Let’s start off by defining what we mean by a credit card company. Typically, people associate credit card companies with networks, like Visa or Mastercard, and issuers, like Chase and Capital One. In this article, we’ll refer to just issuers as credit card companies.
Issuers are financial organizations like banks and credit unions. They issue a credit card, which is a line of revolving credit. Revolving credit means that you can incur debt up to a limit, pay it off, and incur more debt. This is different from an installment credit, like a mortgage, where you can add more debt even if you pay off a portion of your debt (e.g. you can’t add a $20k loan for a car on your mortgage even if you’d paid off $50k on your mortgage).
Issuers make money from three different sources:
- Transactions fees: These are paid by the business when you swipe your credit card. These fees vary significantly from card to card, and even based on how you used the card (e.g. typing in the credit card number has a higher fee than swiping it). In general, you as the customer will not see a transaction fee. However, there are cases when you might incur a transaction fee. Liquor stores typically have higher prices when paying with credit cards and paying certain bills, like rent, may incur a convenience fee that helps to offset the transaction fee incurred by the business.
- Fees paid by the customer: These are fees that you might be charged. Common fees include an annual fee, a late fee, and an over-the-limit fee.
- Interest: This is the “fee” you pay to “borrow” money from the issuer.
Of course, credit card companies make the most money from people who carry a balance, and hence pay interest and various fees. In the industry, these people are called revolvers. In general, you do NOT want to be a revolver. Credit cards, except for some very specific circumstances, are horrible for actually borrowing money because of their high interest rates. If you really want to buy something you cannot afford immediately, get an installment loan (e.g. a loan for a car). If you cannot get it, DO NOT buy it. Period.
To make money, you want to be a transactor–someone who pays off their balance every month. This way, you will earn rewards from your spend, have perks from your credit card, and never pay fees (except for the standard annual fee) and interest.
You might wonder why credit card companies would you give so many rewards without making interest income off of you. There are four main reasons:
- They still make money on transaction fees
Transactors typically have higher spend, and hence credit card companies make a fair amount from transaction fees.
- They expect you to slip-up
You may have gone overboard one month and bought more than you could afford. 20% interest over a few months adds up quite significantly.
- They expect to cross-sell you on other financial products
Most of the large credit card companies are diversified financial organizations, meaning they offer a wide range of financial products, like mortgages and home loans. Their transactors are a great pool of potential customers for their other products, and it’s significantly cheaper to market to their existing customers than to acquire new customers.
- It reduces the cost of capital for the bank
It might surprise people that credit card companies also borrow money and, hence, pay interest. The interest they pay is based on many factors, but the biggest factor is the riskiness of their loans. When banks have many revolvers with large debts, they pay very high interest rates, themselves. Furthermore, when the economy isn’t doing very well, many revolvers default. If enough people default, then the bank cannot pay its loans and will go bankrupt. Hence, most large banks carry a good mix of revolvers and transactors to lower the interest rates they pay to borrow money.
If used responsibly, a credit card is a really great personal finance product. It essentially gives you free money for your everyday spend, a variety of perks like car rental insurance, and helps to build your credit (See How Opening and Closing Credit Cards Impact Your Credit Score). Just always remember to be a transactor and not a revolver.