How Credit Card Companies Make Money
For many of us, whenever we encounter something that looks like a good deal we start to get a little suspicious. We’re all used to self-interest playing a critical role when it comes to financial dealings, so if we can’t see how the other party comes to benefit, an otherwise enticing transaction can start to sour. However, if the mistake is on our end and the other party just has a way of making money that we don’t quite get, then we can run the risk of missing out on a really good deal.
This can often be the case with credit card offers. The world of credit is complicated, with lots of moving pieces and confusing financial terms, so it’s normal for the average person to be confused about exactly how credit card companies can work. This confusion can breed suspicion — we start to wonder just how credit card companies benefit from offering us things like awesome travel perks and, when we can’t find an answer, we start to mistrust the offers themselves.
All in all, this is a good instinct to have, but if you don’t manage it well, you can end up losing a lot of money in the long run by missing out on great deals that you didn’t understand. By wrapping our heads around the profit models that credit card companies use, we can develop the skills to tell which offers are legitimately great deals for all parties involved, boosting our confidence when we sign up for a credit card.
Income for Credit Card Companies
Most credit card companies have three main sources of income. These are:
- Merchant Fees
- Interest and Late Fees
- Cardholder Fees
That’s all there is to it. When you understand how each of these factors works and how they affect you as the cardholder, you can be sure that you’re getting the best deal available on a credit card.
Have you ever been to a store that only accepts debit cards, checks, or cash? If you have, you’ve probably wondered why they don’t accept credit cards. After all, credit cards are so ubiquitous, don’t they lose some business by turning away customers who want to pay with their credit card?
You’re probably right. These businesses do lose some business, but they’ve crunched the numbers for their specific dealings and found out that they can save more money by not accepting credit cards. This works because credit cards companies will ask for fees from businesses that want to work with them.
Think of it like this: I’ve got a lemonade stand. However, a lot of my potential customers don’t carry cash and they’re not comfortable giving me a debit card. If I accepted credit card payments, then I could have a lot more customers buying my lemonade. The credit card company knows this, and they need to make money themselves, so we make a deal. They’ll run transactions through my lemonade stand that are made with their credit cards, thereby increasing the number of customers I have, and I’ll pay them for that privilege. For my lemonade stand — and many other businesses — this is a win-win.
Things can get a little complicated here for businesses. Many credit card companies will either want to charge me, as the lemonade stand owner, a fee per each transaction that I make with their cards or a flat fee that will let my customers use that card however many times they want. My lemonade stand is pretty small, so I just want to pay a small percentage of each transaction. However, if I start selling a lot more lemonade, I might get a better deal by negotiating a flat fee with that credit card provider.
Here’s what’s so great about credit card companies making money in this way: they’re going to offer great deals to you so that they can get more people to use their cards and it costs you literally nothing to gain these great rewards.
Let’s return to my lemonade stand. If there are two credit card companies vying for my business and I only want to work with one, I’m going to choose the one with more cardholders under its wing. Now you probably understand that the company with the most cardholders is usually going to be the one that offers the best rewards programs to those people — people like you.
Interest and Late Fees
When credit card companies charge merchant fees, they can make money without asking their cardholders for a single penny. However, merchant fees are just a portion of a credit card company’s income. The next source of their income is one that you’ve probably guessed before: interest and fees from cardholders who are late on their payments.
If you’ve ever been slapped with a late fee on a credit card, you know they can be pretty hefty. Plus, the longer that you wait to pay, the higher your payment goes up with interest rates. So it makes sense that a credit card company could make money this way.
Let’s get back to the lemonade stand. I’ve actually left the lemonade business and I’d like to deal in books instead, so I start a private lending library. I buy a handful of books with my starting money and I’ve got a plan to make up the cost of those purchases. I know that some number of my patrons will be late in returning the books to me. I’ll charge them late fees and end up making a profit that way.
You might be thinking that this model will only work if I know that a particular portion of my patrons will be late on their returns. In fact, I do know this, and so do credit companies. Studies have shown that about 35 percent of Americans are late on bill payments. Armed with this knowledge, credit card companies can build a secure source of income by charging late fees.
This is actually really good news. Again, credit companies want to offer good rewards programs so that more people will sign up for their cards — after all, one third of 1,000 cardholders is a much bigger number than one third of 100 cardholders. All that you have to do to avoid the negatives attached to your card is stay out of that one third.
Keep up on your payments by budgeting responsibly and you can be one of the two in three people who gets to take advantage of all the rewards of a great credit card deal with none of the downsides.
If you’ve ever had a credit card, this one won’t catch you by surprise. Credit card companies will often charge fees from their cardholders. The good news is that, with two other highly reliable sources of income, credit card companies don’t have to place too much of a burden on their cardholders.
Many credit card fees are unavoidable, but that shouldn’t stop you from trying. If you encounter a fee that you don’t think is fair, call up your credit card company and let them know. Remind that that they rely on your patronage to boost the strength of their brand. Building good credit will also help you to strengthen your negotiating position, as you are a reliable borrower.
There it is! Credit cards demystified! Not every credit card offer is a good one, but now that you understand the inner workings of the industry, you are able to say with confidence when you’re being taken advantage of and when you’ve got a great deal on your hands.
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This post was updated June 25, 2017. It was originally published June 28, 2017.