The Mechanics of How a Credit Card Works

A credit card allows individuals to borrow funds for purchases, offering convenience and flexibility. It functions as a short-term loan, where the cardholder repays the borrowed amount, often with interest, to the issuing financial institution. The credit card system involves a network of entities that facilitate these transactions. Understanding their roles and the transaction journey helps explain how credit cards operate.

The Core Players

The Cardholder is the individual who uses the credit card for purchases. The Merchant is the business that accepts credit card payments for goods or services.

The Issuer, also known as the issuing bank, provides the credit card to the cardholder and manages their account. The Acquirer, or acquiring bank, maintains a contractual relationship with the merchant to accept and process credit card transactions. Payment Networks, such as Visa, Mastercard, American Express, and Discover, connect these banks. These networks facilitate communication, set transaction rules, and ensure the secure transfer of information and funds. Some networks, like American Express and Discover, also act as both the issuer and the network.

The Transaction Flow

A credit card transaction begins when a cardholder makes a purchase.

Initially, the merchant’s point-of-sale (POS) system or online payment gateway sends an authorization request to their acquiring bank. This request contains details like the card number, expiration date, and transaction amount. The acquiring bank then forwards this request through the payment network to the issuing bank.

The issuing bank reviews the request, verifying the card’s validity, checking for sufficient funds or available credit, and assessing for potential fraud. If approved, the issuing bank places a temporary hold on the cardholder’s credit limit for the purchase amount, but funds are not immediately transferred. An approval or decline message is then sent back through the payment network to the acquiring bank and finally to the merchant. This authorization process typically takes only a few seconds.

Following authorization, the transaction moves to the clearing phase. Merchants group approved transactions into batches and send them to their acquiring bank, usually at the end of the business day. The acquiring bank then forwards these batched transactions to the payment network. The network routes each transaction to the corresponding issuing bank for verification.

The final step is settlement, where the actual transfer of funds occurs. The payment network debits the total amount from the issuing bank and credits it to the acquiring bank. The acquiring bank then deposits the funds into the merchant’s account, often deducting various processing fees. This ensures the merchant receives payment, and the cardholder’s account is updated. Settlement generally takes one to three business days after the clearing process.