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It's no secret credit card companies make a lot of money. But have you ever wondered how they do it? Credit card companies make money from interest, processing fees and fees charged to individual cardholders.
And it's not only cardholders who have to pay to use credit cards: Merchants pay for the privilege to accept credit cards at their businesses. Read on to find out more about how credit card companies are making money and how you can minimize how much you pay to these financial giants.
How Credit Card Companies Work
When looking at how credit card companies work, it's important to distinguish between the different types of companies out there: credit card issuers and credit card networks.
A credit card issuer is the bank or credit union that provides the credit card and lends the money used in a transaction. Chase, Citi and Capital One are three well-known credit card issuers. Co-branded credit cards like those you see from airlines or hotels are examples of issuers teaming with outside companies to create a card that offers consumers some type of specific reward.
A credit card network—like Mastercard, Visa, American Express and Discover—is the entity that processes each credit card transaction, handling the technical aspects of electronically moving the money around. American Express and Discover are both card issuers and networks, which means that in addition to processing, they also lend the money used in their cards' transactions.
Card issuers and networks make money in different ways. Networks typically make their money from the merchants, who pay a fee to accept electronic payments from credit cards. The issuers make money from the consumer by charging them interest and fees according to their credit card agreements.
The Ways Credit Card Companies Profit From Cardholders
Credit card companies make money from cardholders in several ways: interest, annual fees and miscellaneous charges like late payment fees. Here is a breakdown of how each of those charges works:
- Interest. When you carry a balance on a credit card, you're typically charged interest in exchange for being able to borrow the money. Your interest rate—or annual percentage rate (APR), which combines interest and fees into one rate to help you understand what the card will cost you in a year—will vary by lender and is based on your creditworthiness. APRs on credit cards can get pretty high (15% to 30% or even higher), which is why you should pay your bill in full each month to avoid these expensive charges.
- Annual fees. Credit card issuers typically charge annual fees on rewards cards and on cards for bad credit. Depending on the card, annual fees can be pretty costly, especially for cards that offer top-tier rewards.
- Miscellaneous charges. This category includes several potential fees. For starters, the card issuer will charge you a late fee if you don't pay your bill on time. They may also charge you cash advance fees, balance transfer fees, foreign transaction fees for purchases you make outside the U.S., or over-limit fees when you spend beyond your credit limit. The fee amounts vary by issuer, but the good news is you may never have to pay these fees if you manage your card well.
How Credit Card Companies Profit From Merchants
Have you ever tried to purchase something at a business that didn't accept a certain type of credit card, like American Express or Discover? These and other credit card networks charge merchants fees to process card transactions, so some merchants opt to only accept cards in certain networks. These fees vary by network, but are typically between 1% and 3%.
Avoiding the Costs of Using a Credit Card
Credit card companies make a large part of their profits from cardholders. But don't let that discourage you from using a credit card: Savvy cardholders can avoid most of the costs of using a credit card. From interest to miscellaneous fees, you can steer clear of many fees if you plan ahead and make sure you spend within your means.
First, make sure to know what your annual fee is on all your credit cards. Then consider whether paying that annual fee is worth it. Do the benefits of the card outweigh the cost of the fee? If you consider the annual fee worth it, carefully read your card agreement and note all the potential benefits—then take advantage of all the card has to offer.
Avoiding interest is simple if you manage your card right: Just make sure to pay your bill in full each month. If you need to carry a balance from month to month, make sure you do it on the card with the lowest interest rate, and pay it off as quickly as you can.
To avoid miscellaneous fees, be aware of what you could be charged for and when. If you know one card charges foreign transaction fees, for example, use a different card that doesn't charge these fees when you travel. Use the same strategy for all your cards. If you're not sure what fees your card charges, read through your cardholder agreement and note all the potential scenarios that could trigger fees.
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Next Steps
Across the country, more than six out of 10 Americans have at least one credit card. Factor in all those people who make late payments and pay annual fees and other charges—on top those who pay interest each month—and it becomes easy to understand how credit card companies are making so much money. But as we've shown, you can reduce your contributions to their coffers with smart card management strategies.
To make the most of your credit cards, make sure you have a card that gives you maximum rewards for your spending. To browse some popular rewards credit cards, check out Experian's card comparison tool to see specialized card offers based on your credit profile.
Also remember that before applying for any credit cards, it's a good idea to check your credit so you know what lenders will see when considering you for an application. You can get a free copy of your credit reports and scores from Experian.