Credit cards have become an integral part of our modern lives. Instead of carrying a bunch of coins and paper money, we carry a stack of credit cards at all times. As online purchases become more popular, money continues to be abstracted into bits of data transferred between computers. Seriously, how often do we actually see the physical cash of our paychecks and purchases? A sale is no longer as simple as it seems: behind the scenes, dollar amounts swing wildly. Between credit card companies’ levies, interest payments, and rewards, a transaction amount gains value, then loses it, then gains it back as it works its way from consumer paycheck to merchant pocket.
Let’s buy an Apple TV: American Express Edition
Credit card networks levy a fee on each transaction they process. Every time you swipe your credit card, the merchant you’re buying from has to pay a fee. Different credit card companies charge different amounts, depending on the retailer and the type of card used. For simplicity we’ll only trace American Express and Discover purchases, which operate under the simpler, closed network of credit card payment process.
Money from merchants: Let’s pretend that you, an average American Express cardholders, just bought an Apple TV online with an AmEx credit card. The TV costs around $100 (it’s actually $99, but we’ll just round up). After American Express processes the payment, it pockets $2.55. Instead of you paying Apple $100 directly, AmEx pays Apple and then bills you at the end of the month. But rather than paying Apple $100 and charging you $100, AmEx only gives Apple $97.45. This “commission” is called the discount charge, and it’s how American Express mainly generates its revenue.
Rewards to cardholders: In reality, American Express doesn’t actually pocket all of the $2.55 it keeps. In the struggle to stay competitive, credit card companies rely heavily on rewards credit cards. American Express, like most issuers, offers substantial rewards to its card members. So of the $2.55 that American Express makes as discount revenue, $0.85 is used for rewards to keep its customers happy.
Interest income: Credit card companies earn more than just discount revenue, of course. We’ve all heard about the horror stories of America’s growing credit card debt, and the proliferation of credit cards seems to feed consumers’ tendency to overspend. In fact, though you purchased the TV for $100, AmEx expects you to eventually pay more than that. The average American doesn’t pay her credit card bills in full every month, and so accrues interest. For the $100 TV, American Express expects to receive $1.14 in interest payments, bringing the true cost of the purchase to $101.14.
Back in the day, you would have handed Apple $100 in cash, and Apple would have given you a TV in exchange. Now, AmEx pays Apple $97.45 and collects $101.14 from you. It then gives, on average, $0.85 back in the form of rewards. If you’re the average AmEx customer, you’ve taken a convoluted route to paying $100.29 for a $100 TV.
Let’s Buy an Apple TV: Discover Edition
Money from merchants: Now, let’s follow the money as it goes through the Discover machine. Discover charges a smaller discount rate than AmEx, approximately 1.87%. This means that Discover will bill you $100 and pay Apple $98.13. Notice that in this scenario, Apple receives more cash for its product. American Express, because of its luxurious rewards programs, typically charges a higher discount rate than its competitors. The higher discount rate explains in part why more places accept Visa and MasterCard than American Express: merchants get to keep more of their money.
Rewards for cardholders: Of the $1.87 that Discover takes as discount revenue from Apple, $0.77 is used for rewards programs. Although Discover spends fewer dollars on rewards, it spends a larger portion of the discount revenue, eschewing higher revenue in order to keep customers loyal.
Interest income: In terms of interest rate payments, Discover expects to make $6.42 from the $100 purchase, substantially higher than AmEx’s assumption. One reason for the discrepancy is that Discover, on the whole, charges a higher interest rate than American Express does. The second reason, and perhaps the more salient, is that the average Discover cardholder is less likely to pay his credit card bill in full than the average American Express cardholder. AmEx, because of its rewards programs and benefits, tends to attract people with higher incomes who are therefore less likely to carry a balance each month. A typical Discover customer, then, pays $105.65 for the $100 TV after interest and rewards.
The higher interest income that Discover receives is not without cost. Because its cardholders are on average less wealthy than American Express’, Discover is more likely write off its credit card loans – that is, to decide that a delinquent cardholder is never going to pay off his debts and swallow the loss. In 2010, Discover’s net write-off rate was 8.08%, compared to American Express’s 5.80%. To “prepare” for the expected defaults on the credit card loans, Discover also sets aside a larger amount of money for loan losses than American Express. These reserves are not count as profit. The book values of the two companies’ interest incomes, as a result, are relatively similar despite the initial gross income difference.
Here’s a table to visualise the breakdown:
Card Issuer Keeps (Discount Revenue)
Card Issuer Spends (Rewards)
Card Issuer Receives (Interest)
Net Profit for Card Issuer
Your Cost after Interest and Rewards
*Numbers are NerdWallet estimates. All data based on 2010 figures, the latest available
Are we stuck in a cycle?
Credit cards have fundamentally changed the way consumers think about spending money. Rather than seeing a purchase as a withdrawal of funds, consumers see it as an opportunity to earn rewards or to spend more than they have. This overspending can be a detriment, but as long as consumers eventually pay their bills, credit card companies actually welcome the debt because it earns interest. In fact, another reason that issuers steer customers towards rewards cards is that the interest is far higher than low APR credit cards, and customers tend to carry a balance even though they know they shouldn’t.
The credit card business forms a cycle: As credit card companies spend more money on rewards, consumers are convinced that they should overspend to obtain the maximum benefits. This overspending will of course lead to consumers to carry balances and pay more interest. The credit card companies, in turn, will capitalise on the extra interest income they receive and renew the cycle by offering better rewards programs.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.