How do credit card companies (issuing banks) make money? Their profit model calls for them to earn revenue through fees and interest in order to offset losses (costs) from defaults.
You need to learn both sides of the equation if you want to understand how banks operate.
The income side of the equation can teach you how to earn rewards, execute balance transfers, and avoid interest charges.
The cost side of the equation can teach you how to manage your debts responsibly, negotiate settlements, and respond to lawsuits.
How Credit Card Companies Earn Revenue
Credit card companies make money through transaction (interchange) fees, interest charges on outstanding balances, and late fees to a lesser extent. Each of these three revenue sources plays an important role in the profitability model.
Each issuing bank employs a unique strategy to maximize its income stream. Therefore, nobody can tell you how much a company earns from each source.
Transaction fees explain how credit card companies earn revenue when you pay in full or take advantage of lucrative rewards programs. Each time you swipe your card or complete an online transaction the merchant pays interchange and assessment charges.
Theses merchant charges generate income for three industry groups.
- Payment processors
- Network associations
- American Express
- Issuing banks receive 1.8% on average (source)
Pay in Full
Credit card companies make money when you pay in full each month. You do not owe interest when you do not revolve a balance – yet the issuing bank still finds the deal very attractive.
The interchange revenue permits a high-return 30-day risk-free loan. It is a sure moneymaker as this simple example illustrates.
- $1,000 in monthly transactions means $18 income
- Default risk is zero when you pay in full
- 21% annual percentage rate (1.8% X 12)
Issuing banks make money on rewards programs through a combination of interchange fees, interest revenue, late fees, slippage (expiring points or airline miles), rotating schedules, and lower marketing costs.
These factors help to offset the cost of compensating the rewards partner companies.
- Interchange fees of 1.8% exceed the average point cost of 1%
- Interest revenue kicks in when members revolve the balance
- Frequent travelers sometimes miss payments and owe late fees
- Members fail to redeem rewards before the expiration date (slippage)
- Rotating schedules make it tricky to maximize cash back amounts
- Reward sign up bonuses lower new account acquisition costs
Credit card companies earn revenue by charging interest when a customer pays less than the full balance owed each month (revolve). People who revolve and pay on time are their most profitable customer segment.
Balance transfers are a cost-effective way to acquire ideal customers, while late fees and penalty rates serve a different purpose.
Issuing banks generate income on zero-percent balance transfers by charging upfront fees, limiting the promotional period, and by focusing marketing dollars towards their most profitable segment (revolvers who pay on time).
The average balance transfer fee is 3%. Banks impose this charge upfront. Therefore, even a zero-interest transfer generates some income.
- Promotional periods expire after 6, 12, or 18 months. Data mining tells the bank that a large portion of cardholders will revolve at expiration and then pay interest.
- Balance transfers are a cost-effective way to gain a greater share of wallet from their target customers – people who revolve and pay hefty interest rates.
Credit card companies also earn income when a customer falls behind on payments. Both late fees and penalty interest rates bump up revenues.
- First offense: $27
- Subsequent offense: $35
- Penalty interest: 29%
However, late fees and penalty interest are not big money-makers. They are early warning signals to get customers back on track – before they reach the default stage.
How Credit Card Companies Minimize Losses
People who think that credit card companies are exploiting American consumers may not understand how defaults affect profitability. Issuing banks lose 100% of the money they lend that consumers never pay back.
For example, one bad customer defaulting on a balance of $5,000 wipes out the income from twenty good ones. It makes you wonder who is ripping off whom. This is a difficult way to make money.
Therefore, banks take multiple steps to curb losses.
Credit card companies routinely decline applications from consumers whom they think will lead to losses (non-payment). Applicants face a denial for three primary reasons.
- Consumers with low FICO or Vantage scores have a very high risk of future delinquency and default and rarely qualify.
- Fraudulent applications from identity thieves and other crooks are flagged by systems looking for certain anomalies.
- Verify income and employment to confirm that the applicant has the ability to pay on time.
Credit card limits help the issuing banks control losses from default. The customer can no longer make a purchase on the account once the balance reaches the limit.
The companies frequently lower limits with little warning when they suspect the customer is running into financial problems. Their data mining operations consider the percentage of balance paid, types of purchases, and activity on other trades discovered through consumer reports.
Report to Bureaus
Issuing banks report account activity to the consumer bureaus as another means to minimize losses from default. Customers are far more likely to pay on time and according to terms when other lenders can learn about their behaviors.
The companies voluntarily report these data to the agencies and receive no money in return.
- Open date
- Account limit
- Current balance
- Payment history
Credit card companies may settle for less than what you owe as another means of minimizing default losses. Often a 1/3 payment to settle the debt is better than nothing is.
However, the banks will not forgive debts when you are current on payments. They only negotiate with customers experiencing financial hardship. In addition, the customer must have a nest egg set aside in order to make a compelling offer.
Issuing banks also file lawsuits as another method of keeping default losses small. The statute of limitations for credit card debt varies by state. Therefore, consult the laws of your state to determine how long before they might haul you into court.
Respond to any credit card debt summons by appearing in court. Hire a lawyer to protect your rights and help you avoid several nasty consequences.
- Garnish wages
- Savings account seizure
- Place a lien against a property
Credit card companies charge off bad debt, close the account, and/or sell the receivables to third-party collection agencies once they determine the person is a lost cause. These sales typically generate pennies on the dollar and do not add much to the bottom line.
The third-party collection agencies now own the receivable. Claiming no contract is not a viable legal defense in these situations. The new collection agency has the right to contact you for payment.