How Credit Cards Work (Q&E)

Here is another “Quick and Easy” post. I’ll come back to money and banking a little later, as it’s getting into the weeds a bit.

Suppose Alice wants to buy a cake from a shop (which sells them for £5 each). She takes the cake to the till, Bob the shopkeeper checks the price, and he agrees that she can have the cake if she pays £5. Bob asks her how she wants to pay. There are several possibilities, including:

• Cash

• Debit card (or cheque)

• Credit card

Here’s a comparison of the 3 means of paying:

Cash

Paying by cash is quite simple. In recent decades, cash is a debt owed by the central bank (the Bank of England in the UK) to the holder of the banknote. So Alice transfers the debt asset to the shop by handing them the £5 note.

Buying cake with cash

Debit card (or cheque)

This is a pretty simple too. Suppose Alice has £200 in her bank account (the bank owes her £200). To pay, Alice sends an instruction to her bank (via the shop’s payment machine) to transfer £5 from her account to the shop’s account.

Buying cake with debit card

The transfer involves writing off £5 of the debt owed by the bank to Alice, and creating a new debt of £5 owed to the shop. So £5 has been transferred from Alice to the shop indirectly, via the bank.

Paying by cheque is essentially the same, except that Alice hands the shop a sheet of paper which instructs her bank to transfer £5 to the shop. (Alice signs the cheque to authorise the payment). A shop employee has to take the cheque to the bank so that it knows that it has to make the transfer. After checking that the signature matches the one which Alice gave them when she opened her bank account, the bank makes the transfer.

Credit card

Paying by credit card involves an extra step (or two), but it is still not hard to understand. Let’s assume she has been issued a credit card by her bank.

First Alice sends an instruction to the bank (via the shop’s payment machine) to pay the shop. But instead of Alice transferring money from her account, she is creating a new debt owed to the bank. At the same time, the bank transfers money to the shop’s bank account.¹

Buying cake with credit card

Notice the difference with a credit card: instead of writing off some of her deposit (green-to-pink arrow), Alice has a new debt (pink-to-green arrow).

All the transfers of net worth have already taken place at this point. All that remains is to settle the new credit card debt, for which Alice typically has up to a month to pay. Near the end of the month, the bank sends her a credit card bill, and she can then pay the bill using the money in her bank account.

Settling credit card debt

Alice writes off £5 of the contents of her bank account and the bank writes off the £5 credit card debt. As always, settling a debt has no effect on anyone’s raw net worth, because it reflects what would happen if everyone pays their debts.

Notice that the green-to-pink arrow from the bank to Alice undoes the creation of the credit card debt when she bought the cake, and all that is left is the same 3 arrows as in the debit card diagram above.

1. In practice, credit card issuers may actually batch together a number of card payments to the shop, and credit the shop’s bank account with the total only once every few days.