How Credit Cards Work: The Benefits and the Catches

By Markets Fool.com

Credit cards have become ubiquitous in the developed world, and a common method of paying for everything from gas to groceries to the car we put them in.The majority of American adults have at least one, and many of us have several.According to the U.S. Census Bureau, there were an estimated 1.2 billion credit cards in the U.S. in 2012. Based on population estimates, that comes out to almost five credit cards for every adult in the country.

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But how do they work? What's in it for the merchants that accept them, and at what cost? What about the perks for cardholders, and how do they make money if you pay off your balance each month and don't pay interest? Most importantly, what's in it for you, the credit card user?

A funny thing happened at the restaurant ...
The credit card has been around since the 1920s, but the first "modern" card was (according to legend) born out of Diners Club co-founder Frank McNamara leaving his wallet in another suit, leaving him unable to pay for a dinner he hosted at a New York City restaurant in the late 1940s. The question, "How would the card have helped him if was in his wallet?" remains unanswered.

Nonetheless, the idea was born in 1950 and became Diner's Club, targeting the affluent and well-travelled.American Express Company began offering the charge card, which is now the core of its business, in 1958. Initially offered as a convenience for spending and traveling for the wealthy and business executives, it would be decades before the credit card became something most adults have.

As a matter of fact, the first Diner's Club and Amex cards weren't "credit" cards at all, but charge cards. The difference? With a charge card -- which still makes up a significant amount of American Express' business -- the account balance is due at the end of each billing cycle, and must be paid in full to remain in good standing. A credit card, on the other hand, allows you to carry a balance each month, and pay over time.

How different credit card companies operate
The core of credit card companies is their broad and pervasive networks that connect merchants and retailers to their financial systems. Whenever you use your card, the retailer pays a percentage of the transaction to the credit card company. The sheer popularity of the "big four" credit cards creates a "network effect," incentivizing merchants to accept the most popular cards.

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However, moving beyond the payment networks, credit card companies operate differently. For example, Visa andMasterCard primarilyoperate so-called "open-loop" payment networks. This is why your Visa or MasterCard actually is issued byBank of America,Citigroup, JPMorgan Chase, or some other bank that extends credit.

American Express and Discover Financial Services, on the other hand, operate the payment network as well as loan the money to their customers. This is known as a "closed-loop network."

There are also millions of "house" cards. This class of cards is branded to a specific retailer, and can only be used there.They are almost always issued by a third-party bank which manages the transactions and provides the credit, with the retailer sharing in the profits. Over the past decade "house" cards have become less popular, with retailers shifting toward a branded Visa or Mastercard, offering exclusive rewards that shoppers can use with the merchant.

How do credit card companies make money?
There are four sources of income for credit card companies: customer fees, finance charges, and interest, which are billed to the consumer directly, and transaction fees, which are paid by the merchant. The banks and Amex, which lend you money, can participate in all of those revenue sources, while Visa and MasterCard get paid transaction fees. For the sake of this conversation, we will focus on that subject.

Transaction fees are typically a percentage of each transaction. There are a number of moving parts in the middle here, depending on whether the merchant deals with a third-party merchant processor, the number of transactions they do, and the type of business they are in. In short, the merchant is billed these fees with each transaction, getting a "cut" of whatever you pay for a purchase.

What's in it for the merchants?
The fees can be quite high, and typically premium cards like Amex and Diners Club charge a premium versus Visa and MasterCard, which is why your favorite small local restaurant may not take Amex. But access to customers is the name of the game, so these fees have largely become a "cost of doing business" for many.

Digital wallets likeApplePay also rely on traditional credit card networks to function. The customer is still using a credit card with these new payment methods, and the transaction is still being processed by the credit card company. So while digital wallets may mean the "death" of the credit card, that's only in the physical sense. The credit card will just become virtual, and the payment networks could become even more important, especially in the developing world.

Reaping the benefits as a consumer
Credit card companies offer dozens of kinds of benefits and points programs, ranging from low (or even no) interest to cash back or points on certain kinds of purchases.

It can be overwhelming to figure out what's best for you, but the most important place to start is by looking at your spending habits. For example, if you travel a lot (and pay for it yourself), then a program that pays out the most rewards for travel-related purchases might be the best. On the other hand, a family of six may benefit from a card that offers the most cash-back on grocery store purchases.

The reality is, most people are probably best off by carrying two or even three cards that pay cash back for different categories, so you can maximize your rewards based on your top categories. For example, my family uses three cards for almost all of our purchases:

  • Travel
  • Gas, restaurants, and groceries
  • Purchases atAmazon.com

The three cards that we use give us the maximum cash back at each of these three categories, which make up almost all of our non-housing monthly spending. We even use one of the cards for several utility bills, to get a small 1% back even from those expenses each month.

Here's the most important thing: We pay the balance in fulleach month.

If you're going to carry a balance, then you're probably better off choosing a low-interest card, and paying the balance down. Many cards also offer an interest-free period, and often for balance transfers. However, be sure to compare the "transfer fee" they charge, which can range from 2%-10%. A card offering six months interest-free with a 10% transfer fee is essentially charging you a 20% annual rate. There are a lot of online resources that compare credit card programs, but I suggest you review more than one before picking a card or cards since these websites are compensated by the credit card companies to promote their cards.

At the end of the day, if you're diligent and responsible, credit card rewards programs can be like "free" money. But do the math before you assume one is the best program for you.

The article How Credit Cards Work: The Benefits and the Catches originally appeared on Fool.com.

Jason Hall owns shares of Amazon.com and American Express. The Motley Fool recommends Amazon.com, American Express, Bank of America, MasterCard, and Visa. The Motley Fool owns shares of Amazon.com, Bank of America, Citigroup Inc, JPMorgan Chase, MasterCard, and Visa. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.