Credit card companies are so profitable that in a recent report the Fed wrote that “credit card earnings have been consistently higher than returns on all commercial bank activities”. These profits come out of customers’ pockets. So if you want to choose and use credit cards wisely, you’d better understand how credit card companies make money.
The number one money-maker for credit card companies is interest charged on outstanding balances. Credit cards charge far higher rates of interest than most other types of loans for three reasons:
- The loans are unsecured, in contrast to mortgages, home equity loans, and home equity lines of credit (HELOCs). Since credit card companies cannot possess your house if you default on your credit card loans, that pushes up the interest rates they charge.
- Credit card companies have limited amounts of credit-related information about their customers, and that also raises the risk of loan default and pushes up the price of the loans.
- We’ve just seen that the credit card business is the most lucrative area of commercial banking. Despite increased competition in the credit card industry in recent years, the spread between credit card companies’ borrowing costs and the interest rates they charge their customers is wide. To put it plainly: the interest rates they charge are high.
Credit card companies also charge an assortment of lucrative fees. They include:
- Late payment fees. If you pay your credit card bill late, you can get hit with a penalty fee for late payment. Worse, the credit card company may determine that you have borrowed your entire outstanding balance from the time of purchase until the time of payment, eliminating the “grace period” between the moment of purchase and the payment due date. The credit card company can then charge you interest on that balance. And if you have any rewards from the credit card, the card company can cancel your rewards due to late payment. And a survey of 140 credit cards this year by Consumer Action found that 85% of the banks raise interest rates after customers pay credit card bills late. The average credit card late payment fee is about $30. According to one industry consultant, credit card companies generated about $11.7 billion from penalty fees in 2003.
- Fees for exceeding your credit limit. If you charge more to your card than the credit card company has allowed, you may find that the charges go through but you get hit with a penalty fee for exceeding your credit limit. Some credit card companies charge a $20 fee for exceeding your credit limit, and will keep charging you that fee every month that you remain above the limit. If you are $100 above the limit, that means you’ll be paying 20% per month to borrow that extra $100.
- Balance transfer fees. Credit card companies often offer balance transfers at low interest rates. Namely, if you move an outstanding balance from another credit card to their card, they will charge you a low interest rate. However, the small print often reveals that you will be charged a balance transfer fee. The balance transfer fee is often a percentage of the amount being transferred, with a minimum.
- Cash withdrawl fees. Credit card companies encourage you to use your credit card as an ATM card. But if you withdaw cash from an ATM machine using a credit card, you’ll probablly be billed a one-time fee in addition to paying interest from the moment you receive the cash.
- Annual fees. Some credit cards charge an annual fee. They get that money up-front, before you start using the card.
Credit card companies also generate revenue from transaction fees. Visa and MasterCard charge merchants about 2% of the value of every transaction billed to their credit cards, usually with a minimum per transaction. American Express charges about 2.6%. Visa and MasterCard get about 20% of their revenues from merchant fees. American Express gets 65% of its revenues from merchant fees, because it relies less on interest payments (most American Express card holders don’t carry a balance). But American Express is now trying to expand its lending business, so expect its revenues from interest payments to rise.
In total, transaction fees, late fees, over-limit fees and other types of fee accounted for about 33% of credit card companies’ revenues in 2003. The other 67% came from interest payments.
Think about this. It means that when you sign up for a credit card, the credit card company is hoping for two things: that you’ll “carry a balance” and that you’ll get hit with fees. However, you can make money from credit cards. That’s what we’ll look at next.