Swipe it, charge it, blink it, whatever you’re doing, that business card sized piece of plastic is the centerfold of much of our lives.  Some people have sworn off all credit cards and so you’ll think this class isn’t for you, you’re wrong.  If you even use a debit card you should at least pay attention to the section on the credit card networks (like Visa and Mastercard).

How Credit Card Issuers Make Money
Credit cards are a mystery to many on us.  Sure we know that Visa and Mastercard show up on many of the popular banking cards from Citi, Chase, and Bank of America, and we know that if we don’t pay off the balance we’re charged an interest rate, and we can usually find a few fees snuck into our bill a few times a year.  But all of that money goes to the bank issuing the card.  Let’s just pick Citi for our example.  Citi bears the risk that you won’t pay your card, so they set the interest rate and the fees.  If you don’t pay off the card then Citi starts to make the good money.  But what if you’re like me and pay the card off every month?  Does that mean Citi isn’t making any money off of you?  Yeah right, you think they’re that stupid?

How Credit Card Networks Make Money
In order to understand how credit card companies make money, we must identify all the players.  You’ve got the network manager (like Visa), the customer (you), the credit card issuer (Citi) , the merchant (Joe’s Gas-n-Ass fuel and donkey retailer), and the merchant’s bank (Wells Fargo).  You’re heading to Joe’s to pick up a pack of cigs, a King Cobra 40oz, and some pop-tarts (because you’re either in college, or a deadbeat) and the total bill comes to $10.  You hand over your Citi Visa card and Bertha, the Joe’s cashier (nice lady, smells like donkeys), swipes the card.  In the blink of an eye Joe’s has his money and you have your stuff.  But what just happened?

In a matter of seconds, here’s what happened:  The card reader recognizes who you are and contacts Citi.  Citi sends $10 to Wells Fargo (Joe’s bank) and Wells adds the $10 to Joe’s merchant account*.  Citi then increases the balance of your credit card the appropriate $10.  So we get how all of them made money, but what about Visa?

Companies like Visa and Mastercard are “retail network managers”.  In other words, if all the other participants are driving down the freeway to make these transactions, Visa is the asphalt.  Like a toll road, you have to pay to play.  The short version of this is that Visa and companies like it charge the merchant a small (but significant) fee.  Depending on company, country, and merchant this can range from 1% to 6%.  Traditionally, American Express charges the most.  The way this works in the example is Wells Fargo won’t give Joe the full $10, they’ll subtract 20¢ (assuming 2% fee) and give Joe $9.80.  Another way to say this is simply for a $10 purchase Citi charges your account $10 but only gives $9.80 to Joe’s via Wells Fargo.  That 20¢ is given to Citi who then splits it with Visa.  Though I couldn’t confirm this, I assume the amount the bank gets and the amount Visa gets is a negotiated deal.  One final note this arrangement, Visa and Mastercard charge the banks an annual fee, to simply be a part of their network.

This process works a little differently with Discover and American Express.  Instead of partnering up with the banks, they are the banks.  So in the example above it wouldn’t be Citi sending the money to Joe’s it’s American Express.  This is why you don’t see American Express Citi or Discover Wells Fargo cards.  This method has its own advantages, tighter networks means more secure information, one stop customer service, and sometimes exclusivity.  But they aren’t accepted as widely and your options for cards are limited.

So what we have here is a system that adds grease to our economy. Many might blame credit cards for some of the problems facing Americans’ personal finances, but that’s like blaming oil for climate change. It isn’t its presence that causes the problems, it’s how you use it.

*In actuality, merchants usually upload these sales daily instead of on the fly.  They usually get paid the next business day or two, which is why these transactions don’t immediately appear on your credit card statement.  In the example, Citi would send an “approved” message to Joe’s saying you can have the items you’ve purchased and that Citi will pay the merchant in the next batch upload.

Photos: andresrueda, thetruthabout

By The Weakonomist

The Weakonomist is the founder of Weakonomics. Clicking the picture of the puppy will tell you more about him. If you like what you're reading consider subscribing to the blog, following him on Twitter, and checking out the related posts below. Please consider a donation if you really enjoy Weakonomics.

categories: banking, business, loans