A lot of people wonder how credit card issuers are able to offer massive cash sign up bonuses and travel rewards. Surely they must be loosing money on these offers? I thought it’d be interesting to take a look at how card issuers identify different consumers and how they make money from consumers. Hopefully you can use this to educate yourself to ensure your paying as few fees as possible.
Identifying Different Customers
Card issuers almost always identify potential customers as one of two things, either you’re a: revolver or transactor.
- A revolver is somebody who makes purchases with their credit cards and also carries a balance. Card issuers make the majority of their money from these customers through interest charges.
- A transactor is somebody who makes a lot of purchases with their credit cards, but never carries a balance. Card issuers make the majority of their money from these customers through interchange fees.
Card issuers make money from annual fees and miscellaneous fees from both types of customers (although annual fees are more targeted towards transactors).
How They Make Money & How You Can Avoid It
- Interest. Card issuers charge a very high interest rate, usually in the 10-25% range. This is how they make the majority of their money off their revolving customers. These interest charges add up quickly (especially when in combination with late payment fees) and can lead to consumers being buried by the debt and feeling helpless.
The best way to avoid interest charges is by always paying off your bill before the grace period ends. If you don’t have the cash to purchase something, then you shouldn’t purchase it with a credit card. If you often find yourself carrying a balance, analyze your spending habits and cut back. If you’re going through a particularly tough period and can’t reduce your expenses, look at getting an low interest loan.
- Interchange fees. When a merchant accepts a credit card, they are required to pay a fee of around 2.2%-2.7%. The majority of this goes to the bank that issued the credit card in the form of an interchange fee (generally about 1.6%+), the rest of it is divided by between the acquiring bank, payment processor and assessing processor.
Because you don’t pay these fees directly yourself, a lot of people forget about them. Because merchants are charged these fees, they build that into the price of their products (which is why sometimes they offer a cash discount) so you’re effectively paying these fees without realizing it. The best way to “avoid” these fees is to make sure you’re using a credit card that earns at a high rate (either through a specific category bonus or just one that earns at a high rate on everyday spend).
- Annual fees. A lot of credit cards come with an annual fee, this is typically waived for the first year. This is because card issuers are hoping one of two things happens:
- You forget to cancel your card and the annual hits forcing you to pay it
- You find the benefits of keeping the card outweighs the cost of the annual fee
This is why card issuers will offer benefits such as lounge access, free checked bags and good earning rates in select categories. You can avoid annual fees by either applying for cards with no annual fee at all, or cards with the annual fee waived for the first year and then cancelling it before the second year annual fee hits. I always advocate that consumers should downgrade their credit cards where possible as this will help to increase their average age of accounts and thus their FICO score (if you’re not familiar with how the FICO score is calculated, I recommend reading this).
Annual fees are typically only on cards that are targeted to transactors. Somebody who carries a balance is much less likely to want to pay an annual fee and will see little benefit to high category spend as they are likely to be low spenders comparatively.
- Misc fees. Card issuers love random fees, it’s a good way for them to derive as much “value” as possible out of each cardholder. Here are some of the more common miscellaneous fees and how to avoid them.
- Late payment fee. If you don’t make your minimum payment on time then you’ll be charge this fee. Set up automatic payments and you can avoid this type of fee. You should be able to set it so it either pays the minimum or the full amount, obviously paying the full amount is preferable as this way you’ll avoid any interest charges.
- Foreign transaction fee. Use your card for a transaction that’s not in USD? There’s a charge for that. Even if a merchant overseas charges you in USD, chances are your paying a dynamic currency conversion fee. Avoid these fees by declining dynamic currency conversion and using a card that does not have a foreign transaction fee.
- Cash advance fee. If you use card to get cash, or if a transaction is coded as a cash advance you’ll not only be charged a cash advance fee but you’ll also pay a higher than normal interest rate that is immediately payable (there is no grace period). You can avoid these fees by setting your cash advance limit to $0.
- Balance transfer fee. If you transfer a balance from one credit card to another, you’ll be hit with a fee. This is typically a fixed fee or a percentage of the amount you’re transferring, whichever is higher. Avoid these fees by not doing a balance transfer unless there is no fee involved and the APR is lower.
- Returned payment/check. If your payment is returned for some reason (e.g bounced check) you’ll be charged a fee. Make sure you always balance your check book and ensure there is enough money in your account before trying to pay your credit card bill.
As a consumer you should be worrying about your own bottom line rather than the card issuers. What’s best for you usually ends up being what’s worst for the financial institution. Here is what you should be aiming to do:
- Earn more than the credit card interchange fee. You should be trying to maximize category bonuses where possible and using a card that earns at a high rate on all purchases when not possible. You might find the following pages particularly useful if you do a lot of spending in certain categories, they list the best cards for those categories:
- Never pay interest fees. Paying interest is for suckers, credit card interest rates are extremely high. If you really need a short term loan look elsewhere (e.g a personal loan from your friendly low APR credit union)
- Avoid annual & miscellaneous fees. It’s ok to have credit cards with an annual fee, just make sure you’re getting value out of the annual fee and regularly re-evaluate.
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