You probably know credit card companies make money via interest payments. That’s not their only means of raking in the big bucks, though. Keep reading to learn more about how credit card companies turn consumers into cash cows.
Understanding this is very important if you have a credit card. Even if you never carry a balance, credit card companies profit whenever you use their lending products in certain ways. Consequently, they incentivize those behaviors – often against your best interest.
Let’s pull back the curtain and help you counteract this, shall we?
How do credit card companies make money?
Method #1: Interest
Let’s get this out of the way first since it’s the most obvious way credit card companies make money. If you carry a balance on your credit card beyond its grace period, the provider will start charging interest.
As obvious as this may seem, there are some nuances regarding the grace period worth highlighting here.
According to the U.S. Consumer Financial Protection Bureau, credit card companies stateside aren’t legally required to offer grace periods. Most do anyway.
In Canada, meanwhile, federally regulated credit card providers must offer grace periods, per the government.
In both countries, grace periods typically range from 21 to 25 days after the current billing cycle’s end. What many people don’t realize, however, is that the grace period only applies if you pay the balance off in full.
For example, let’s say you buy a new air conditioner for $4,000 with your credit card on June 1. If your billing cycle ends on June 15, you have until July 6 to pay the credit card’s balance off in full before interest begins accruing.
The balance you need to pay off includes any amount you may have owed prior to making the $4,000 air conditioner purchase. So if you already had $1,000 on the credit card, you need to repay the full $5,000 before July 6 to avoid paying interest on the $4,000 purchase.
The grace period also typically doesn’t apply to transactions classified as cash advances or balance transfers. Those transactions begin accruing interest immediately, and often at a much higher rate than normal purchases.
Credit card companies make lots of money from people who don’t understand how interest works. I hope I shed some light on the mechanism here. For a more in-depth look, check out this article from WalletHub.
How to avoid getting fleeced on credit card interest payments
The solution here is simple. Never carry a balance on your credit card. Instead, only spend what you can afford to pay off immediately or within the current month. Do this and you’ll never have to worry about keeping track of grace periods.
Method #2: Fees
Another way credit card companies make money is by charging fees. Common examples of credit card fees include the following.
- Annual fees: Providers of high-reward credit cards often charge annual fees to offset the associated costs. These can range from $100 all the way up to $500 and beyond, depending on the card. Credit cards marketed towards people with low or no credit also often come with annual fees, despite the lack of rewards. One of my very first credit cards, for example, charged $150 annually.
- Late payment fees: When you miss a credit card payment, companies will often hit you with a fee. This could be upwards of $40 if you’re a repeat offender. If it’s your first time missing a payment, they might charge you a lesser amount.
- Cash advance fees: When you make a transaction classified as a cash advance (i.e. withdrawing cash from your credit card at an ATM or moving funds from the card directly to a bank account), your credit card issuer will typically charge a fee. This can be as high as 5% of the cash advance amount.
- Excessive transaction fees: While you might assume credit card companies simply deny transactions that would exceed your available credit, this isn’t always the case. You can opt in to have them permit excessive transactions for a fee of up to $35 per instance in the United States, per the CARD Act of 2009.
- Currency exchange fees: If you buy something in a currency other than your credit card’s default, they’ll typically tack on a 2.5% currency exchange fee.
How to avoid getting fleeced on credit card fees
Before signing up for an annual fee credit card, run the numbers and make sure the rewards are actually worth it. You’d be surprised how many cards charge fees far in excess of the actual benefits they provide.
As for the usage-based fees, be aware of them and plan your spending accordingly. If you use your credit cards wisely, you shouldn’t ever have to pay things like cash advance, late payment, and excessive transaction fees.
Method #3: Merchant fees
Every time you spend money with your credit card, the recipient (i.e. the store you’re purchasing goods or services from) pays a merchant fee. This is a percentage of the total transaction amount.
Now, you might be thinking that because merchants cover this fee, you don’t have to worry about it. However, that’s not the case.
You see, as a study by MIT professors Drazen Prelec and Duncan Simester found, people typically spend up to 100% more with credit. This is no coincidence. Credit card companies are very intentional in convincing people (even those who never carry a balance and consider themselves responsible credit card owners) to spend more than they should.
Think about it. How often have you been even a little excited to swipe your credit card at the grocery store and receive those points? Pay attention next time this happens. Chances are you’ve got a few items in your cart you don’t really need.
Even the grace period can work against you here. When you spend with cash or debit, there’s no grace period; the money comes out of your account immediately. Meanwhile, the 21 to 25 day grace period many credit card companies offer places your first payment far enough into the future that it hardly seems real. Consequently, you’re willing to spend more.
My point? While merchants pay this fee, you make it worth their while by spending more money than you otherwise would have.
How to avoid getting fleeced via merchant fees
Be conscious of the fact credit card companies make money via your transactions even if you never carry a balance or incur other fees. Go one step further and consider that since the previous statement is true, credit card companies are also likely incentivizing you to spend more and increase their take per transaction.
One of my favorite ways to counteract this is by using cash or debit for non-fixed expenses that are prone to impulsivity (i.e. buying groceries). It’s much easier to control your spending that way.
I hope this article has helped you understand how to avoid becoming a cash cow for credit card companies. To read more of my debt management-related content, click here.