Anatomy of Credit Cards and How Banks Make Huge Profits from Credit Cards

In my last blog post, I mentioned that I have 10 credit cards but I never pay interest. I hold that many credit cards because I can maximize the benefit from purchases via different cashback programs.

I treat credit cards as if they were debit cards or even paper money. Before I make purchase using credit cards, I ensure I have enough money to cover that transaction. Yet, most people do not. They are usually tempted to buy unnecessary stuff even though they don't have enough money. As a result, they run into debt. According to a report released by the Federal Reserve, Americans had $1.023 trillion in outstanding revolving credit - often summarized as credit card debt in November 2017. NerdWallet's research also found that the average US household that has debt has more than $15,000 in credit card debt.

Inspired by Youtube video Why Credit Cards Are A Scam - Honest Ads, I decide to mention how credit card works and how issuing banks make money from it.

While the video is mainly a comedy, it somehow reflects how credit-card issuers can make tremendous money from irrational cardholders.

When we make purchase using credit cards, we actually borrow money from issuing banks to pay merchants. We agree to repay the issuing banks by the end of next statement cycle. If we do not pay in full by the end of statement cycle we have to pay interest. If we even fail to make minimum payment, penalty fee will also apply on top of the interest.

Merchants which accept credit cards have to pay transaction fee (more precisely, interchange fee) to issuing banks. This is how issuing banks make money even though cardholders make payment in full and never pay fees of any kind. This is also the reason issuing banks launch cashback or reward programs - they actually share a portion of interchange revenue with cardholders.

In credit card industry, yet, interchange income is lower than interest income. According to industry research organization R.K. Hammer, interest income topped $63.4 billion in 2016 while interchange income was $42.4 billion. Credit card issuing banks also earned significant fees imposed on cardholders whose financial management skills are generally lower. In 2016, there were income from cash advance fees of $26.6 billion and income from penalty fees of $12.2 billion.

Credit card is like a knife. It can be either beneficial or harmful. If one uses credit card to get discount (i.e., cash back) on necessities, credit card is his/her best friend. Nevertheless, if one treats credit card as a loan center and borrow money from it to buy luxury stuff, s/he is actually using a knife to cut his/her pulse.

In the next article, I will mention how I use my 10 credit cards to maximize cash back. Please follow me @moneyhacker on steemit.