How Credit Cards Work

Although phone companies, gas companies and department stores have their own numbering systems, ANSI Standard X4.13-1983 is the system used by most national credit card systems.

Here are what some of the numbers stand for.

The first digit in your credit card number, the major industry identifier (MII), signifies the system.

Here are the major MIIs, along with examples of the most popular cards using a particular number:

Most consumers will only have credit cards that start with one of these four numbers, unless they have store-specific credit cards, which follow different rules. The structure of the card number varies by system. For example, American Express card numbers start with 34 or 37; Discover with 65, 644, 6011.

A card's MII, plus the five digits following, are called the issuer identification number or the bank identification number. Together, these tell you which credit card company issued the card and what network it belongs to, plus indicate which benefits it carries for the cardholder. For example, the initial digits 414709 mean the card is a Capital One Signature Visa.

The next several digits before the final one, which generally range from seven to 10, comprise your individual account number. And that last digit? It's called the checksum, and lets people or computers know if the number is valid. This helps catch both numbers that are incorrectly entered and fake ones generated by scammers.

The stripe on the back of a credit card is a three-track magnetic stripe, often called a magstripe. The magstripe, which is very similar to cassette tape, contains encoded information about your account via tiny iron-based magnetic particles enclosed in a plastic-like film. Each particle is really a small bar magnet about 20-millionths of an inch long. Information can be "written" on a magstripe because the bar magnets can be magnetized in either a north or south pole direction.

If a magstripe reader — such as those within an ATM or at a checkout — isn't accepting your card, your problem is probably either a dirty or scratched magstripe, or one that has been erased. The most common causes for erased magstripes are exposure to magnets, like the small ones used to hold notes and pictures on a refrigerator, or exposure to a store's electronic article surveillance(EAS) tag demagnetizer.

Once you successfully swipe your card, your potential purchase is authenticated to help ensure it's really you who is using your card, not someone else. There are several types of authentication being used. Gas pumps often require inputting your ZIP code, for example, while online purchases may require a password or a code sent to your cellphone. Sometimes your card may be declined when traveling, as authentication may be based on location. So if you live in Chicago and charge most items in that region, but a charge suddenly pops up from a store in Alabama, that charge may fail to be authenticated.

One of the biggest downfalls to magstripe cards is that skimming devices on readers can capture your information, which thieves can then use to create fake new cards. But don't fret. Magstripes are being phased out of credit cards in favor of the more secure chip-based credit and contactless cards, with Mastercard leading the way. Starting in 2024, most new Mastercard credit and debit cards won't be required to have a stripe, with a complete phase-out by 2033.

Smart cards first debuted in France in the 1960s, but didn't take off right away because the cards didn't work with every reader. It wasn't until the 1990s that they became ubiquitous in France and all of Europe, when the global EMV chip became standard for the cards. (EMV stands for Europay, Mastercard and Visa.) The U.S. took much longer to pivot to smart cards, first using them in 2014. As of 2015, all U.S. merchants were required to accept EMV cards

A smart card has a microprocessor, or computer chip, built into it — the EMV chip. This allows it to encrypt its own information and interact with more types of readers. You use a smart card by inserting the chip end into a reader or by contactless payment, which involves holding your card near a contactless-enabled terminal. While many people refer to this latter method as tap-to-pay, you don't have to tap your card against the reader. You simply need to hold it close to the terminal. When you do so, information from your card travels to the reader via short-distance radio frequency. Thus, this method is sometimes called radio-frequency identification technology, or RFID.

While not all chip cards also offer contactless payment, most contactless cards also come with a readable chip. To figure out if your card offers contactless payment, look for its symbol on the back of the card: four curved lines that get bigger, like a WiFi sign tipped on its side.

Cryptography is essential to the functioning of these cards. The card and the card reader execute a sequence of encrypted sign/countersign-like exchanges to verify that each is dealing with a legitimate counterpart. And once this has been established, the transaction itself is carried out in encrypted form to prevent anyone, including the cardholder or the merchant whose card reader is involved, from "eavesdropping" on the exchange and later impersonating either party to defraud the system. Using the contactless system is faster than chip, swipe or cash payments — it often takes just a second or two.

Besides being secure, smart cards are capable of many kinds of transactions. For example, you can make purchases from your credit account, debit account or from a stored account value that's reloadable. The enhanced memory and processing capacity of the smart card is many times that of traditional magstripe cards, and can accommodate several different applications on a single card. It can also hold identification information, keep track of your participation in an affinity (loyalty) program and even provide access to your office. This means no more shuffling through cards in your wallet to find the right one — the smart card will be the only one you need!

Bluetooth cards such as Fuze are a new form of smart card beginning to emerge. This type involves the Bluetooth radio frequency, and lets you load up to 30 credit card numbers on it, along with their expiration dates and security codes. You can also load debit cards, gift cards, etc. Since Fuze connects to your phone remotely, you can erase the data on it if it's lost or stolen.

Americans are making some 20 percent of their retail purchases online, for a total of nearly $800 billion in 2020. While e-tailers (electronic retailers) would love these figures to keep climbing, consumers still have some worries about shopping online. Credit card fraud is always a threat, both on the internet and out in the real world. And hackers have found ways to steal credit card numbers from websites.

In 2019, Capital One admitted 100 million of its credit card applications were accessed by hackers, resulting in an $80 million fine. These are the kinds of stories that deflate consumer confidence in online credit card use. While internet companies and businesses with an online presence have taken responsibility for security breaches and resulting losses to credit card users, there's also the problem of identity thieves who use stolen credit cards to make online purchases. And while unfair or fraudulent practices by credit card companies are not commonplace, they do happen.

The good news is that consumers are protected by law. In the case of credit card fraud online or off, federal law limits your liability to a maximum of $50 of the amount stolen. Often, you don't have to pay a dime.

There are also a lot of simple steps you can take to protect yourself and your credit card. Here are several.

When you're applying for a credit card, make sure to pay close attention to the application form. Some forms provide a box that you can check to allow or disallow the selling of your information to mailing lists. You can also protect yourself by taking your name off the major credit bureaus' mailing lists.

One way to do this is to visit The Consumer Credit Reporting Industry Opt-Out Prescreen website, run by Experian, Equifax, TransUnion and Innovis, the four major consumer credit bureaus. On this site you can fill out a form and opt out of receiving pre-approved credit or insurance offers in the mail for a five-year period. You can also call 888-5-OPT-OUT (888-567-8688). If you'd like to permanently opt out, you must do so by mailing in a form that you can access online or request over the phone. When you write to these companies, you'll need to provide your complete name, mailing address, date of birth and Social Security number.

The Direct Marketing Association (DMA) also tracks consumers who prefer not to receive solicitations by mail or phone. Check their Consumer Assistance site for more information.

Next, let's look at all of the fine print that comes on credit card applications. What is it really saying?

Before we get into shopping for a card, let's go over some important terms you'll encounter in credit card brochures or discussions with potential lenders.

Experts say that if you're smart, you'll do the same kind of comparison shopping for a credit card that you do when you're looking for a mortgage or a car loan. This is a good idea because the choices you make can save you money. The process is not a simple one, so here are some tips to help you get started.

Do some research. There are plenty of places, both online and offline, where you can read about credit card offerings and even get credit card ratings. But since rates and plans change so often, it's a good idea to call the institutions you're interested in to confirm the information and to see if there are other plans that might work for you. A reliable and non-commercial resource is the Federal Reserve Board. Also, a lot of companies such as NerdWallet and Bankrate offer expert credit card reviews and recommendations.

Make a list. Make a list of credit card features that fit your financial needs and rank the features according to how you plan to use the card and pay your monthly bill.

Review the plans. Review all of the information you've gathered on different plans. Pay special attention to the APR — you want a low rate, but not necessarily the lowest. This is because, depending on your lifestyle and payment habits, you might benefit more from a card that offers cash rebates, discounts or frequent-flier miles.

Check out credit unions. Look into the possibility of joining a credit union. Credit unions are nonprofit and they have lower overhead so they can charge lower interest rates. Credit unions are newer to the credit industry, so they may be eager to generate credit card loans. However, you'll probably be required to open a share account or savings account to join. Credit unions typically are limited to a particular employer and its employees, but that's changing. Due to industry consolidations, credit unions are rapidly expanding their fields of membership. To find out which credit union you may be eligible to join, contact the Credit Union National Association (CUNA).

Compare plans. If you already have a credit card, be sure that you're making a good move before you swap cards. If you are a current cardholder and have a good credit rating, see if the institution that issued your card will lower your current rate. Don't be afraid to negotiate.

These are steps to take when deciding on a credit card. But your actual breadth of options depends in great part on your credit history.

If you've had credit problems, you might have to settle for a credit card with a slightly higher interest rate. If you have poor credit or no credit, some banks will issue you a secured credit card. This means that you deposit money into a savings account that acts as collateral against your credit line. A secured credit card's interest rate and/or associated fees may be high, but it offers you the convenience of a credit card while you work on rebuilding your credit. Secured cards are often the best option available to those with a bankruptcy in their past. Be sure to choose a secured card that pays you interest on your deposit.

If you have a very good credit score and would like a higher spending limit or extra perks, check into applying for a gold card or platinum card. These cards often carry steep annual fees (Amex's platinum card cost $695 per year in 2021) and may require you to pay off the balance in full every month. But depending upon your circumstances, the extra perks you receive for these fees may be worth it. Perks may include earning points on purchases toward a rewards program or even dining credits.

With all of this money getting spread around, and lots more of it out there, it's no wonder why most of us are constantly receiving notice that we're "pre-approved" for an endless stream of credit cards. There's got to be a catch ...

Sometimes there is, and it goes like this. Let's say you get an offer for a new credit card account with a pre-approved credit limit just slightly higher than the balance on your current card. The fine print many of us ignore could reveal an extremely high interest rate, plus a notation that by accepting the offer, you agree to transfer the entire balance of your other credit card account to this new, high-interest account.

Obviously, you don't want to pay more interest each month, so always read all of the details before signing on. And before you toss one of these offers into the garbage, shred it so that no one can fish it out and try to impersonate you.

No matter what kind of card and plan you choose, you should have access to the following information under the federal Truth in Lending Act so that you can compare one loan to another:

Card Types

There are three basic types of credit cards:

T&E cards and national house cards have the same terms and conditions no matter where you apply.

You may also be familiar with what is known as an affinity card. This card — typically a Mastercard or Visa — carries the logo of an organization in addition to the lender's emblem. Usually, these cardholders derive some benefit from using the card — maybe frequent-flyer miles or points toward merchandise. The organization solicits its members to get cards, with the idea of keeping the group's name in front of the cardholder. In addition to establishing brand loyalty, the organization receives some financial incentive (a fraction of the annual fee or the finance charge, or some small amount per transaction, or a combination of these) from the credit card company.

No one card is right for everyone. Basically, the right card for you is one that's accepted where you shop and charges you the smallest amount of money for the services you use. Almost any U.S. business or establishment that takes Mastercard also takes Visa, and vice versa. So if you only spend money in the United States, you probably don't need both.

Now we come to the core of the credit card selection process — which plan to choose. The costs and terms of your credit card plan can make a difference in how much you pay for the privilege of borrowing (which is what you're doing when you use a credit card).

If you always pay your monthly bill in full, the best type of card is one that has no annual fee and offers a grace period for paying your bill before finance charges kick in. If you don't always pay off your balance each month (and the majority of American cardholders fall into this category), be sure to look at the periodic rate that will be used to calculate the finance charge.

One of the major factors to consider in a credit card plan is whether it has a variable or fixed interest rate, as this can have a significant impact on what you pay to use your card.

Fixed-rate credit cards, which are generally only offered by credit unions and smaller banks, carry an interest rate that's not tied to the economy. The rate generally stays the same, although it may change based on your payment history and other factors. Since the rate is more predictable, you will have the advantage of knowing what your bill will be every month. Should your card issuer decide to raise the rate, the Truth in Lending Act requires the lender to provide at least 15 days'notice. In some states, there are laws that require more notice.

Credit cards with variable rates tie the interest rate to indices such as the prime rate; the one-, three- or six-month Treasury Bill rate; and the federal funds or Federal Reserve discount rate. Because they're tied to the economy, they can change over time. The card issuer doesn't have to notify you of rate changes.

Some financial analysts argue that because a fixed rate can be increased with only a 15-day notice, this plan is not that different from a variable-rate plan, which is subject to change at any time. They advise looking closely at both plans. If you do choose a variable-rate card, check to see if there are caps on how high or how low your interest rate can go. If the lowest variable rate possible on your card, for example, is 15.9 percent, and rates are trending downward, you may want to switch your card to another lender.

In addition to the interest rate, make sure to check out the terms listed in the issuer's disclosure form (usually a small, fine-print brochure). Specifically, look for the information on late charges and over-limit fees. Late fees may run as high as $29 the first time you're late making a payment (as of Jan. 1, 2020, federal law stipulates they can't be any higher), and up to $40 for subsequent infractions. And while over-limit fees are declining in usage, they may add another $25 or so to your bill.

Regardless of which card and plan you choose, you're going to be making payments. Let's take a look at how this is done.

Some credit cards require you to pay off all of your charges each month. As a benefit, they may offer no finance charge, and sometimes no maximum limit. (These might be more properly called charge cards.) Some types of American Express cards still use that model.

Most cards, including Visa, Mastercard and Discover, offer what is known as revolving credit. This means they let you carry a balance, on which they charge interest (finance charges), and they require you to make a minimum payment. The minimum payment is calculated differently by each card issuer. For example, Capital One charges either $25 or 1 percent of your new balance, plus interest (whichever amount is higher). Citibank, in contrast, charges whichever amount is higher: $35, or 1 or 1.5 percent of your new balance (depending on various circumstances, such as the terms of your credit card).

Here are three ways financial institutions calculate finance charges:

What you pay will vary depending on your balance, the interest rate and the way your finance charge is calculated. Here's an example that shows how much difference the interest rate can make in what you actually end up paying:

Late fees are used by pretty much all credit card issuers now. And increasingly, issuers are drastically raising interest rates (to as high as 29.99 percent) after a set number of late payments. Unfortunately, once you have a couple of late payments, the credit card company can charge you the inflated interest rate for the remaining life of the account. Try to avoid this — all credit card companies report your payment record to credit-reporting agencies, and even a few late payments could cause you problems when you try to buy a car or a house.

And as most of us know, even credit card companies make mistakes. The next section discusses how to make sure you're paying only what you owe.

One way to avoid billing errors and unjustified fees is to carefully go through your monthly credit card statement, making sure all the transactions are legitimate and that other charges — finance charges, late fees, etc. — are justified. Many times, a simple call to the credit card company will solve the problem.

If the credit card issuer doesn't agree there was a billing error, unjustified fee or other problem, you can use the Fair Credit Billing Act for assistance. Here's how to do so.

There are a number of nonprofit and noncommercial organizations that provide credit information and assistance to consumers, such as the National Consumer Law Center.

So, now that you know all this, let's find out what it takes to qualify for a credit card in the first place.

There's no way to know if you'll qualify for a credit card without doing some research. Some of the basic things that lenders look for include:

Once you qualify for a card, or several cards, there's always the chance that you'll end up spending more than you've got. A pretty good chance, actually. The next section discusses what you can do if you find yourself in credit card debt.

If your credit card balance has crept up to uncomfortable levels, you're not alone. Millions of Americans have learned the hard way how easy it is to use and abuse their credit cards, and how difficult it can be to pay them off. Here are some credit card debt elimination tips.

It's true that it's really easy to fall into the credit card trap, and not so easy to get out. But don't give up. There are nonprofit centers across the country that provide debt counseling and will even (at no or low charge) contact your credit card company and try to get your rate lowered or a different payment plan worked out.

For more information on credit cards and related topics, check out the links that follow.