credit card is a plastic rectangle containing some information about you, the issuer and how you can use it to spend money. The most common ones have your name written on them and include a 16 digit number printed horizontally in the bottom right corner of the front side of the card. That number is unique to that specific card and doesn’t change over time.
The name of the cardholder is also printed on the front side, right next to said number.
The left edge of the card contains a magnetic strip which encodes your information about you and can be read by any payment terminal which supports that technology.
These strips are different from one country to the other but it is generally possible to find terminals which use more than one standard.
The back side of the card contains your name, an expiry date and sometimes other useful information printed in different places.
The right edge has another set of numbers printed on it called PAN or primary account number. This number can be used by merchants to look up your record when you swipe your card to pay for something.
The numbers on the left edge are used by merchants to determine how much money they can withdraw from your account, while the ones on the right are used by you to see how much remains in your account. These two numbers must be equal at all times because otherwise it would mean that either your or the merchant made a mistake when processing the transaction.
And that’s basically it. A credit card is nothing more than an identification document (the PAN) and a way to access your account information (the number on the right edge).