How credit cards make money

When I got my first credit card, I couldn’t understand how companies made money. I took my stuff home from the store without paying for it until the end of the month. I used someone else’s money in the interim –an interest free loan.

KIEV, UKRAINE - March 11: Pile of credit cards, Visa and MasterCard, credit, debit and electronic, in Kiev, Ukraine, on March 11, 2014.

And icing on the cake, they paid me to use the card with “cash back” on my dividend card. What kind of crazy business model is this?

Older and wiser, I now know how they make money. They charge businesses for each transaction and add penalties for those who don’t pay off their balances at the end of the month.

Of course, transaction fees drive up costs and I end up paying a bit more for the items I buy. I feel a bit guilty using credit cards because I pay the same as those  with cash pay without the benefits.

Some merchants give buyers a break. When I was driving in Washington State recently I noticed that gas stations gave a discount for cash, which is only right since the merchant’s costs are less. I haven’t noticed it in Canada.

Just how much credit card companies charge became an issue recently when Walmart Canada accused Visa of charging them too much.  Without revealing how much Walmart pays to which credit card company, they said they pay $100 million in fees annually to Visa and MasterCard. Walmart made good on their threat this week by denying Visa cards in Thunder Bay. Across Canada, credit card companies charge a total of $5 billion, an average of 1.5 per cent on transactions.

What I don’t understand is why consumers don’t pay off their balance monthly. It may be free money until the end of the month but then –wow. Unpaid balances are essentially loans at exorbitant rates 12 to 14 per cent.

“Now, why would a consumer take out a loan at rates like those?” wonders Noah Smith, “If you’re buying a house, you would get a mortgage at a rate of about 3.5 per cent. If you’re buying a car, you’d get an auto loan, which are at more like 1 to 3 per cent (Globe and Mail, July 1, 2016)”

For cheaper items like furniture, clothes and electronics, it’s easier to save up the money and buy things outright. The exception might be, say, when you are young and get your first job and you need a credit card to furnish your apartment.

There are a lot of people who can’t or won’t pay off their balance at the end of the month. Credit card companies depend on buyers to be irrational and buy things they can’t afford. They prey on the most vulnerable –the poor and less educated.

“Credit-card companies need people to spend more than they can afford, but not so much that they default on their payments. So they could benefit from targeting individuals who are more likely to have cognitive failings. This is the dark side of behavioural finance.”

The vulnerable are burdened with more debt and I with more guilt knowing my interest-free loan is paid for by those who can least afford it.

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