Credit Cards 101: Where Does All of the Money Go?

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During 2013, Americans made more than $2 trillion in credit card charges and carried over more than $850 billion in credit card debt.

The payments on the debt alone were more than $100 billion. That is a lot of money and it’s a fair question to ask where it all went.

In order to answer the question, we need to know a bit about the credit card industry as a whole.

The American credit card industry is very complex and we have a lot to learn. We’ll start by looking at everyone involved. 

  • Credit Card Network – The credit card networks (Visa, MasterCard, Discover, American Express, etc.) provide an electronic network that is used to approve and process transactions, move money between banks, and much more. Credit card networks are also known as credit card associations.
  • Cardholders – A consumer with a credit card is known as a cardholder. Cardholders can use their credit card at participating merchants to buy goods and services. Cardholders receive bills from and make payments to the issuing bank.
  • Merchant’s Bank – The merchant’s bank processes the purchase information and forwards the data to the issuing bank and receives payment in return. Once the merchant bank receives payment, it transfers the money to the merchant’s account, less any appropriate fees. The merchant’s bank is also known as the acquiring bank.
  • Credit Card Issuers – Credit card issuers (the bank that issues the credit card to you) process credit card applications, make payments to the merchant’s bank, issue bills to the cardholders, and manage the cardholders’ accounts. In the case of American Express and Discover, the companies are both network and issuer.
  • Merchants – The business (brick and mortar, over the phone or internet) that accepts your credit card as a form of payment in exchange for goods and services. Merchants transmit the purchase transaction to their merchant bank.

Now that we have a good understanding of the roles, let’s take a look at where the money goes within the credit card industry. We will start with you, the cardholder.

Costs to the cardholder

There are many costs in the form of interest and fees that are paid by the cardholder.

  • Cost of the purchase – This one is pretty straight forward. If you bought something using your credit card, you must pay the card issuing bank for the full cost of your purchase.
  • Late fees – Cardholders must pay late fees when they fail to make their minimum payments by the due date.
  • Returned Check fees – If your check bounces, the card issuer will charge you a fee.
  • Foreign Transaction fees – When you travel abroad and make purchases with your credit card, you may be charged a fee. Typical foreign currency transaction fees are approximately 1% to 3% of the transaction.
  • Membership fees – Many credit card companies charge a monthly or yearly membership fee for the privilege of becoming a cardholder.
  • Interest – If you carry over a balance from one month to the next, you must pay interest on the amount carried over.
  • Over limit fees – When a credit cardholder exceeds the limit placed on his credit card, they must pay an over limit fee to the credit card issuer.
  • Cash advance and convenience check fees – Each time you make a cash advance or make a purchase with a convenience check you will be charged a fee. These fees typically amount to 3%.
  • Loading fees – The cost of exchanging foreign currencies may be covered by a loading fee of 2% to 3%.

Interest payments are the largest source of credit card profit for the card issuing bank

To be clear, once you start making interest payments, you are paying above and beyond the cost of your purchase.

Here is an example. You use your credit card to purchase a new flat screen TV for $1000. Congratulations, I am sure you will get many thousands of hours of enjoyment from your new TV.

If you pay off the TV before your credit card’s grace period has expired, you won’t pay one penny in interest. You might even get some cash back rewards or frequent flyer points for your purchase. The credit card network and banks make a few dollars off of the fees they charge each other, but that is all paid by the merchant who sold you the TV.

However, if you plan on making only minimum payments on that $1000 and your interest rate is 13%, you will end up spending much more than the $1000 purchase price on your new TV. After 8.4 years of minimum payments (101 months at $20.83 per month) you will have paid $1,605.10 for your TV. When you were standing in the aisle looking at that TV, would you have thought the full cost of $1,605.10 was a good price to pay for that $1,000 TV? That’s a 60% increase in the cost of the TV and all of it went to the card issuing bank.

Costs to the merchant

After the cardholder makes a purchase using a credit card, the merchant sends the transaction’s details to the issuing bank via his own bank (merchant’s bank aka the acquiring bank). The credit card issuer processes the transaction and, transmits the money charged by the cardholder back to the merchant’s bank once a day, less any interchange fees charged by the credit card issuer and processing fees charged by the merchant’s bank.

  • Interchange fees - Interchange fees are typically 2% of the transaction amount. Interchange fees are split between the credit card network and the issuing bank.
  • Processing fees - The merchant typically pays the acquiring bank (the merchant’s bank) a small fee (approximately $0.50) to process the payment made to the merchant.

For example, let’s say that you make a purchase of $100.00 from a local auto parts store.

By the time the transaction makes the loop from the merchant, to the issuing bank, to the merchant’s bank, and back to the merchant, the merchant will receive only $97.50 ($100.00 less 2% and less $0.50.) That 2% – 3% that he did not get back is the merchant’s cost for letting you pay with a credit card.

Why would a merchant be willing to lose 2% to 3% on every credit card purchase you make? The simple answer is that he is not. The merchant simply builds that cost into the price he charges you for the TV. He also knows that if you can pay with a credit card, you won’t’ feel as much pain as you would if you had to pay with cash from your pocket. Less pain means that you will probably be willing to buy more from him or pay a higher price. 

Costs to the credit card issuer

The card issuing bank has costs of its own.

  • The cost of lending - Lending you money (remember a credit card charge is a loan) costs the issuing bank money because the bank borrows that money at a low interest rate so that it can lend it to you. If the issuing bank borrows at a 5% APR and then loans the money to you at a 13% APR, the difference is the bank’s gross profit on the loan.
  • Association fees - The issuing bank must pay the credit card network multiple fees to cover such expenses as data integrity, brand usage, card validation, and network usage.

Costs to the credit card network

The credit card network does not pay any fees for any of the transactions that occur during the entire credit card purchase process. Instead, the network’s expenses represent the enormous cost of buying equipment, software and hiring people to operate, administer, and maintain the credit card network and oversee the process. These costs as well as the credit card networks profits come from the pennies per transaction fees and association fees that it collects from the card issuing bank. Millions of credit card transactions add up to a lot of pennies.

The bottom line

After learning more than you expected about the credit card industry, we can sum it all up as follows:

  • The merchant gets about 98% - 97% of the money you pay for his product or service.
  • The card issuing bank and the credit card network split about 2% - 3% for the money you charge on your card with each purchase.
  • The merchant’s bank (acquiring bank) makes less than $1 off of each credit card transaction.
  • If you carry a balance from month to month, all of the interest you pay goes to the card issuing bank in the form of extra profit, costing you above and beyond the initial price you charged on your credit card.
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