ELI5:
The Business Of
Credit Cards

How exactly do credit card businesses work?

May 23, 2023

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This summer, I’m interning at Ramp, a startup involved with corporate cards and expense management. Even so, a little while ago, I realized I didn’t really understand how credit cards work. I knew the basics – you borrow money from a bank to make a purchase right now, and then pay back what you borrowed at the end of some period.

But what do Visa, Mastercard, and Amex do? How does the bank make money when I always only pay back what I’ve borrowed? Why do some credit cards cost money? And cashback – why would a lender reward you for taking away their money? How much money do the banks make, and how many other intermediaries are there? And how are credit cards any different from the Buy Now Pay Later (BNPL) model (see Affirm)?

I figured I should have answers to these questions if I was going to work at a credit card company. So here goes.

The Schumer Box

The fundamental point of a credit card is to enable purchases that cost more money than you may have at the point of sale.

Let’s say Bob wants to purchase a shiny new $500 TV without having to dip into his savings. He doesn’t have any more money to spend, so borrows $500 by swiping his credit card.

He agrees to pay back the $500 by the end of the month when he gets paid from work. On the 31st, he receives his salary, and pays back the credit card company exactly $500. Done.

But what if Bob had some other unexpected expenses and couldn’t pay back the $500 by the end of the month? That’s actually no biggie – the credit card company is all good with that. They give Bob some more time to pay back the $500. They only ask for a minimum payment – some fraction of the $500, say $100, by the end of the month. They then give Bob the option to pay back the rest of the $400 by whenever. Except now, they add on an additional 0.05% (the DPR; Daily Periodic Rate) of whatever Bob has left to pay every day that he has outstanding charges. The APR (Annual Percentage Rate) – typically between 15% to 30% – is just the DPR expressed on a larger time scale (year).

But what if Bob can only pay back $50 by the end of the month? In that case, the credit card issuer will charge him interest (0.05% daily) on the entire $500 until he pays back all of it. And because Bob cannot pay back all the money he borrowed on time, his credit score goes down.

This interest on the $500 is the credit card issuer’s largest source of revenue. Interest accounts for about 45% of credit card issuers’ annual revenue (The Motley Fool).

Some credit card issuers also charge an annual fee. This can either be because they’re lending money to consumers with a modest credit history (so there is more risk attached to their lending) or because they offer significant rewards for spending in certain ways (cashback), which I’ll cover in a little bit.

Federal law requires issuers to prominently disclose all annual fees and interest rates in a chart called a Schumer Box. At first glance, the Schumer Box looks intimidating – supposedly, people frequently gloss over it without fully understanding every number. Hopefully, some of those terms now make more sense.

Interchange

Let’s go back to when Bob swiped his credit card at the store to buy a TV. The sticker price of the TV is $500, but that’s not actually what the store receives at the end of the day.

There is a lot of work going on behind the scenes when you swipe your credit card.

Let’s say Bob buys his TV at Alice’s Fantastic TV Emporium. Bob has a Visa Credit Card issued by Chase Bank, and Alice’s business account is with Bank of America. Here, Alice is the merchant, Visa is the card network, Chase Bank is the issuer, and Bank of America is the acquirer.

The merchant pays a fee to the network, the issuer, and the acquirer for services rendered. This fee is called interchange. The interchange fee is typically a flat fee + a percentage cut that together comprise around 3% of the entire transaction, and is split (unequally) between all these (and other) stakeholders.

The payment network (Visa in this case) connects the issuer and the acquirer bank with APIs that enable the electronic transfer of funds. Without the card network, every bank would have to have an agreement with every other bank for how to handle transfers between one another. The card network abstracts away all of this detail.

The issuer and acquirer banks are paid for handling costs, fraud detection, and the risk they take on by approving the transaction.

Interchange fees may be why you see stores that don’t accept credit cards, or offer discounts if paying with cash. It’s also why some stores often have a “credit card minimum” – they would lose too much money off the flat interchange fees with small transactions. Interchange makes up another ~30% of revenue for credit card issuers (The Motley Fool).

Take Your Cash Back!

So why do credit card issuers advertise bountiful cashback and points deals if it means giving up their own profits?

The answer again is in interchange. When a consumer has a cashback rewards program, their “cash back” is simply a cut of the interchange fees that are paid out to the issuer. So the issuer does not lose any money through the program.

Really, the consumer is incentivized to spend more money when they have cashback (after all, they’re “earning” money by spending it!), which ultimately results in more profit for the issuer.

Cashback is merely a motivator for consumers to use their credit cards when making payments rather than cash or debit cards (which don’t earn issuers any money). The more a consumer uses a credit card, the more interchange fees the credit card company earns, and the more likely the consumer is to pay (more) interest to the issuer if they fall back on payments.

Credit card reward points work on a very similar principle. You have to spend money to earn points, all the while earning the issuer revenue through interchange and interest.

It makes sense, then, that credit cards that offer the most generous sounding rewards programs also often carry the highest fees and interest rates.

The bottom line is that contrary to popular belief, cash back rewards programs do not drain corporate profits. They actually dramatically increase credit card companies' revenue.

This is all not to say that rewards programs cannot inherently be profitable to consumers – they can be exceedingly lucrative if you always pay back your balance on time and use your credit card on the right purchases.

"It's a company card!"

How are corporate cards any different from personal credit cards? The obvious distinction is that they are funded by a corporation rather than any individual. But they also offer the issuing company a lot of granularity with regards to spending limits and access control. Plus, you never again have to keep track of all your receipts, hand them over to HR, and wait three weeks before being reimbursed.

Companies like Expensify, Brex, and Ramp have also built expense management platforms on top of their corporate cards. Finance teams that use these cards gain access to deep insights on spending and save time with automated expense reports.

In fact, corporate cards from Ramp and Brex are actually free to use – there are no fees for issuing cards (as far as I can tell). They also offer charge cards as opposed to credit cards – payment is due in full at the end of the month (as opposed to a minimum payment like with credit cards).

So with no possibility for interest at all, how do companies like Ramp and Brex actually make money? Interchange again! They take a cut.

Buy Now, Pay Later!

The Buy Now, Pay Later (BNPL) industry, shepherded by companies like Affirm and Klarna, grew 77% in 2022 (by volume of transactions). BNPL loans allow consumers to buy something today, then repay the amount over time with regular, interest-free installments.

Let’s take the example of Bob’s TV once again. Bob might take out a BNPL loan on Affirm. Affirm would then finance the purchase right then and take on the risk associated with the loan (much like the issuer with credit cards).

How do they make money? BNPL issuers levy an interchange equivalent charge on the merchant, effectively a cut of the transaction amount. They then rely on Bob to pay back the amount in full and charge interest and fees on late payments.

How do they compare to credit cards? As far as I can tell, their core concepts are very similar. You can think of a BNPL loan as a credit card to finance just one purchase.



That was my primer on credit cards. This is a massive topic and I’ve only just scratched the surface. There are so many more questions that still need answering:


More to come!