How Credit Card Companies Make Money By Giving It Away

For several years now, credit card companies have used 0% introductory rate offers to attract new cardholders.  These offers come in one of two forms.  First, cards offer 0% on balance transfers, enticing consumers to transfer high rate credit card debt over to a new card with no interest for six to 12 months.  These offers can help pay off debt faster if you use them responsibly.  Second, many issuers offer interest free credit cards on purchases, again typically for six to 12 months.  And in some cases, a card will offer 0% interest on both balance transfers and purchases.

While offering free money is a great way to market a credit card, it raises an interesting econ 101 question—how do credit card companies profit by giving money away?  A reader recently asked this question and assumed that the profit came when the introductory offer expired and the card company hit you with exorbitant rates.  While the interest rates that apply following the introductory rate are certainly part of the equation, the answer is a far more complex.  And the starting point of the analysis is understanding a critical difference between a 0% offer for balance transfers and one for purchases.

When a consumer uses a credit card for a purchase, the credit card company receives a fee from the merchant.  Called an interchange fee, the amount of these fees varies depending on the type of card.  Did you ever wonder why Visa and MasterCard are more widely accepted than American Express or Discover?  Part of the reason is that they charge a lower interchange fee.  Anyway, the average interchange fee is about 2% of the amount of the purchase.  Because a balance transfer does not involve a purchase, the credit card company does not receive an interchange fee.

With that background, here are 5 ways credit card companies can profit from 0% APR offers:

Interchange Fees:  As just described, credit card companies receive about 2% of each purchase you make with a card.  So while you won’t pay interest on the purchase for a time, the credit card company pockets the 2% fee.  And if you continue to use the card for purchases after the introductory rate expires, the credit card company continues to receive these fees.

Balance Transfer Fees:  Because interchange fees aren’t paid on balance transfers, credit card companies charge a fee for each balance transfer.  The fee is typically a percentage of the amount transferred, and it generally ranges from 3% to 5% depending on the issuing bank and the length of the offer.  At one time, cards offered no fee balance transfers, but those offers have long since gone away.  There are some ways to use a 0% on purchases card to effectively get a free balance transfer, but it will take some work on your part.

Repayment Gotcha:  Credit card companies also devised a sneaky way to get extra interest payments from cardholders.   Suppose you transfer a balance to a new card at 0% and also make some purchases at the card’s regular interest rate of say 12%.  If you make more than the minimum payment the following month, where does the amount that exceeded the minimum payment get applied—the 0% balance or the 12% balance?  As you might have guessed, it gets applied to the 0% balance, while you continue to get hit with 12% interest on your purchase.

The Credit Card Act that passed this year eliminates this trick, but it does not go into effect until February 2010.

Low Cost of Capital:  Credit cards have not always offered 0% interest.  In fact, this marketing tactic materialized when interest rates sunk to historically low levels.  By accessing capital at an extremely low rate, credit card companies can offer 0% interest for a short time without exposing themselves to huge losses.  This factor doesn’t actually enable the credit card company to make money directly—even a low cost of capital costs something.  But coupled with the other factors listed here, it does allow them to give away money interest fee and still make a profit.

Interest:   As the reader correctly noted, the 0% offer will eventually expire.  If you continue to carry a balance, the credit card company will make money on the interest payments.  For this reason, if you don’t think you will pay off the balance before the 0% rate ends, be sure to check what the regular APR interest rate will be.  For most of the popular transfer offers from the likes of Citi, Discover, and Chase, the rates depend on your credit history, and currently start as low as about 11%.

Ultimately, the credit card company is hoping that you continue to use the card long after the introductory rate expires.  If you do, they’ll have no trouble profiting from the 0% offer through interchange fees, interest payments, or both.  On the other hand, if you use the card just for the 0% offer, the card company will take a loss on you.  In the end, they profit from these offers more often than not, and that’s why you’ll continue to see 0% credit cards for some time.

This guest post comes from DR, the managing editor of the Dough Roller, a personal finance and investing blog, and Credit Card Offers IQ, a credit card review site.