How does a credit card company make money?

Understand how a credit card company makes money from you and save yourself from unnecessary fees while becoming a smarter credit card shopper

A credit card company makes money in three ways :
  • Annual fees
  • Merchant fees
  • Finance Charges

In the good old days, most credit cards would charge an annual fee. These days, most credit cards have no annual fee (unless you are talking about sub-prime credit cards). Merchant fees are pretty standard which is negotiated between merchants and the credit card company. Where credit card companies make the most money is in the finance charges imposed on consumers when they do not pay their balance in full.

Credit card companies have also introduced measures over the years to make higher profits. We look at some of these tactics below.

Reducing Grace Period - It used to be that the standard grace period given when you make a purchase on your card is 25 days. This has now whittled down to 20 days for most cards with the exception of most sub-prime cards. Grace period is the period of time that you are not charged any interest after you make a purchase if you have $0 balance. Reducing the grace period simply means that you have less time to pay off a balance and a higher probability of incurring finance charges if you are not careful.

Using 2-cycle average daily balance method - Your grace period can be wiped out if the card you have is using the 2-cycle average daily balance method and you carry a balance. Because, your monthly balance is calculated using the average of 2 cycles (or 2 months) instead of one, interest charges may be applied retroactively.

The 2-cycle average daily balance may also result in higher balance for those who only occasionally carry a balance.

Using the Daily Periodic Rate instead of a Monthly Periodic Rate - In a past a typical credit card company would use the monthly periodic rate to calculate your finance charges if you carry a balance. These days, most credit card companies use a "daily periodic rate" to calculate your finance charges. Under the monthly periodic rate method, your apr is divided by twelve (twelve months in a year) multiplied by your monthly balance. When the daily periodic rate is used, the apr is divided by 365 and multiplied by the average daily balance. This results in higher finance charges because of the compounding effect. To fully understand this read our article on How to calculate the effective interest rate on your credit card?.

Universal Default Clause - This is a recent develop that many credit card companies have embraced. A universal default clause gives credit card issuers the right to increase your apr if you have made a late payment on another of your loan obligation (could be another credit card or your loan) even though you have make timely payments for your existing card. Once a credit card company gets alerted from the credit bureaus that you have missed a payment on another obligation, they will raise your apr. In fact, credit card companies do not even need to explicitly have a clause in the terms and conditions to trigger this.

Using your payments on lower apr credit first - If you carry a balance at 12% apr and took a cash advance at 19%, then any payments you make to your credit card company will be used to pay off your regular balance first (in this example). Only after your regular balance has been paid off will your payments be used to reduce your balance on the cash advance. Hence, many consumers who transfer their balance to a new credit card offering a 0% apr deal find their monthly payments is used for the 0% portion first, and the portion of their balance from new purchases that incur normal apr rates keep accumulating.

Increasing late fees - Late fees are on the rise as well. Some late fees go as high as $35.00 depending on your balance. The best way to prevent late fees is to pay on time via online payment services or enrolling in automatic payment from your bank account.

To sum up, a credit card company today relies more on finance charges from their cardholders to make money (since most credit cards now do not have annual fees). Beware of these so-called "fineprints", make your payments on time, try to pay your bills in full and you will save money from unnecesary charges that may be imposed by your credit card company if you are not careful.

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