What Credit Card Companies Don’t Want You to Know: How They Make Money.

Credit is not actually overly complicated. What banks and credit card companies have done is make it as opaque as possible so that it looks complicated. In this series of posts, we’re going to explore credit cards in details, as it’s the most commonly used and misunderstood form of debt. As we get through the concept of credit, I am also developing a glossary of most commonly used credit card terms, to help you make sense of it all. 

In these posts I may use ‘credit card company’ and ‘bank’ interchangeably. No matter where the card comes from, even if it’s a retail store card for example, there has to be a company considered a bank or a lender part of the process. If you read the details of your Costco MasterCard for example, you will see that CIBC is the bank issuing the card. 

Let’s first explore how credit card companies make money.

Credit card companies make money in two ways. One way you pay for directly, and one indirectly (and there is a cheeky 3rd one that is really just a way to manage their economics and entice you to spend. I.e. to make sure they don't lose money) . 

(1) Interest: Every time you don’t pay what you owe (i.e. your balance) in full, the credit card company will start charging you interest on whatever is left unpaid at the end of the month. This is usually by far the most lucrative for banks. This interest is added to the balance, and you now have to pay that larger amount back. You own that money, so you will eventually pay for this directly. Let’s walk through an example: 

- You have a 20% Annual Percentage Rate on your card. That means every month you carry a balance, they will charge you 1.67% on whatever you haven’t paid off by the date your payment is due (20%/12 months).

- In December, you purchased for $1500 on this card.

- When your payment date comes around, you pay $500.

- You now start incurring interest on the $1000 ($1000-$500).

- The next month, you now owe $1017 even if you don’t purchase anything else on your card!

$1000 that you didn’t pay off last month

+ $17 ($1000*1.67%) the interest on that balance

= $1016.7

- The tricky part is that this interest compounds. Meaning that if you don't pay the $1017 next month, you now owe interest on the $1000 again but also owe interest on last month's interest portion! So next month if you still haven’t paid, you now owe $1034!

$1017 that you owe from last month

+ $34.3 ($1017 * 1.67%)

= $1034.3

It’s actually even more complicated and expensive than this as the interest that gets added to your bill once you start not paying in full is usually calculated on an average daily balance. But conceptually, you can see that even with a relatively small amount owed, interest will quickly balloon up even if you make some minimum payment at the end of each month. 

(2) Interchange: Every time you use the card (transact), the store you buy from (aka the merchant) pays the credit card company a small portion of the transaction (this is called ‘interchange’). So you use your MasterCard at the bookstore for $100. The bookstore pays back $1-2 to MasterCard as a ‘thank you’ for giving clients like you a vehicle to spend money at their store. This amount varies depending on which card you use to make the purchase. I say you pay for this indirectly, as merchants will usually inflate the cost of their goods accordingly so that they manage the profit they make on their sales (i.e. if credit cards didn’t exist, perhaps your book purchase would’ve only been $98. You will sometimes see merchants, especially small businesses for whom this fee is a hefty one, offer you a small discount if you pay cash vs credit, and this is why).

(3) Annual Fees: Some cards have monthly or annual fees. Usually those cards are for higher earners and spenders (customers with a higher credit score and income. We will go over credit scoring in a subsequent blog post). Usually those are cards that offer you rewards (i.e. points, miles etc) and perks (i.e. insurance, lounge access, etc). The credit card company will use the interchange revenue (see #2 above) and to some extent some of the interest revenue to pay for the perks and rewards they give you. In some cases that’s not sufficient to make up for the cost of these rewards and perks so they charge an extra fee. The fee is also there to ensure that psychologically these clients will use the product frequently and generate interchange and interest revenue for the credit card company (if you pay for this card every month, you are more likely to want to use it to make it ‘worth it’). 

Now that we know how they make money, you understand why it’s in a bank's best interest to entice you to spend as much as possible on your card, but not encourage you to pay your balance in full every month. They want you to pay back eventually (otherwise they end up footing the entire bill) but if you take a few months to pay your balance, they will profit from that immensely, and you will get absolutely nothing back from all the extra money you spend on interest. 

Now it’s easy to say ‘credit card companies are evil!’. Let’s be honest, they are not charitable organizations. Even the ones who are ‘on your side’ etc, are companies that are looking to make a profit. But I don't see this as any different from other corporations out there (i.e. you might go to Walmart thinking ‘what a good deal’ but be assured that they are also out for the profit… as someone who’s owned their stock for quite some time, I can tell you that’s their #1 priority). If you know how to use them, credit cards are great tools and offer a lot of benefits. What frustrates me is how they make it so opaque for the customer, and it can quickly become a slippery slope. In my next post, we’ll explore how to use credit cards intelligently when you are ready.