How does credit card interest work?

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Brief introduction of a credit card: A credit card has become a normal instrument of settling financial transactions in today’s times. This is a wonderful piece of invention which, if judiciously used can result in tremendous benefit to the user. Now the question which may arise that, if this is so wonderful an instrument, how do the banks offering this facility make ends meet? Hence it becomes imperative that one should understand as to how the whole system works.

Parties involved in a credit card transaction: In any credit card transaction there are a minimum of four parties involved. One is the purchaser and the second one is the business enterprise. Each of these parties has their bankers standing right behind them. This makes it four, isn’t it?

Basic functioning of a credit card: Let us now understand the basics of a credit card transaction. One goes to a merchant establishment to purchase an article of one’s choice. When the time for payment arrives, a credit card is swiped on a machine known as a credit card swiping machine. This machine has been provided to the merchant establishment by his banker. This machine is linked to his account with his banker. Every credit card has the details of the holder embedded in the instrument itself either in the form of a magnetic strip or in the form of a Subscriber Identification Module card (SIM card). These details include the name of the bank account of the customer is held, his account number, the sanctioned limit as well as the available drawing power on the card at that particular moment. The moment the card is swiped, these details are accessed by both the banks and depending upon the veracity of the claim, it is honored or rejected as the case may be. Once the claim is honored, the account of the customer is debited and the account of the merchant gets credited immediately and thus the transaction is deemed to be complete. This happens in an instant, thanks to the quality of telecommunication nowadays.

Concept of Minimum amount due: The card issuing bank now has to claim this amount from its client as it had offered a credit based upon the sanctioned limit. Each bank has a pre-determined billing day when the transactions are billed with payment of the same expected by a date known as the due date. The customer has the option of paying the entire dues by the due date, or effects a part payment, subject to the extent of the “minimum amount due”. This “minimum amount due” is usually 5% of the total amount due.

Methodology of charging interest on a credit card account: Once the entire payment is made on or before the due date, there is no question of charging any interest. It is only in cases of part payment that banks have a right to levy an interest on the balance amount due right from the date of the transaction to the date of actual payment. The rate of interest charged by banks varies from bank to bank but in any case is not less than 3% per month which in effect makes it 36% per annum. The limit is kept alive as long as the minimum amount due is paid. It must be noted that in such cases, every subsequent transaction too attracts the interest at the decided rates irrespective of date of transaction. Kindly note that the interest free period ceases to exist in card accounts where the part payment of dues occurs. Now the banks start charging interest on daily balance system, meaning as and when one pays off a certain sum of money towards the dues, the interest charged gets adjusted. This interest is charged on a compounding basis. Over and above this, the banks start charging late payment fees. This goes on and on till the entire dues are paid off. Once the entire dues are cleared, the interest free period automatically gets restored.

Conclusion: This can be explained by means of a table, but paucity of space has restricted this method of explanation. Now it should be clear that the credit card is one of the most expensive financial instruments in the market.

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