How credit card works ? A simple explanation
When we use credit card, the bank bill us after 30 days and allow us to pay within 20 days. In this way, we can pay for a purchase after (and up to) 50 days of the date of purchase. In other words it simply means the bank give us 50 days interest free loan on our purchase. Then how does the bank get benefited from this ? Read a simple explanation of this system in the form of a conversation :
Priya: I want to buy a Sony digital camera costing Rs.20,000, but I don?t have any cash right now.
Raj: Why don?t you use your ICICI Bank credit card? Never heard them say ? Hum Hain Na ??
Priya: I am quite skeptic about using these cards. I pay using the card, get a bill after 30 days and pay after another 20 days. This is a maximum of 50 days interest free loan. Why does any bank do it?
If I borrow Rs.20,000 on personal loan at 11%.
Interest to be paid for 50 days = Rs. 20,000 * 11% * (50/365) = Rs. 301.40.
Here the bank is giving me a loan without interest when I use the credit card. Something is wrong somewhere!
Raj: Well? let me tell you how it works when you use your card to pay for the camera.
- You present your ICICI Bank credit card ? a VISA card.
- Sony World swipes your card on a machine provided by Citibank. Lets call Citibank ? the acquirer bank and the process of Sony World swiping the card on that machine ? requesting authorization .
- Citibank communicates with the card issuer ? ICICI Bank through VISA Network to check if the card is valid and has the required credit limit.
- ICICI Bank reviews and approves / declines which is communicated back to Sony World.
- You sign a receipt called Sales Draft given by Citibank. This is the obligation on your part to pay the money to ICICI Bank. Data on this receipt can be captured electronically and transmitted.
At the end of day or at the end of some period Sony World chooses:
- Sony World submits the receipt you signed to Citibank who pays Sony World the money. Sony World pays Citibank a fee called Merchant Discount . Let us say this is 6% of the sale value = 6% * 20,000 = Rs. 1200
- Citibank sends the receipt electronically to a Visa data center which in turn sends it to ICICI Bank.
- ICICI Bank transfers the money to a settlement bank which in turn transfers the funds to Citibank.
- Citibank pays ICICI Bank an Interchange Fee of 4% of the sale value = 4% * 20,000 = Rs. 800
- 20 to 50 days later ICICI Bank gets the money from you ? and you don?t pay the interest!!
Priya: Interesting! So Sony World pays more than the interest that I should have paid for the loan that I take. I, as a cardholder have the following benefits
1. Convenience of not having to carry cash.
2. Credit availability ? free of interest.
However what benefits does Sony World get for paying so much money? Isn?t it more profitable for them to take cash? They can save as much as Rs.1200.
Raj: Certainly. Some retail outlets offer you discounts if you pay by cash, don?t they?
However when you don?t count the money that you are spending, you tend to buy more! Cards encourage this ? called impulse purchase .
If you did not have access to credit, you would not have bought the camera this month ? or may be not any time soon either. By accepting cards, the merchant is actually extending you credit at the risk of the card issuer. He pays money to the banks to carry that risk.
Priya: So ICICI Bank uses this money to pay back to us when they announce 5% cash back. They insist that the Sales draft that I sign at the retailer should also be from ICICI Bank. This means they are saving on the Interchange Fee and also pay me a part of the Merchant Discount that they get.
Raj: Exactly! If you have noticed, ICICI Bank gives you the cash back in the next credit card statement. They keep the ?cash back? money for a maximum of 60 days before passing on a part to you. This accrues them interest too.
Say if ICICI Bank earns an interest of 6% per annum for the cash they carry ? they get Rs.1000 * 6% * (60/365) = Rs. 10
That is not huge, but money nevertheless. And when you consider that almost everyone in this city shops with a credit card these days, it is a big sum.
Priya: And that also explains why banks tie up with petrol pumps ? like ICICI Bank has tied up with HPCL and I could re-fuel there without having to pay the fuel surcharge of 2.5%. The card issuer and the acquiring bank is the same and that saves interchange fees.
Raj: Good! You seem to have figured out how it all works! Let me summarize:
All the numbers used to explain concepts in this article must be treated only as an example. Merchant Discounts may vary from bank to bank. Interchange Fee is regulated by VISA and MasterCard.
Source : This article is contributed by Madhusudan N Sunkara ( and send to me by a friend). A vitality Hire from IIM Ahmedabad, Madhusudan comes in with over 2 years of experience telecom. Madhusudan has previously worked with Hughes Software Systems . He joined IGSI in May 2005 and is currently working as a Business Analyst in the Global Function Point Delivery Center at FSS.