How Debit and Credit Cards Work: The Definitive Guide

how debit and credit cards work

This guide tackles a topic that so many of us are introduced to with little preparation — debit and credit cards.

Part of the reason why we don’t get a gentle introduction is that it’s not in the interest of credit card companies to educate their customers. They introduce cards when you’re most impressionable, like the first few days of college.

They give you the terms and conditions in microprint and include dozens of pages, virtually assuring that you won’t read every word. They add in counterintuitive business practices, like universal default and double-cycle billing, that appears to go against all conventional wisdom about borrowing.

They do this not because they’re trying to screw you, they’re doing it because their responsibility is to the shareholders of their company and the almighty dollar. They’re not trying to bankrupt you, but many aren’t going to hold your hand and, let’s be honest, we’re all adults capable of making our own decisions.

Here’s the beginner’s guide that should prepare you more than a hundred pages of 4 pt. font claiming to be terms and conditions!

What’s in this guide:

Different Types of Cards

Despite the title of the post, there are actually three, if not more, types of plastic “credit” cards.

A debit card is a plastic card with a magnetic strip that can be used by a consumer as a means of payment. Unlike a credit card, there is no line of credit, the debit card is linked to your checking account. Funds charged to a debit card are directly deducted from the bank account it is associated with.

An unsecured credit card is like a debit card except it’s linked to a line of unsecured credit with a bank. Credit cards bill monthly, with a grace period built in that lets the consumer borrow short-term credit between the time they make the purchase and when it is due, and balances can be carried over from month to month with interest. When I talk about credit cards, unless otherwise specified, I mean unsecured credit cards.

A secured credit card is more like a debit card than an unsecured credit card because you have to deposit funds into your secured credit card account. Funds charged to a secured credit card are deducted from that balance. Secured credit cards, which I won’t discuss much in this post, often have high fees because they are designed for low credit score customers who need them to rebuild their credit.

A charge card is similar to a credit card during transactions but consumers cannot carry a balance from month to month. They are required to pay off the balance on the card when due each month. Until recently, American Express was just a charge card. Only recently did they introduce consumer cards that let people carry balances from month to month.

Credit or Debit?

Think back to the last time you used your credit or debit card, chances are you were asked whether it was a credit or a debit card right? Ever wonder what the difference was? Thankfully we have readers like Joe because he explained the difference is fantastic detail:

The debit card holder who says “debit” will be prompted to use a PIN # and does not need to sign the receipt. The debit card holder who responds “credit” will be prompted to sign a receipt, not use a PIN #. Think of this second option as replacing a paper check. Either way, the money comes out of the cardholder’s checking account. The difference is in the fee structure for the merchant and the bank. The merchant asks the question “debit or credit” because they hope all the debit card customers will say debit and use their PIN #. This is an extremely inexpensive payment method which saves the store a lot of money.

Banks, on the other hand, will often offer all sorts of incentives or reward points to remind their debit card holders to sign for their purchases, which means the consumer would have to respond “credit” to the “debit or credit” query. This is because banks get a much larger percentage fee from the merchant when the card is processed as a credit card. This is a huge source of non-traditional revenue for banks of all sizes. Luckily, this is transparent to the consumer in most cases. I have only rarely heard of banks charging any fees on debit card use, and the purchases are debited from their accounts in either case.

Anatomy of a Credit Card

The basics of the credit card are simple, you have the credit card number on the front of the card, which can range from thirteen digits (some VISA cards) to sixteen digits (most cards). Underneath you’ll see your name, expiration date, and sometimes an opening date. On the back, the important parts are the magnetic strip, the signature panel, and the numbers printed on the signature panel.

Depending on which type of card you have, you’ll want to know where to find the Card Security Code (or Card Verification Value or Card Verification Code) number. The only number you will be able to read is the CVV2 or CVC2, that’s the four-digit number on the front of American Express cards and the three-digit right-most number on the signature panel on most other cards. Online stores will request this because it’s “proof” that you are in possession of the card (and they’ll have a picture of where to look). Incidentally, CVV1 or CVC1 is encoded onto that magnetic strip and read when the card is swiped.

Paying Back & Grace Periods

I recommend that you set up online account access for every one of your credit cards and that you setup online billpay. Each month, the credit card company will send you a statement and you’ll have a few weeks before payment is due. With online billpay, you can schedule payments so that they are deducted from your bank account a few days before the bill is due (that way you can continue to earn interest on your savings). With a paper bill, you have to mail in a check (that could get lost), you have to pay for postage, and you have to remember to mail it. Online also offers a second advantage, if you forget to pay, you can do it immediately and reduce your interest costs by the few days it takes the letter to go through the mail.

Debit cards don’t have grace periods because you aren’t borrowing any money. Credit cards offer a grace period between the day you charge and the day payment is due as long as you don’t carry a balance. If you carry balances from month to month, you don’t get the 25+ days of grace period given to people that don’t carry a balance. The reason for this is unclear other than it would force them to keep track of your balance as more than just one bucket of debt.


Here are some fees charged by these cards and how to prevent them:

  • Annual fee: Some credit cards will charge an annual fee and there’s no way around this, except to get a card without this fee. I personally believe you should not get a card with an annual fee unless there is a very compelling reason for it.
  • Late Payment Fee: If you fail to make your payment before the due date, be prepared for a late payment fee. The best way to fix this is to set up an ACH electronic payment link (so you can pay the same day if you discover your error) and continually set reminders for yourself. Put it on a calendar you look at frequently, set it in Outlook to remind you, and set your email address in the account to your primary address. Most importantly, when you see the reminder or the email, schedule the payment.
  • Over the Limit Fee: This is like the overdraft fee for a bank account, it’s when you exceed your credit limit on a credit card. The credit card company will usually deny the charge and charge you the fee. The only way to prevent this is to keep track of what your balance is and what your limit is.
  • Balance Transfer Fee: This is a fee charged for balance transfers and one you can avoid completely by avoiding balance transfers! It is very difficult to accidentally request a balance transfer so you don’t have to worry about that.
  • Cash Advance Fee: This is a fee charged for cash advances and, again, you avoid this by avoiding cash advances. However, unlike balance transfers, you can be hit by this fee if you try to withdraw cash from an ATM using your credit card. This fee is not charged to debit cards.

Joe’s back to tell us a little bit about debit cards and overdraft fees:

… debit cards are not as useful or convenient as we are made to believe. They are the single biggest cause of overdrafts in customers’ accounts, because almost no one carries a transaction register around to record all their daily debit card purchases, and it’s easy to lose track. Lots of small purchases do add up, and without overdraft protection can cause major problems and fees. Also, debit card purchases can be “pending” for 2-3 business days before actually “posting” to someone’s account. Add in a weekend or a bank holiday and now we’ve got stuff almost a week old out there!

Lastly, I’ve had customers on vacation who used debit cards to rent a car or reserve a hotel room, and then saw pending authorizations in the hundreds of dollars, which held the funds in their account so they couldn’t even use the ATM to take cash out of their account! These holds can take up to 7-9 days to come off the account. Much better to use a credit card, that way you’re just tying up your credit line, not your actual bank balance! Same with fraudulent transactions–until the investigation is complete, which can take 10 business days from the date you report the fraud, that money is gone from your checking account!

Reward Programs

A reward program is when a card will give you points, miles, or cash back based on your spending. Credit cards can afford to do this because they are charging stores and merchants a higher percentage to accept credit cards, with American Express and Discover charging the most (that’s why they’re less widely accepted). In most instances, they charge stores 2-3% and then pass on 1% to you in the form of rewards.

How can some cards offer 5% on certain spending categories? They offer 5% in certain categories to get a “share of wallet,” the term they use for the percentage of your total spending you put on their card. They are willing to lose 2-3% on the special 5% categories in order to get in your wallet so they can earn a profit on the regular categories.

How do I evaluate reward programs?

  1. Review your spending. Compare the categories they offer rewards on against where you do most of your spending. Get cards that match your big spenders and then a backup card for “everything else.”
  2. Check the rewards structure. 50% reward in points is worthless if they jack up the points cost of things in their rewards catalog. The easiest way to compare apples to apples is to see how much a gift card or a statement credit costs. On Citi’s Thank You Network, a $100 statement credit costs 14,500 points! At 1% rewards, you would need to spend – $14,500 to get the $100 statement credit, effectively reducing your reward percentage to 0.69%!
  3. Check the annual fee. Most cards nowadays don’t have an annual fee but many of the airline reward cards do, review the annual fee to get a better idea of how it reduces your spending. Let’s say you had a Citi card with a $50 annual fee, if you only spent $14,500 a year then you are effectively reducing your $100 statement credit down to $50. That reduces your 0.69% effective cash back to 0.34%!
  4. Check rewards limit. Some cards limit the rewards you can earn on special categories each month or limit the total rewards each year. Some Citi cards cap your rewards at $300, Discover’s gas card caps your monthly rewards on promotional categories to $20. These limits will reduce your rewards percentage because you stop earning above that cap.

Lost or Stolen Cards

If you discover your card is lost or stolen, call your issuer immediately. If you left it at a bar, don’t bother going back, just cancel and get a new card. The only reason why you should keep your card is if you can’t possibly do without it for a few days (like if you’re on vacation) or if you “lost” it on the mess that is your desk. If you left it at a bar, you have no idea who had access to it, who scanned your card and captured all the data, etc. You’ll be better off canceling it and waiting for a new one, both you and the credit card company will be better off.

What if you are the victim of some fraud? What if you see fraudulent charges on your account? Call your issuer and ask them about it. Don’t try to figure it out yourself, don’t look it up on the internet, don’t try to guess at what it is, and certainly don’t dismiss it. By calling, you notify them of something suspicious and you may get a definitive answer as to what it is. If it is fraudulent, well then you’re already on the phone with them.

The Fair Credit Billing Act (FCBA) governs credit card loss and fraudulent use. By the FCBA, you are liable for only $50 per card if you discover the loss or theft after the charge occurs. If the thief buys $20,000 of home theater equipment on your card, you’re liable for only $50. If you discover the loss before they are used, you are not responsible for a cent. This is why reporting them lost ASAP is crucial. If you never lost the card in the first place and someone simply stole the number, you’re not liable for a cent.

The Electronic Fund Transfer Act governs debit card loss and fraudulent use (and ATM use, etc, everything dealing with debit cards). Here the law is slightly different but shares one important common directive – if you report the loss of your ATM or debit card before it’s used, you are not liable for unauthorized use. If you discover the loss or theft afterward, your liability is based on the amount of time that passes after the statement on which the authorized charge appears is mailed to you. If the loss involves only your debit card’s number, you are only liable for unauthorized activity after 60 days following the mailing of the statement.

  • Loss reported before unauthorized use: $0
  • Loss reported within 2 business days: $50
  • Loss reported after 2 business days: $500
  • After 60 days: Unlimited liability

One unspoken distinction between credit cards and debit cards when it comes to fraud is enormous. When your credit card is fraudulently charged, you temporarily lose access to a line of credit. Losing access to that line of credit will likely not affect you too much. When your debit card is fraudulently charged, you temporarily lose access to the funds in your checking account (at least the amount of the fraudulent charge) and that can become a massive headache. Heck, I’ve heard of stories where people have typed in the wrong charges ($19.50 becomes $195.00) and the deluge of overdraft and rejected charges (with their enormous fees) can break someone’s financial infrastructure. This is the main reason why I almost never use debit cards.

Finally, some issuers offer a higher level of protection over the legal requirements. For example, all VISA cards at protected by their VISA Security Program’s Zero Liability section. All VISA cards, debit or credit, are protected such that you will not be held liable for unauthorized purchases made with your card or account information. There are some terms and conditions (US issued cards only, doesn’t apply to ATM transactions, etc.) but other issuers and processors may have similar guarantees. Again, check with the issuer to find out for certain.

That’s It!

Despite the somewhat basic nature of the information above, the vast majority of people don’t know it because we have never had a reason to know it. I rarely use debit cards so until I researched it, I didn’t know what the liability limits were. Fortunately, you don’t have to remember it because it’s all written down here. Bookmark it, send it to your friends, whatever you want, but let me know if there is something I missed because I will personally turn to this page the next time I need to refresh myself on the basics of debit and credit cards.

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