How Do Credit Card Companies Make Money?

As you may expect, credit card companies don't work for free. But when you're looking at a $200 sign-up bonus for a card with no annual fee, you start to question how they still manage a profit. How do credit card companies make money when they're giving away rewards, seemingly for free?

Well, you don't have to worry. Your credit card issuer is doing just fine -- no matter how many cash back rewards you earn. And so are all of the other credit card companies that are cogs in the great payment card machine.

How each type of credit card company makes its money depends on its particular role in the payment ecosystem. Let's start with taking a look at what the different types of credit card companies actually do, then we'll explore how they make money doing it.

The different types of credit card companies

To a cardholder, making a credit card purchase seems like a simple process. You swipe, tap, or insert your card in the terminal. Then, like magic, a few seconds later you're on your way.

In reality, there's a lot that happens behind the scenes in those few seconds -- and long after you leave. Other than you, the cardholder, and the merchant, there are three main players in the credit card game.

1. Credit card issuers

A credit card represents a line of credit from a bank that you use and repay. The credit card issuer is the bank that backs the credit line. When you make a purchase, the issuing bank pays the merchant. When you make a credit card payment, it goes to your card's issuer to repay the money it gave to the merchant.

In the vast majority of cases, the only credit card company you deal with directly as a cardholder is your issuer. (The most common exclusion to this rule is for specific benefits offered by networks. These can require contacting that network to file a claim.)

If you have a co-branded retail credit card (aka, a store credit card), you may actually manage your account through the retailer's website. However, the associated credit line will still be issued by a bank. Your payments will go to that bank, even if they route through the retailer's website first.

2. Credit card networks

Making a credit card purchase requires a lot of communication. Initially, the merchant needs to contact the bank to get approval for the transaction. Then, the bank needs to send the funds to the merchant's account to cover the purchase.

All of this communication does not occur directly between the merchant and your bank. Instead, it all goes through the credit card network. There are four major credit card networks in the United States:

• Visa
• Mastercard
• Discover
• American Express

Credit card issuers partner with a specific credit card network for each of their credit cards. Any given card can only operate on one payment network. You can see which network your card operates on by looking for the network logo on your credit card.

You can only use your credit cards to make purchases at merchants that work with your card's network. For example, if a retailer only accepts Visa credit cards, you can't use your Mastercard to make a purchase with that retailer. (We're looking at you, Costco.)

3. Credit card processors

Not only do merchants rarely deal directly with your card issuer, but they also don't deal directly with the networks. Instead, most merchants -- especially small businesses -- work with a credit card processing company.

Essentially, credit card processors are the go-between for the merchant and the network. This gives the merchant a few distinct benefits:

• Equipment: That terminal where you insert or tap your card? That's usually provided to the merchant by the processor. Depending on the nature of their contract, merchants may even get the equipment for free or at a discount.
• Security: Credit card processors are the first line of security for your account information. This means the merchant isn't responsible for trying to encrypt your payment information, or for finding a secure way to send it to the network. The processor deals with all of that instead.
• Bookkeeping: Many processors provide merchants with access to accounting dashboards that make it easier to manage their card transactions. This can be a lifesaver for busy small business owners.
• Bargaining power: As we'll see below, card issuers and networks both charge fees for each transaction -- fees that merchants are forced to pay. Credit card processors with many merchant customers can often use the size of their client base to negotiate lower fees than the merchants could get on their own.

Unlike issuers and networks, processors don't have anything to do with your specific credit card. You won't find their logo on your card, and a merchant's choice of processor will have minimal impact on your purchase.

How credit card issuers make money from cardholders

As a cardholder, it can seem like you're the main source of profit for every credit card company. But that's actually not true. Of the different types of credit card companies, the issuer is the only one that profits directly from the cardholder.

The money issuers make from cardholders typically come from fees. On the plus side, most of those fees can be avoided by savvy consumers.

Annual fees

These are fees you pay as the cardholder just to keep the account open. Most cards that charge annual fees are rewards credit cards. In this case, annual fees help offset the cost of those rewards.

At the other end of the spectrum, some credit cards for bad credit also charge annual fees. For these cards, the annual fee helps offset some of the risk to the issuer of giving credit to someone with a troubled credit history.

How to avoid annual fees

Annual fees are fairly easy to avoid because you can simply choose cards with no annual fee. Many of the top cash back rewards cards, for instance, don't have any annual fees. You can even find a few decent travel cards without annual fees.

On the other hand, annual fees are sometimes worth it. For example, many of the best travel rewards cards have sign-up bonuses and cardholder perks that can be worth thousands of dollars.

Interest fees

For most issuers, the bulk of their profit comes from interest fees. These are fees charged by the issuer when you carry a balance on your card past your due date.

Basically, when you make a purchase with your card, the issuer pays the merchant. Until you pay off your balance, the issuer is out that money. Interest fees compensate the issuer for that lending.

Interest fees are charged as a percentage of your credit card balance. That percentage will depend on your credit card's APR, or annual percentage rate. The higher your APR, the higher your interest fees will be.

Credit card APRs generally reflect your credit risk, which is determined by your credit history. If you have excellent credit, you'll likely receive a lower APR. If you have bad credit, you'll be given a higher APR. With most popular credit cards, a good APR is between 10% and 14%. At the other end, some subprime credit cards charge as much as 36%.

How to avoid interest fees

There are two main ways to avoid interest fees. The simplest is to pay your balance in full every month. That's because most credit cards offer a grace period during which you won't be charged interest fees. That grace period extends from the close of your statement to the due date on your bill.

The other way to avoid interest fees is with a special interest rate offer. Many credit cards give new cardholders an introductory deal for a lower (or zero) interest rate for a set period of time after opening a new account. These 0% intro APR offers can last from six months up to 21 months (or, rarely, longer).

Transaction fees

Other than simple purchases, most other types of credit card transactions come with a fee. If you make a balance transfer, for instance, you'll need to pay a balance transfer fee. The same applies to credit card cash advances. Many cards also charge foreign transaction fees when you make a purchase in another country or currency.

How to avoid transaction fees

It's easy to avoid transaction fees by just avoiding making transactions with fees. You won't be charged a balance transfer fee if you never make a balance transfer. Same with cash advances.

Foreign transaction fees can be harder to avoid, particularly if you travel a lot. But many great cards, especially travel cards, don't charge any foreign transaction fees at all.

Penalty fees

Opening a credit card account initiates a contract between you and the issuer. If you break the terms of that contract, most issuers will charge you a fee. For example, if you pay your bill after your due date, the issuer will probably charge you a late fee. Similarly, if you spend more than your credit limit, you may need to pay an over-limit fee.

How to avoid penalty fees

If you stick to the terms of your cardholder agreement, you can avoid penalty fees. Pay your bill on time every month, and you won't be stuck with late fees. Try setting up automatic payments with your bank if you struggle to remember due dates.

Over-limit fees can also be avoided by staying well below your credit limit. Many issuers will even offer a feature to completely turn off your ability to make purchases that would put you over the limit.

How credit card companies make money from merchants

Although credit card issuers are the only card companies that profit directly from cardholders, pretty much everyone profits from merchants. Issuers, networks, and processing companies alike all get their share from merchants through various processing fees.

Interchange fees

Each time you use your credit card, your issuer charges the merchant a fee to handle the transaction. This is called an interchange fee.

Interchange fees are charged as a percentage of the transaction amount and typically range from 1% to 3%. However, the exact amount of the interchange fee can vary a lot by issuer, merchant category, how you pay, and even by the card you use.

Interchange fees cover the cost of maintaining your credit card account, including fraud mitigation and account security. Even if you never pay a single annual or interest fee, your card account is still profitable to the issuer as long as you're making purchases. This is why issuers will close accounts for inactivity. If you're not using your card, they're not profiting from the account.

Assessment fees

Cardholder fees and interchange fees cover the issuer's costs. So, how do the credit card networks make money? That's where the assessment fee comes in.

Each payment network charges the merchant a flat-rate assessment fee on every credit card transaction that uses their network. This fee goes to covering the cost of maintaining their payment networks.

Assessment fees are typically a small percentage of the transaction amount. They can range between 0.13% and 0.15% of each transaction. The assessment fee can vary based on the specific payment network, as well as the size and type of transaction (credit vs. debit card, etc.).

Processor fees

Finally, we get to the processor fees. The credit card processing company that the merchant uses will charge the merchant for the privilege. Processor fees come in many shapes and sizes, depending on the specific contract between the processor and the merchant.

Generally, merchants will pay a per-transaction fee that includes the interchange and assessment fees. The processor will then pass those fees on to the issuer and payment network.

Processors will also charge various fees to cover their own costs. For example, if a merchant buys or rents their payment terminal, the processor will charge an equipment fee. There are also usually service fees to cover the processor's overhead. Service fee structures can vary, and may be charged per transaction, by month, or by year.

Of all the fees merchants must pay to accept credit cards, the processor fees are usually the only ones they can influence. Most merchants aren't large enough to influence interchange or assessment fees. They do this by shopping around for the processor willing to offer the best rates.

Who profits from credit card "convenience" fees?

It's not uncommon for many merchants or service providers to charge a "convenience" fee for credit card payments. But they don't usually profit from these fees.

In most cases, "convenience" fees are just the various merchant fees (interchange, assessment, and processor fees) being passed on to the customer. This is most common when it comes to utility providers, such as water or electric companies. You'll also see this type of fee if you try to pay your taxes with a credit card.

Still have questions?

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