You may have heard that if you use credit cards right, the credit card companies won’t make a cent off of you. Pay every balance in full; get cash back, points or miles; receive perks if your card has them, and you’re sitting pretty while your credit card loses money on the interest you AREN’T paying.
But that isn’t accurate. Your credit card issuer is not losing money on you. In fact, if you’re a credit card power user – even one who pays off the balance in full each cycle – issuers are still happy to have you and they’re still making money off you in the form of fees you pay as a cardholder as well as the processing fees merchants pay each time you use your card.
Let’s break down the basics of how credit card issuers make money.
What are processing fees?
Every time you spend use your card, the credit card issuer charges a processing fee to the merchant, sometimes referred to as an interchange fee or an assessment fee.
We’ll start here because this is a good way to illustrate that no matter how brilliant you are managing your credit cards, your card issuers will always make some money off of your purchases.
Credit card processing fees generally average between 1.5% and 3.5% of the sale, and the merchant pays that, not the customer (at least not directly). If we think the merchant doesn’t pass that cost onto the consumer in some way, as the cost of doing business, we’re awfully naïve.
How the credit card companies decide on the processing fee depends on “sophisticated algorithms that track a number of market variables,” says Joseph Stasio, a serial entrepreneur and an associate professor of marketing at Merrimack College in North Andover, Mass.
Essentially, Stasio says, credit card issuers provide a sliding scale for businesses depending on usage.
“For example, a client that has a large volume of credit card usage for their business will often get a favorable rate, at the lower end of the scale, say, 1.5%,” Stasio explains. “Other companies whose volume usage is lower, will pay at the higher end of the scale, say 3.5%.”
It certainly works out well for the credit card companies. Last year, according to the Nilson Report, merchants paid $160.7 billion in processing fees for credit, debit and prepaid credit cards, to accept $10.589 trillion in payments.
Making money off credit card interest
Credit cards, as you can imagine, make a lot of money from cardholders’ interest payments. How do issuers determine your APR?
As you’re probably aware, every time the Federal Reserve raises its key rate, that leads to a credit card’s interest rate going up. But exactly what your interest rates will be, since there’s generally a range of interest rates your credit card will offer, is determined again by algorithms, Stasio says.
If you have a good credit score, as you know, you’ll get a better interest ran interest rate that is on the low end of the range. If your credit score isn’t so healthy, the banks will likely charge you a higher interest rate.
“Some may call it price gouging,” Stasio says. “Others say it is the proper use of risk/reward decision-making.”
In any case, the interest rates are the primary source of a credit card’s income, says Mitchell Franklin, associate professor of accounting in the Madden School of Business at Le Moyne College in Syracuse, NY.
Franklin, whose specialty of research is in taxation, financial accounting and auditing, says that “banks make money by loaning it for more than they borrow it.”
Franklin puts it this way: When you put money into a bank’s certificate of deposit, they pay you interest. But when you take out a loan on a credit card and don’t pay the bank back within those 30 days, you pay them interest. And the interest you receive from a certificate of deposit or having money in an interest-bearing savings account is generally far less than the interest you pay out on a credit card loan.
The banks do not want you to pay on time every month. In the banking industry one who pays credit cards timely is known as a ‘deadbeat.’ They need people to carry balances to make the bank profitable.
But you aren’t exactly destroying capitalism if you are a so-called deadbeat to a credit card company. Again, the banks are still making money when you do (remember the processing fees), and Franklin says that financial institutions often make additional revenue off the so-called deadbeats, the cardholders who do pay off credit card loans in full every month.
“Many of these customers are higher net worth individuals,” Franklin explains. “If the customer is happy, they will bring other banking/financial services to the bank issuing the card, such as high deposit accounts for checking, savings, CD’s, mortgages or other loans that will bring in a nice profit for the issuer. The credit card is essentially a loss leader from a marketing standpoint to generate other business.”
Making money on key credit card fees
Credit card issuers make money through annual fees, too. It isn’t easy nail down exactly how much credit card issuers make from these fees, but in 2016, Bloomberg reported they hauled in $12.5 billion in annual fees, and it’s a safe bet that that number is far higher now.
Annual fees are those that cardholders agree to pay, too. It isn’t like anybody has to pay an annual fee to use a credit card; there are plenty of good credit cards without annual fees. But as you probably know, an annual fee is a little like paying a membership to a warehouse buy-in-bulk store like Costco and Sam’s Club. You’re paying money for access to deals that will presumably make the membership fee worth it and then some. Credit cards that charge annual fees usually include a lot of perks that, if you use them, will more than pay for the membership fee. The annual fee helps to offset the credit card’s cost of offering the perks such as airport lounge access, travel credits, auto rental insurance and more.
And, of course, if you don’t travel or use the perks that the credit card offers, then for the credit card issuer, that annual fee is pure profit.
The Consumer Financial Protection Bureau (CFPB) estimates that households pay credit card issuers collect about $12 billion a year in late fees. So any time a cardholder is late with a payment, they aren’t just putting their credit score at risk, they’re putting a lot of money into the pockets of credit card executives and shareholders.
But credit cards may find in the near future that they won’t profit quite as handsomely from late fees. Banks typically charge late fees of about $41; the CFPB recently proposed a rule that would cap late fees to $8. So that could make things interesting for credit cards if that happens, and maybe interesting for consumers, if that causes annual fees to climb for everyone or if other credit card benefits are taken away. Stay tuned, in any case. It’ll probably take awhile before anything happens, if it happens. But, sure, it would be nice for consumers to not have to pay ridiculously high late fees.
Foreign transaction fees
Every time somebody takes an international trip or busy something online in a foreign currency, 3% or so of each purchase goes into a credit card company’s bank account. That’s assuming you aren’t using a credit card without foreign transaction fees.
Cash advance fees
Exactly what the bank will charge varies – it’s often a flat fee or a percentage of the money you’re borrowing. But the credit cards make out like a bandit whenever anybody takes out a cash advance. If you buy something on a credit card and pay it off within the grace period, the period between the end of a billing cycle and when your payment is due (at least 21 days), you won’t pay any interest. Borrow cash from your credit card, though, and banks charge you a fee for that privilege – and interest accrues immediately. It’s a great business move for credit cards; it’s a lousy one for the cardholder.
Balance transfer fees
Balance transfers can be a money saver for a cardholder. If you have a ton of money on your credit card and you can move it to a low-interest credit card or one with a 0% APR introductory period for 12 or more months, and you pay off the debt within that time, you should make out well. But the credit card offering you the low or no interest rate will make out well, too.
Even if you are putting the money onto a card that, for now, has a 0% APR, there will usually be a balance transfer fee, which could be 3% to 5% of the amount of money you’re transferring to the card. So if you put $10,000 from a high-interest credit card to one with an 0% APR, there’s a good chance you’ll be charged a balance transfer fee ranging between $300 and $500. It sounds like a lot, and it is, but it’s often nonetheless a money-saver to transfer a huge balance from one credit card, if it means avoiding paying a lot of interest in charges over the next several months or years.
Like the annual fee, these are generally fees that you agree to pay, to be allowed to spend a little over your limit (instead of having your credit card declined at the register). They tend to go as high as $35. You have to opt in to this service though, so it’s pretty easy to avoid this fee.
Returned payment fees
These are unpleasant to pay. These occur if you, for instance, set up an autopay so that your credit card is paid, but alas, you don’t have the money in your checking account to cover the payment, and so your credit card payment is returned. As an insult to injury, you’ll be charged about $40.
Final thoughts on how credit card issuers make money
There’s no question that if you use credit cards responsibly, with the cash back deals, the points and miles you can accrue, as a credit card cardholder, you can save a lot of money every month. But there’s also no question that you shouldn’t feel guilty if you essentially beat the system by saving a ton of money from your credit card. No matter how you manage your money, the executives and shareholders at your credit card company are doing just fine.