How credit cards make money

Patrick McKenzie (patio11)

Payments are deceptively complicated—everyone has used them and thinks they have good intuitions for how they work. However, payments require coordination of a dance between different parties who have extremely different incentives, both on a transaction-by-transaction basis and what they get out of participating at all.

Consider the humble credit card. Swipe it. Tap It. Dip it. HTTP GET it. You have probably used one, mostly oblivious to how it is a complicated bundle of services with a pricing structure strictly more complicated than a venture capital fund’s.

Here is how your bank thinks about it. (A useful jargon word to know: if you have plastic with your bank’s name on it, that makes the bank the issuer of that card. This helps to distinguish it from the other banks involved in a credit card transaction.)

Bundling and unbundling

It’s a truism that there are two ways to make money in financial services: bundling and unbundling. Credit cards aren’t just a bundle, they’re a Mandelbrot set of bundles. The bundles contain bundles. It is bundles all the way down… and all the way up.

One way to think of bundling is as cross-subsidization: you can charge users (or other parties, but we’re getting ahead of ourselves) more for X to give them Y for less than they expect, or even free (or negative!) Credit cards are cross-subsidization engines, both within a particular card as used, within a portfolio of customers using a particular card, and across a financial institution’s customers.

This last bit is very important: sometimes credit cards make money by losing money on the card itself. This is fairly rare, and mostly limited to a small number of issuers at the higher end of their product lines and customer archetypes. You can lose money on e.g. a particular entrepreneur’s personal rewards card to capture their deposit banking business, mortgage, and business banking, and while most financial institutions don’t set out to do this, individual accounts being single-product losers within large portfolios of users is unexceptional and very, very planned.

But let’s talk about the vastly more common case cards are designed around, where a good-fit, non-fraudulent user is expected to pull their own weight revenue-wise.

Revenue levers for credit cards

Net interest. Interchange. Fees. Marketing contributions. There, that’s (just about) every way your card can make money. Taking them in turn:

Net interest

Credit cards facilitate high-frequency minimal-human-involvement extensions of relatively tiny consumer loans bundled (ba dum bum) into an ongoing relationship with parameters negotiated very infrequently relative to individual transactions.

It’s often forgotten, but prior to credit cards, many Main Street retailers like e.g. pharmacies maintained hundreds or thousands of credit accounts for customers individually, necessitating their own back offices, accounting, and collections headache. This was in the ultimate service of getting customers to choose them over competitors, transact in larger sizes, and come back more frequently, the “only three aims of marketing.”

Credit cards represented banks saying: “You know, if you had a specialist doing that for you, it would be much more efficient. They’d have computers doing the math, not bookkeepers. They’d have departments doing collections, not clothing salespeople worried about offending customers who they’d need again at Christmas. They’d have access to cheap deposits to fund loans, rather than expensive working capital. They’d be adequately capitalized against losses, rather than having tiny margins backed by almost no equity, like most retailers. They’d diversify against regional and sectoral risk, rather than being all-in on the plant down the road still being open.”

So credit cards generate loans. A lot of loans. The traditional business of banking makes money on loans by funding them with a mix of cheap deposits and more expensive equity, charging adequately, collecting a spread, and using a portion of that spread to pay for operational costs and defaults.

Credit cards made the business of making loans work much better, by encouraging loans to be automated (rather than bespoke), by encouraging them to be more frequent, and by making them be iterative games rather than one-shots. This, and credit cards’ other revenue streams, let banks relax the “credit box” for loans originated by cards versus comparable unsecured signature loans.

The credit box, a metaphor from consumer underwriting, is conceptually a matrix which maps customer quality, loan amount, and similar to the prices you’d need to justify the underwriting decision or an outright denial, representing “This loan is negative expected value at all conceivable prices and we shouldn’t make it, at all.” Relaxing the box means approving more customers, approving smaller (less lucrative) and larger (riskier) loans, and giving borrowers better pricing.

Interestingly, credit cards make originating loans a distinct business from holding loans. Depending on a bank’s appetite for consumer credit risk and how much in deposits and equity they can back their loan portfolio with, they might not be able to satisfy all customer demand with their own resources. Some banks will package “pools” of those originated loans and sell them on to investors, earning a fee for the ongoing servicing of the loan (they are still the ones receiving payments and on the other end of the telephone, after all) and generally a premium to the pool’s face value (because investors are willing to pay more than $100 for the promise to repay $100 and 12% annual interest over time).

But as mammoth of a business as lending is, lending is not the reason credit cards took over payments in much of the world. Interchange is.

Interchange

When you swipe your card at the local cafe, multiple sales have necessarily happened. One is selling you a coffee. One was selling you a credit card. And one was selling the cafe on the desirability of accepting your credit card brand.

The sale to the cafe went something like this: You’d sell a lot more coffee if you accepted our credit cards. The best coffee drinkers carry our plastic, and they will drink coffee where they can use our plastic. You should pay us a bit for bringing you these desirable coffee drinkers, just like you’d pay for an ad in the paper that brought you desirable coffee drinkers.

That fee is called interchange. (Technically speaking, the industry dices up the fee into a few different parts and has different names for them, but let’s agree to call it interchange for the moment.)

The lion’s share of interchange goes to the card issuer… at least for the moment (oh don’t worry, we’ll get to that). Issuers have this argument for why they should get most of the fee: they do most of the work in the ecosystem. They signed you up for a card. They take the credit risk if you drink your coffee but don’t pay your bills. They will answer a phone call at 3 AM in the morning on the second ring if you have a problem with the card.

A much smaller portion of interchange goes to the credit card processor, to the acquiring bank, and to the credit card network. (Stripe makes a very large portion of our revenue by taking a small portion of the cost of interchange which we charge our business users.)

Interchange makes cards so valuable you’re paid to use them

Interchange ended up with different regional equilibria as credit cards ate parts of the payments pie worldwide.

In the United States, issuers quickly discovered some customer archetypes which absolutely printed money via interchange. A major one was business travelers, who were largely not customers of the credit but only needed the cards for money movement. And they moved a lot of money, mostly between their employers and airlines/hotels.

Competition for the business of business travelers caused one of the most important innovations in both consumer banking and the travel industries ever: cross-subsidization of credit card customer acquisition with travel company loyalty points. This economic engine became so massive that it is now worth strictly more than the airlines themselves, and it sparked a change of practice across U.S. cards: competing aggressively for customers by rebating interchange in the form of either rewards (such as airline loyalty points) or cash back (a post-transaction discount).

This had fascinating implications for the microeconomics of credit cards. For one, competition for desirable credit card users is so intense that profit margins for banks decline midway up the credit score ladder (and for some segments are actually persistently negative), before recovering for the most desirable users (who spend so much that their interchange finally outruns the rewards expense). (See Table 3 in this PDF.)

For another, this ended up being an almost peculiarly American experience. In Europe, regulators were worried about the cost of interchange to businesses (rather than consumers) and capped it. Since issuers didn’t have the margin to compete on rewards paid for by interchange, they instead leaned into branding and convenience, and credit cards became a smaller portion of the payment mix (about 47% of electronic payments, compared to almost 70% in the U.S.).

Curiously, in Japan, interchange is uncapped (and, according to the government, maddeningly opaque) but financial institutions held the line on rewards at 1%. This makes card issuance an extremely profitable business to be in in Japan, so much so that it subsidizes the rest of consumer banking in Japan’s persistent low interest rate environment (which depresses the net interest margin that consumer deposit accounts generally generate most revenue from, historically and in much of the world).

Fees

Fees have gone out of favor in much of consumer-facing finance, but credit cards have historically been rich sources of them. You can broadly categorize them into account fees and usage-based fees, with the former applying to most holders of a particular card (though issuers frequently waive them for marketing/etc purposes) and the latter based on user behavior that the issuer wants to discourage and/or price.

The two dominant types of credit card fees are over-the-limit fees and late payment fees. Both have declined as a percentage of the revenue mix over the last several years, due to consumers having better visibility into their usage (largely via mobile apps and IVR systems) and due to regulatory pressure to compress fee levels. The CARD Act alone probably returned over $10 billion a year to consumers.

Marketing contributions

One insight the industry had is that there is a limit to business’ desire to pay for payment acceptance but a much higher willingness to pay for customer acquisition. As technology has allowed credit card companies tight loops to their customers, they are increasingly attempting to nudge their purchase behavior in provable ways then invoice businesses for a portion of the marginal revenue driven.

A very customer-visible example of this is on Square’s Cash App, which periodically offers “Boosts” which rebate much more than interchange rates for particular purchases. These are sometimes paid for by the issuer as a marketing expense, but more frequently they’re the marketing spend of the boosted business. For example, Cash App (as of this writing) offers 10% off on one use at any grocery store and 5% off up to ten online purchases at Adidas. Without any internal knowledge, the first of these is very likely to be Square subsidizing the customer to motivate future behavior; the second is likely Adidas paying Square to send them more sneakers-hungry consumers (and send less to Nike). This sort of thing makes credit cards into a “channel” where advertisers compete with money, just like they compete for placement on retailer’s shelves or in the weekly insert in a newspaper.

If you are familiar with Bank of America or Chase mobile apps, you may have noticed partner rewards programs that periodically offer you, e.g., 5% cash back for a transaction at Starbucks. These are administered by a publicly traded company called Cardlytics, which charges the likes of Starbucks to drive them business, pays the consumer incentive out of the marketing spend, and also pays the bank for lending them the customer relationship. It is real money; they paid banks more than $100 million in 2020.

It is believed by many that banks make lots of money selling "your data." This is not a significant contributor to the economics of credit cards, for reasons which are slightly too complicated to get into in this piece. The short version: much like Google and Facebook, issuers can demonstrate to the most sophisticated organizations on the planet that they can deterministically influence actual purchasing behavior. That's easier to sell than a CSV file and worth more to more businesses.

That is substantially every way to make money with credit cards. Balancing these against each other is a fascinating exercise in marketing and product design, which will revisit later in this series.

Debit cards: a horse of a different color

Debit cards are a very similar product with enough under-the-hood differences that they deserve their own moment in the sun. In particular, due to a quirk of U.S. interchange regulation, they basically fund most of the fintech industry.

See you next time for it. Later in the series, we’ll discuss how the microeconomics of these products have helped turn payments infrastructure into a platform and ecosystem.

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