Making Bank: How Credit Cards Make Money

There are three types of people on campus - students, professors and smiley people in vests. You see the latter waving around "free" frisbees and t-shirts. As a broke student, the prospect of free stuff was (and still is) super intriguing.

But as we all know, there's no such thing as a free shirt. They wanted a credit card application in exchange. As I'm not keen on selling my data, I politely declined.

The moment always stuck with me. Why would banks work so hard to give away credit? There must be something in it for them.

Well, you bet there is! Banks make billions off credit cards, this is how.

Interest

When you don't pay off your credit card in full on the due date, you will be charged interest on the balance. Average annual interest rates on credit cards are around 20%. This is an incredibly high price to pay and an insane return for the banks. When you consider that the average return of the stock market is about 7-8%, the return they earn on lending you money is more than 2x that.

Fees

There are a bunch of fees associated with credit cards. Annual membership fees, cash advance fees, balance transfer fees, late fees, over-limit fees and balance protection insurance (just to name a few). In the R.K. Hammer study, it showed that credit card fees made banks $100 billion and this number has grown steadily every year.

Interchange

Interchange is a percentage of your purchase that goes to the bank. Interchange is about 2-3% and is paid by the merchant. If you ever wonder why some places requires a minimum purchase to accept credit or is cash-only, interchange is your answer.

Wrap Up

Banks make a lot of money from credit cards. They can afford to give away t-shirts because they know they'll make that back and then some. Understanding how they make money will help you be smarter with your credit card usage.

Simple rules of thumb, pay off your balance every month and avoid all fees if possible (there are great credit cards out there with no membership fee). If you do pay a membership fee, make sure the rewards are worth it.

Credit cards can be great. They're convenient, help build your credit and can offer some pretty sweet rewards. You just need to understand how they make money so you can ensure the benefits of using them are not trumped by the costs.

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