Money and Models Part 4: How Credit Cards Make Money

The whole point of a business is to make money. This series will give a basic crash course in the language of business (accounting), and how various business models work.

How Credit Cards Make Money

When I was a kid, I thought credit cards were pieces of plastic with infinite money. My hopes were dashed after getting my first credit card. Stuff’s tricky man.

When I first wanted a credit card, I had to apply for one. This involved telling the credit card company my income, my credit score, my SSN, and a bunch of other demographics. After they accepted my application, I was given a credit card with a credit limit and an annual percentage rate (APR). The credit limit was the max amount I could spend on my card at any given time. When I was using my credit card, there would be a monthly statement once every month. On the statement was a statement balance and a minimum payment. I had 30 days to pay off the minimum payment, or I would get dinged on my credit score, and I had 30 days to pay off the statement balance, or I would accrue interest based on my APR.


To start off, the first main fee a credit card can collect is the annual fee. An annual fee is essentially a yearly subscription fee for using the credit card. There’s nothing inherently complicated or interesting about this fee, but it does exist. Starter credit cards usually don’t have an annual fee, since it usually turns off a lot of people from credit cards.


The second main way a credit card earns money is through interest. If I don’t pay off my full statement balance within 30 days of the statement release, the statement amount would increase by a certain interest rate. This monthly interest rate is calculated by the card’s APR, divided by 12.


When I use a credit card at a place, the process is dramatically different from cash or debit. When I use cash, I give the merchant  dollar bills, and the transaction is done. The merchant is a few dollars richer, and I am a few dollars poorer. A similar concept exists with debit cards. When I use my debit card, my bank’s balance decreases, and the merchant bank’s balance increases. The process is slightly different when I use a credit card.


When I use a credit card, the merchant doesn’t immediately get the money. Instead, the merchant’s records says I paid with my credit card a set dollar amount. At the end of the day, the merchant will tally all the credit card transactions it has gotten that day, and get the money all at once from the credit card company.


This brings us to the third main way a credit card makes money. Whenever a merchant collects money from the credit card company, the credit card company charges a fee for giving money to the merchant. This is usually a small number, plus a set percentage of the transaction. This means that, even if a credit card user pays off his monthly balance in full every month and doesn’t accrue interest, the credit card company still makes money from merchant processing fees.


There are other fees usually involved in credit cards. This includes stuff like cash advance fees (a fee for getting cash from a credit card), transfer balance fees (using one credit card to pay off another credit card), and so on. While these fees may exist, they usually don’t make up a major portion of a credit card company’s revenue, and aren’t really worth talking about.


You may notice that many credit cards have perks in the form of reward points or cash-back programs. These perks are similar to how banks offer an interest rate to customers depositing their accounts. The point of these perks is to attract individuals, and therefore increase their revenue base.


You may also notice that your card has two companies on it. For example, Visa and Chase, or MasterCard and Citi.These are separate companies that do different things. Visa, MasterCard, Amex, and Discover are credit card networks. Companies like Chase, Citi, Capital One, etc. are credit card companies. Credit card companies issue credit cards, and give merchants their money, and are the companies talked about this article. Credit card networks provide transaction services and infrastructure to make these credit card transactions possible. If credit card companies are the taxis that transport money from one place to another, credit card networks are the roads that allow the taxis to move around.


Credit card companies have different revenue dynamics between higher-income and lower-income individuals. Higher-income individuals will have the means to afford annual fees, spend a lot, and pay off credit card debt. Credit card companies will make their money from higher-income individuals through annual fees and merchant processing fees. Lower-income individuals will typically not want credit cards with annual fees, spend less, and occasionally accrue credit card debt. Credit card companies will usually make their money through interest and credit card debt from lower-income individuals. Moreover, higher-income individuals are lower risk, because they have a much lower chance of defaulting on credit card debt. This is why credit card companies care about your credit score and income.


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