- We break down the many ways in which banks make a profit from credit cards.
- Handled properly, a credit card can be profitable for the cardholder too.
- The secret is to make sure that you’re not the one who pays the bank. Learn how.
Banks. They’re the bad guys, right?
As a result of the Banking Royal Commission, we’ve all grown accustomed to hearing about the sins and failures of our financial institutions, found guilty of gouging and overselling and definitely not putting customers’ welfare front and centre..
But at the end of the day, banks are businesses. They have a duty to shareholders, an obligation to make a profit. And, while we want them to stick to the rules and also show compassion when required, they’re not charities. They need to make a buck.
Credit can’t always be free
Credit was never free, and never will be (except for savvy credit card users who know how to extract every last particle of value from their card – more on this later). Someone has to pay.
The history of credit goes back 4,000 years to ancient Mesopotamia, when farmers borrowed seeds or animals and repaid the loan in kind at harvest time, with a profit margin for the lender. In this way, excess wealth lying idle was transferred temporarily to those who could make use of it to fuel growth, and this is still the basic premise behind all lending – including credit cards – today.
It means that extending credit costs the banks money – they have to borrow the money they then on-lend via loans and lines of credit, including credit cards. So it should come as no surprise that credit cards are just one of their ways of contributing to their bottom line, via interest charges, annual fees and other fees paid by cardholders, plus transaction fees paid by merchants – businesses which accept credit cards.
Free credit, in the form of introductory balance transfer and purchase offers and standard monthly interest-free days, has to be paid for somehow. The trick is to make sure that you are not the one paying for it.
So let’s take a look at the various ways banks make money from credit cards.
Credit card interest charges
Interest charges are the main source of credit card profit for banks. Credit card interest rates and terms vary widely. While they all offer interest-free days on purchases, cash advances will attract interest charges immediately, partly because the bank has no opportunity to recover any of its costs via the type of fee it levies on merchants for processing purchases. Cash advance interest rates, and balance transfer revert rates, are often higher than the interest rates charged for overdue purchases. The number of ongoing interest-free days on purchases ranges between 44 and 55 or more.
That’s a lot of variables to take into account. Add in other card benefits, like rewards points and complimentary insurance, and other charges, like annual fees, merchant fees and other charges, and it’s safe to assume that the banks use a complex algorithm to determine their interest rates. As a result, cardholders are offered both low interest credit cards, with purchase interest rates usually ranging between 9.9% and 15% p.a., and premium rewards credit cards, with a fairly narrow purchase interest range normally lying between 19.75% and 20.75% p.a.
Why are some of these interest rates so high? Part of the reason is that they are effectively offering unsecured loans, but that’s not the whole story, since personal loans are also usually unsecured and don’t often incur such a high interest rate. A second reason is that credit card debt is inherently risky. In the USA, the anticipated default rate on credit card debt in times of severe economic stress is 13.7%, compared with a residential mortgage default rate of only 2.2%.
But there’s a third reason. The cardholders paying those interest rates are the ones who don’t clear their debt when ongoing interest-free days or an interest-free promotional period come to an end. They are the credit card issuers’ main source of profit, and they are funding the credit cards and benefits of cardholders who clear their debt every month.
Credit card annual fees
Credit card annual fees can have several components. There’s usually a primary cardholder fee, and there may be a fee charged for each supplementary cardholder. Some rewards cards charge an additional annual fee for the optional rewards program.
Annual fees are basically defraying admin costs, and partly offsetting the cost of any rewards points and complimentary benefits. This is not likely to be where banks make most of their money.
Some credit cards have no annual fee. These are usually very basic cards (except in cases where the fee is only waived for the first year), but there are a few cards that never charge an annual fee but still offer rewards points or other benefits, such as the American Express Velocity Escape Card and Qantas American Express Discovery Credit Card.
Overall, premium rewards cardholders will pay the highest annual fees, from around $300 to as much as $1,450, or even more for business credit cards. But the annual value of rewards points and other benefits usually recovers the annual fee several times over.
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Other credit card fees
Annual fees are not the only type of fee attached to credit cards. There are quite a few other fees, but many of them are avoidable. They include:
Cash advance fees, payable in addition to interest, e.g. the greater of $2.5 or 2% of the amount withdrawn. (Avoid them by steering clear of cash advances.)
Late payment fees, e.g. $15. (Always make at least the minimum payment on time to dodge this fee.)
Balance transfer upfront fee – a credit establishment fee – e.g. 2% of the amount transferred. (Look for a balance transfer offer with no upfront fee.)
Foreign transaction fees, payable on any transaction processed overseas, even when the merchant charged in Australian dollars, e.g. 3% of the transaction amount. (Some cards have no foreign transaction fees.) You may also be charged an ATM withdrawal fee for cash advances taken overseas.
Other fees you may encounter include over limit fees, dishonoured payment fees, overseas emergency card replacement fees, overseas ATM balance enquiry fees and duplicate statement fees. If you are organised about your finances you should be able to escape them.
Credit card merchant fees
Merchants who accept credit cards pay a fee to their bank, typically 1%-1.5% of the transaction amount for Visa and Mastercard, and 2%-3% for American Express cards. Some merchants absorb this cost, while others pass it on to the purchaser in the form of a transaction surcharge. In this situation, it’s the purchaser, not the merchant, who is ultimately paying the bank. In the past, some merchants were imposing surcharges well in excess of their costs, but this practice has been illegal since September 2016.
Any surcharge payable for using a credit card should be clearly displayed at every in-store or online checkout, so that you can decide whether to use your credit card or another form of payment, such as cash or a bank transfer of funds. You can also choose to vote with your feet and take your custom elsewhere, to a business where no surcharge is imposed.
How to minimise your credit card costs and maximise your benefits
The bottom line is that you can let other people – those who are financially undisciplined – pay the bank for your credit card convenience and benefits, by:
Avoiding upfront balance transfer fees by choosing a card with no balance transfer fee.
Making full use of monthly interest-free days on purchases, but repaying the full balance every month.
Setting up payment alerts or automated repayments, to avoid interest charges and late payment fees.
Avoiding credit card cash advances by keeping some accessible cash in a bank savings or transaction account, and using a travel money card for cash withdrawals overseas.
Doing your research to choose a card where your spending pattern means you will be able to extract value in rewards and benefits well in excess of the annual fee.
Doing your research means someone else pays the bank
Here at Credit Card Compare, we know the banks have to make money, but we’re also here to help cardholders make the right choice to get a card that delivers maximum benefits at the lowest cost.
Here’s how to achieve this:
Look at your lifestyle and spending pattern to decide if you need a low cost, no-frills card (possibly with a low interest rate) or a premium card with rewards points and/or other benefits. i.e. don’t pay for a premium card if you won’t spend enough to cover the cost in benefits received, or if you expect to be paying interest.
Once you’ve decided, look at Credit Card Compare’s ‘Features’ section (there’s a link at the top of every page on the site) to find listings of the type of card you are looking for.
Check the Pros and Cons of possible cards, and read our reviews for a more detailed explanation.
Compare cards by clicking our ‘+Add to comparison’ tool at the foot of each card’s main features display, then clicking ‘COMPARE’ at the top right of the page.
Choose your ideal card, plan to be financially savvy in the way you handle it, and let someone else pay the bank!