article courtesy of: www.howstuffworks.com
| Have you ever stood behind someone in line at the store
and watched him shuffle through a stack of what must be at least 10 credit
cards? Consumers with this many cards are still in the minority, but experts
say that the majority of U.S. citizens have at least one credit card --
and usually two or three. It's true that credit cards have become important
sources of identification -- if you want to rent a car, for example, you
really need a major credit card. And used wisely, a credit card can provide
convenience and allow you to make purchases with nearly a month to pay
for them before finance charges kick in.
That sounds good, in theory. But in reality, many consumers are unable to take advantage of these benefits because they carry a balance on their credit card from month to month, paying finance charges that can go up to a whopping 23 percent. Many find it hard to resist using the old "plastic" for impulse purchases or buying things they really can't afford. The numbers are striking: In 1999, American consumers charged about $1.2 trillion on their general-purpose credit cards. In this edition of HowStuffWorks, we'll look at the credit card -- how it works both financially and technically, and we'll offer tips on how to shop for a credit card. (Experts say this should be a project on the scale of shopping for a car loan or mortgage!) We'll also describe the different credit-card plans available, talk about your credit history and how that might affect your card options, and discuss how to avoid credit-card fraud -- both online and in the real world. A Bit of History The first universal credit card -- one that could be used at a variety of stores and businesses -- was introduced by Diners Club, Inc., in 1950. With this system, the credit-card company charged cardholders an annual fee and billed them on a monthly or yearly basis. Another major universal card -- "Don't leave home without it!" -- was established in 1958 by the American Express company. Later came the bank credit-card system. Under this plan, the bank credits the account of the merchant as sales slips are received (this meant merchants were paid quickly -- something they loved!) and assembles charges to be billed to the cardholder at the end of the billing period. The cardholder, in turn, pays the bank either the entire balance or in monthly installments with interest (sometimes called carrying charges). The first national bank plan was BankAmericard, which was started on a statewide basis in 1959 by the Bank of America in California. This system was licensed in other states starting in 1966, and was renamed Visa in 1976. Other major bank cards followed, including MasterCard, formerly Master Charge. In order to offer expanded services, such as meals and lodging, many smaller banks that earlier offered credit cards on a local or regional basis formed relationships with large national or international banks. Now we know where credit cards began. Ever wonder what the numbers
on your credit card mean? Let's find out! By the Numbers Here are what some of the numbers stand for: The first digit in your credit-card number signifies the system: The Stripe The magstripe can be "written" because the tiny bar magnets can be magnetized in either a north or south pole direction. The magstripe on the back of the card is very similar to a piece of cassette tape (see How Cassette Tapes Work for details). A magstripe reader (you may have seen one hooked to someone's PC at a bazaar or fair) can understand the information on the three-track stripe. If the ATM isn't accepting your card, your problem is probably either: A dirty or scratched magstripe Track one is 210 bits per inch (bpi), and holds 79 6-bit plus parity
bit read-only characters. The information on track one is contained in two formats: A, which is reserved for proprietary use of the card issuer, and B, which includes the following: Start sentinel - one character The format for track two, developed by the banking industry, is as follows: Start sentinel - one character There are three basic methods for determining whether your credit card will pay for what you're charging: Merchants with few transactions each month do voice authentication using a touch-tone phone. Electronic data capture (EDC) magstripe-card swipe terminals are becoming more common -- so is swiping your own card at the checkout. Virtual terminals on the Internet This is how it works: After you or the cashier swipes your credit card through a reader, the EDC software at the point-of-sale (POS) terminal dials a stored telephone number via a modem to call an acquirer. An acquirer is an organization that collects credit-authentication requests from merchants and provides the merchants with a payment guarantee. When the acquirer company gets the credit-card authentication request, it checks the transaction for validity and the record on the magstripe for: Merchant ID The PIN is not on the card -- it is encrypted (hidden in code) in a database. (For example, before you get cash from an ATM, the ATM encrypts the PIN and sends it to the database to see if there is a match.) The PIN can be either in the bank's computers in an encrypted form (as a cipher) or encrypted on the card itself. The transformation used in this type of cryptography is called one-way. This means that it's easy to compute a cipher given the bank's key and the customer's PIN, but not computationally feasible to obtain the plain-text PIN from the cipher, even if the key is known. This feature was designed to protect the cardholder from being impersonated by someone who has access to the bank's computer files. Likewise, the communications between the ATM and the bank's central computer are encrypted to prevent would-be thieves from tapping into the phone lines, recording the signals sent to the ATM to authorize the dispensing of cash and then feeding the same signals to the ATM to trick it into unauthorized dispensing of cash. If this isn't enough protection to ease your mind, there are now cards
that utilize even more security measures than your conventional credit
card: Smart Cards. The "smart" credit card is an innovative application that involves all aspects of cryptography (secret codes), not just the authentication we described in the last section. A Smart Card has a microprocessor built into the card itself. Cryptography is essential to the functioning of these cards in several ways: The user must corroborate his identity to the card each time a transaction is made, in much the same way that a PIN is used with an ATM. 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. 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. This elaborate protocol is conducted in such a way that it is invisible to the user, except for the necessity of entering a PIN to begin the transaction. Smart Cards first saw general use in France in 1984. They are now hot commodities that are expected to replace the simple plastic cards most of us use now. Visa and MasterCard are leading the way in the United States with their Smart Card technologies. The chips in these cards are capable of many kinds of transactions. For example, you could 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 magnetic-stripe 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 or 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! Experts say that internationally accepted Smart Cards will be increasingly
available over the next several years. Many parts of the world already
use them, but their reach is limited. The Smart Card will eventually
be available to anyone who wants one, but for now, it's only available
to those participating in special programs. Your financial institution
will contact you directly regarding new chip-enhanced services when
they're available in your area. (If you're able to participate in one
of these programs, you will receive your Smart Card from your bank or
credit union, credit-card issuer or bank-card association.) Online Safety These are the kinds of stories that deflate consumer confidence. Some e-tailers blame consumer reluctance on the inability in cyberspace to make the kind of personal contact that a shopper gets when he looks into the eyes of a store merchant. Experts say that this kind of comfort level will be boosted when online payment methods and security measures are standardized -- much as they are in the retail and mail-order industries. While Internet companies have taken responsibility for security breaches and resulting losses to credit-card users, there remains the growing problem of people who use stolen credit cards to make purchases on the Internet. 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 case of credit-card fraud online or off, you are only liable for a maximum of $50 of the amount stolen. And fortunately, the Federal Trade Commission (FTC) and the media are watching closely. The FTC recently ordered Trans Union credit-reporting bureau to stop selling "sensitive" consumer data, on 160 million Americans, to junk-mail producers. The FTC charged that Trans Union violated the Fair Credit Reporting Act by selling consumer information to target marketers who lack any of the allowable purposes listed under the act. Trans Union denies that it sells information that could affect customers' credit rating or breach customer confidentiality; it appealed the FTC's ruling, but lost. If the mailing-list issue bothers you -- and it bothers most of us -- pay attention when you're completing that credit-card application. Some application forms now 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 credit bureaus' mailing lists. When you write to these companies, include your complete name, name variations and mailing address, Social Security number and signature and state clearly that you want your name removed from their mailing lists. You can write or call either of these major reporting bureaus and they will contact the other major bureaus with your request: Experian Consumer Opt Out, 701 Experian Parkway, Allen, Texas, 75013;
1-800-353-0809 These tips are important and universal: Sign your card -- as soon as you receive it! (Obviously, this is only as effective as the clerk who's checking it.) When you use your card at an ATM, enter your PIN in such a way that no one can easily memorize your keystrokes. Don't leave your receipt behind at the ATM. Your PIN and account number from a discarded receipt could make you vulnerable to credit-card fraud. Also, don't throw out your credit-card statement, receipts or carbons without first shredding them!
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: Annual fee - A flat, yearly charge similar to a membership fee Many companies offer "no annual fee" cards today, and lenders who do charge annual fees are often willing to waive them to keep your business.
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 -- here are some tips that should 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.
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; they are non-profit, have lower overhead and so charge lower
interest rates (an average of 13.14 percent currently on a fixed-rate
card). Credit unions are newer to the credit industry so they are eager
to generate credit-card loans. However, you'll probably be required
to open a share account or savings account to join.
Credit Issues On the other hand, if you have a very good credit rating and would
like a higher limit ($5,000 or more), check into applying for a gold
card at the same interest rates but with a slightly higher annual fee.
Most gold cards require that your annual income be at least $35,000,
and platinum cards -- even higher! Pre-approved? A word of caution about those "pre-approved" card offers you get in the mail: You may get an offer for a new credit-card account with a pre-approved credit limit just slightly higher than your balance on your current card. The fine print could reveal an extremely high interest rate and also state that, by accepting the offer, you agree to transfer the entire balance of your other credit-card account to the new, high-interest account. This is a trick, since you would never consciously choose to pay more interest each month. Read everything carefully so that you don't fall into this trap. And before you toss this offer 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: Finance charges in dollars and as an annual percentage rate (APR) There are basically three types of credit cards: Bank cards, issued by banks (for example, Visa, MasterCard and Discover Card) Travel and entertainment (T&E) cards, such as American Express and Diners Club House cards that are good only in one chain of stores (Sears is the biggest one of these, followed by the oil companies, phone companies and local department stores.) T&E cards and national house cards have the same terms and conditions wherever 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 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). In the disclosure form from the credit-card issuer (usually a small, fine-print brochure), look closely at the credit terms we discussed earlier. Don't forget about specifics like late charges (usually $15 to $30) and over-the-limit fees (around $20 to $25). Consider these factors along with how you pay your bills each month. For example, 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 seven out of 10 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
is has a variable or fixed interest rate. The next section discusses
the details of this distinction. Variable vs. Fixed Rate Once the interest rate corresponding to the index has been identified, the credit-card issuer then adds a number of percentage points -- called the margin -- to this index rate to come up with the rate the consumer will be charged. In some cases, the issuer might choose to use another formula to determine the rate to be charged. These issuers multiply the index or index plus the margin by another number, the "multiple," to calculate the rate. Fixed Rate If your rate is fixed, the Truth in Lending Act requires the lender to provide at least 15 days notice before raising the rate. In some states, there are laws that require more notice. 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. Few experts will argue with the fact that a low interest rate is a
good thing. To illustrate the importance of a low interest rate, let's
look at a simple example of how much your annual savings might be if
you switch to a credit-card plan with a lower interest rate and no annual
fee. In our example, the average monthly balance carried forward equals
$2,500, which is about the national average for consumers with credit-card
debt. Total annual savings in this example -- $120. Average monthly balance $2,500 $2,500 APR 0.18 0.14 Annual finance charges $450 $350 Annual fee $20 $0 Total cost $470 $350 Regardless of which plan you choose, you're going to be making payments. Let's take a look at how this is done. Paying the Bill Adjusted balance -- This system, which consumer experts say favors
the cardholder, takes the balance from your previous statement, adds
new charges, subtracts the payment you made and then multiplies this
number by the monthly interest rate. High-rate card: Suppose you charge $1,000 on a 23.99-percent credit
card. After that, you make no further charges and pay only the minimum
each month. The payment will start at $51 and slowly work its way down
to $10. You'll make 77 payments over the next six years and five months.
By then, you will have paid $573.59 in interest for your credit privilege.
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 or over-the-limit charges -- are justified. The Fair Credit Billing Act applies to credit card and charge accounts and to overdraft checking (but not to checks or debit cards). You can use this act to defend against billing errors, unauthorized use of your account, goods or services charged to your account but not received or not provided as promised, and charges for which you request an explanation or written proof of purchase. Here are some important steps to take when you encounter one of these problems: Write to your card issuer or creditor within 60 days after the first
bill containing the disputed charge is mailed to you. (Even if more
than 60 days has passed since you were billed for the item, you still
might be able to dispute the charge if you only recently learned about
the problem.) article courtesy of: www.howstuffworks.com
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