Credit card companies make money by charging interest on account balances and by levying an array of fees on both cardholders and merchants. These fees may apply to a variety of transactions, though these conditions can vary widely from one credit card offer to the next. But how do these sources of revenue translate into the enormous profits enjoyed by the major credit card networks and card issuers?
Well, that depends on you…the cardholder. The better you manage your own credit spending and repayment obligations, the less money you’ll ultimately contribute to the bottom line for your card card provider. While credit lending is a generally profitable enterprise, it’s fair to say that credit card companies make much of their money from less-than-savvy credit card users. Your goal is to avoid being among them. Take a look at these Ten Common Credit Card Mistakes and How to Avoid Making Them.
Or read on to find out exactly how credit card companies make their money (and how you can keep more of your money in your pocket).
How do credit card companies work?
In the simplest terms, credit card companies work by giving users access to lines of credit for spending and cash advances. Credit card networks provide the service of processing credit-based transactions, and consequently processing fees and interest charges connected to user accounts on behalf of lenders, or credit issuers. Credit card networks also process transaction fees from merchants, who must pay for the right to process credit card payments over a given network.
There are four major credit card networks—Visa, Mastercard, Discovery, and American Express. Each of these networks is responsible for the processing and technical aspects of facilitating credit card transactions.
According to Experian, two of these networks, Discovery and American Express, also function as card issuers. Card issuers are the financial institutions responsible for providing the funds to back credit card purchases. Visa and Mastercard function only as credit card networks, and work in direct partnership with card issuers such as Chase, Citi or Capital One.
In this equation, the card holder is essentially a borrower with the responsibility to repay a loan to the card issuer.
How do credit card companies make money?
Credit card companies make their money through a combination of fees, interest charges, and merchant charges.
Most credit card accounts come with an array of both inbuilt fees and fees related to certain types of transactions. The fees that you pay will usually be specific to your type of account. For instance, those with poor credit may pay higher fees for access to credit spending. Alternatively, credit card offers with generous rewards programs may also charge higher-than-average fees. The most common types of fees include:
- Annual Fees: Some credit offers come with annual fees, especially accounts with generous rewards and benefits, and accounts made available to “subprime” borrowers, or those with poor credit.
- Penalties For Late Payment: Failing to pay your monthly bill on time will typically result in penalty fees. In 2020, $12 billion, or 7 percent of total credit card revenues came from penalty fees.
- Balance Transfer Fees: Though some cards may offer 0% interest repayment promos that make them attractive for balance transfer, this transfer may come with a processing fee.
- Cash Advance Charges: Getting a cash advance will typically be the costliest transaction you’ll make using your credit card. Fees for cash advances are typically high, and may include both a flat fee and a percentage-based fee per transaction as well as a heightened interest rate for repayment.
Nerdwallet notes that the vast majority of the revenue earned by credit card issuers comes from interest payments. The Consumer Financial Protection board notes that this is where credit card companies draw their greatest profits.
In essence, credit cards serve as a source of lending. And as with most loans from financial institutions, you must pay interest on your principal loan balance. The rate of interest will depend on your credit card offer. In many cases, the better your credit score, the lower the borrower interest rate for which you will qualify.
According to Value Penguin, “The periodic rate is the annual percentage rate (APR) divided by 365. In the United States, the average credit card interest rate paid by interest-bearing accounts is 19.33%.”
The good news is that this interest rate is based entirely on the balance that you carry forward every month. So the lower your balance, the less you’ll pay in interest. In fact, you can avoid interest charges altogether by paying your balance down in full, on time, every month.
Of course, there is substantial numerical evidence that many credit card users do carry balances forward from month to month. This results in handsome profits for card issuers. Chase Bank alone cleared more than $51.66 billion in interest charges in 2019.
Value Penguin notes that, behind interest charges, merchant fees amount to the second greatest source of revenue for credit card companies. Every time a merchant accepts a credit card payment, a percentage of that sale is transferred directly to the card issuer. This is referred to as the interchange fee. This fee constitutes an enormous source of profit for card issuers every year. Once again at the top of the list, card issuer Chase Bank pulled in well over $20 billion through interchange fees in 2019, according to Value Penguin.
How can you spend less on credit cards?
So that’s how credit card companies make their money. But what can you do to avoid becoming a major contributor to your card issuer’s bottom line? There are some key steps that you can take to build credit while keeping more money in your pocket:
Look for credit card offers with minimal fees. If possible, find an offer for a card with no balance transfer fees or annual fees. Nerdwallet makes an exception here though, advising that you should only apply for a credit card offer with an annual fee if “the rewards you’ll get from the card will exceed the cost. Remember that rewards and sign-up bonuses can put money in your pocket, but card fees and interest can eat right through it.” Do the math before choosing a high-reward, high-fee card.
Don’t Carry a Balance
Always pay your balance in full and on time every month. This is the easiest way to avoid interest charges. If you must carry a balance, be sure that you pay more than the minimum due each month. Naturally, the lower your balance, the less you’ll pay in interest.
Stay Away from Cash Advances
Once again, the cash advance is likely the most expensive transaction you can make using a credit card. The fee structure surrounding cash advances is designed to be onerous. You may pay both a flat transaction fee for receiving a cash advance and an additional percentage-based fee (usually between 2-5%) on the total sum borrowed. Not only that, but you would likely also pay a higher interest rate on the resulting balance than you would on a credit card purchase balance. Cash advances should be avoided in all but the most desperate situations.
Have Good Credit
This is the number one thing you can do to minimize the amount that ultimately goes from your pockets into the deep coffers of credit card networks and issuers. Credit cards that offer 0% interest promotional repayment periods typically reserve these offers for borrowers with good to excellent credit scores. The same is true for credit card offers with extensive rewards programs and $0 in annual fees. A borrower with a lesser credit score will typically be limited to credit card offers with higher interest rates on repayment, annual fees, and fees on activities like balance transfer.
Obviously, it’s easy to suggest having good credit, but it’s a lot harder to actually achieve it if you’ve struggled to pay down balances, manage debt, or stay on payment schedules in the past. So before you even consider opening a new credit card, we would strongly advise taking a few important steps to improve your qualifications for attractive offers. Jump from here to our guide on How to repair your credit.