Beginner Series Part 2:
How credit cards work
We all know what credit cards are, but how do they work? How does a tiny piece of plastic give us the chance to ability to earn points and turn them into things like gift cards, cash, and unforgettable travel experiences? In this article, we discuss the basic and often misunderstood parts of the world of payments and credit cards.
Why is this important? When you understand the dynamics and how money moves from one pocket to another, you start to understand why things tend to happen within the industry like, "Why does Costco only accept Visa?" or "Why does my AMEX card tend to get rejected often?" These bits of information are meant to help inform your card strategy if you decide to add new cards to your card mix.
The basics
A credit card is a plastic or metal card that is used to make transactions against a line of credit that has been issued by a bank. Credit cards can be used for all types of transactions, which can include basically anything you can think of as long as the seller is willing to accept the card as payment. Payment with credit cards has increasingly become more popular due to its ease of use, its built-in security measures, growth of acceptance by merchants, and the ability for cardholders to earn valuable rewards.For the sake of this article, let's specifically focus on why banks provide perks and rewards with credit cards. Let's first state the obvious on WHY banks do this: it's super profitable. In fact, credit card margins have reached an all time high APR margin rate of 14.3% in 2024 according to the Federal Reserve. Compare that to mortgages, where the profitability is relatively minuscule in comparison, and sometimes even unprofitable.
Source: Federal Reserve
So how do credit cards make money for banks? The short answer is there are four ways credit card make money for banks:
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interest on revolving balances
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annual fees
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late fees
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interchange fees
Let's dive into each of these and discuss what you need to consider as part of your points-earning strategy.
Interest on revolving balances
Interest charges are the banks' bread and butter. When they agree to issue you a revolving credit card account, they are betting that more often than not, you will not pay your card in full and carry a balance into the next billing cycle, giving them the right to charge you interest on the balance carried. These interest charges can range from 0% up to 29.99%, which not only costs you extra money on top of the balance you're carrying, it devalues the rewards you're earning from the spend. Think about it: even if your points-earning card is earning you a generous 5% cash back, that 22% interest rate can easily wipe the value of those rewards completely.
Annual fees
Cards with annual fees typically come with premium perks or rewards structures. For banks to be able to offer these perks, they often charge an annual fee to offset their cost to serve the cardholder. Let's take the American Express® Platinum card, which charges a relatively high $695 annual fee. This seems like an insane amount of money to pay every year to own a credit card, but the card offers upwards of $1,200 in value in the form of travel perks, statement credits, and rewards multipliers on airline purchases. Needless to say, it won't make sense for everyone since not everyone has the same lifestyle or perception of value from the card, but for those who are savvy enough to take advantage of the benefits, then the annual fee more than justifies the annual fee.Takeaway: Annual fees are charged to offset the cost to service the benefits of the card. When considering a new credit card for your card portfolio, make sure you calculate the total value of benefits you will realize compared to the annual fee.
Late fees
This is an easy one. These are fees charged when the minimum payment is not met by the payment due date. If you're not going to pay the balance in full, AT LEAST pay the minimum payment due before the due date. You run the risk of more fees, higher interest rates, and (probably the worst of all) a late payment remark on your credit report, which can haunt you for the next 7 years.
Interchange fees
Interchange fees are fees that are charged by card networks to merchants to run the cashless payment on its network. Each card is processed on a designated network, which is indicated on the bottom right hand side on the front of the credit card. According to Wallethub.com, about 53% of credit card transaction volume was handled by Visa, about 24% of volume was handled by Mastertcard, about 20% of transaction volume was handled on the American Express network, and about 4% was handled on the Discover network. Why does this matter? Because different networks charge different fees depending on the network and depending on whether the transaction is in person or online, as you can see below.
Network | In person rate (avg per swipe) | Online rate (avg per transaction) |
|---|---|---|
1.79% + $0.08 | 2.43% + $0.25 | |
1.98% + $0.08 | 2.51% + $0.25 | |
2.68% + $0.08 | 3.18% + $0.25 | |
2.05% + $0.08 | 2.40% + $0.25 |
At first glance, you can see that American Express is the most expensive and charges about 50% more than Visa, the least expensive of the group. And this probably has you wondering, "why on earth would any merchant accept American Express?" Well, there's a very simple yet compelling reason for that: American Express card members spend more than other cardmember types...like, A LOT more.
Network | Avg spend per transaction |
|---|---|
$91 | |
$94 | |
$150 | |
$58 |
During my 4-year tenure at American Express, I learned why our cardmembers spent so much more money on our cards versus other cards in their wallets. The specific reasons varied from one cardmember to the next, but AMEX cardmembers collectively value the power of its products and all that they have to offer SO MUCH that it's the first card they reach for when making a purchase. The rewards-earning capabilities and purchase protections specifically appeal to more wealthy individuals because every single American Express cards offers some type of rewards incentive, whether it's cash back rewards, its ultra-valuable Membership Rewards points, or other rewards currencies, including hotel points and airline miles. And since wealthy individuals like to travel, they use these rewards to upgrade their travel experiences. It's a very appealing value proposition for everyone involved, so merchants are usually more than willing to pay the premium to accept AMEX cards as payment.
To illustrate the flow of payments, consider the example below. Here, we see a customer using $100 of his hard earned money to purchase goods from a merchant who paid $60 for the goods being sold.
Entity | Activity | Bank Cost/Benefit | Customer Cost/Benefit | Merchant Cost/Benefit | Network Cost/Benefit |
|---|---|---|---|---|---|
Bank issues card to customer | |||||
Merchant pays $60 to stock its shelves with goods | -$60 | ||||
Card member uses card to pay merchant $100 for $60 worth of goods | |||||
Merchant accepts card for payment of $100 worth of goods | |||||
Merchant pays $1 to network to accept card as payment | -$1 | +$1 | |||
Bank pays merchant $98 for goods | -$98 | +$98 | |||
Card member pays $100 statement balance to bank | +100 | -$100 | |||
Bank rewards card member 1% worth of rewards to cardmember | +$1 | ||||
Total | +$2 | -$99 | +$37 | +$1 |
So where am I going with this? Well, if you've ever wondered by some places are "cash only" or why some merchants prefer specific credit cards over others, this is likely why. The cost can often be too high for some merchants to justify accepting certain cards such as AMEX or any credit cards at all for that matter. In the example above, the fee was a mere $3 off of the $100 transaction, but the $3 cost ate away not at the $100 transaction, but rather at the $40 would-be profit, which was reduced to $37 a 7.5% decrease in profit! Because of the economics, merchants have to decide what customer payment options work best for them to maintain profitability and a sustainable business model. This was a lot to take in, but it's probably one of the most important fundamental points about credit cards because when you understand the mechanics, then you understand why things work the way they do and why the industry in constantly changing.
Key points
When you really think about it, credit cards are pretty simple products to understand. At its core, they are small pieces of plastic that represent a bank's trust to lend you money in exchange for on-time payment of at least the minimum monthly payment. If that payment is late, you are charged fees. If you do pay the minimum but still have a balance, you will pay monthly interest until you pay it all off. As long as you continue to pay at least the minimum payment, you'll receive rewards at the end of the billing cycle when using a rewards card. These rewards are subsidized by the swipe fees charged to the merchant by the banks. However, if you carry a balance, you'll have to pay interest on the carried balance, which then devalue the rewards you earn. To make sure that your rewards aren't devalued, pay your bill in full every month.
In the final chapter of the Beginner Series: How to Choose a Card, we will discuss the different types of cards, how each type can play into your points earning and free travel strategy, and how to pick cards that make the most sense for you.
The Chase Sapphire Preferred® Card
Current Welcome Offer
100,000 Membership Rewards Points after spending $4,000 in the first 3 months of card membership
The American Express® Gold Card
Current welcome offer
90,000 Membership Rewards Points after spending $6,000 in the first 6 months of card membership
The American Express® Platinum Card
Current welcome offer
125,000 Membership Rewards Points after spending $8,000 in the first 3 months of card membership
Top Card Picks
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