Archive for the ‘Credit Card’ Category

Where do credit card fees come from?

posted on 10 April, 2007 under Rates and Fees, Featured, Visa and MasterCard by Bryan Johnson


It is known by some, but not all, that businesses pay fees in order to accept credit cards as a form of payment. In fact, over 7 million merchants in the U.S. accept credit cards. During 2006 they collectively paid over 30 billion in fees to offer customers that convenience.

Despite the size of the industry, its a mystery to most as to who is pocketing these billions of dollars in fees and why it has to be so unbelievably complicated. I had a CPA tell me the other day, “I’m a smart guy. I understand numbers, pricing and reconciliation, but for whatever reason I just cannot get my head around credit card processing fees.” He’s not alone. Hopefully this article will clear up some of that confusion as I provide some context about where credit card fees come from, who’s making the money, and how fees and rates are determined.

Banks make roughly 80% of all credit card processing fees
Yes, banks are the biggest benefactors of consumers using plastic. Banks co-issue debit and credit cards with Visa and or MasterCard (AMEX and DISV don’t issue cards through banks). Visa and MasterCard are essentially membership associations owned by the issuing banks, and collectively own about 70% of the market. For example, Visa is a membership association of over 13,000 banks nationwide.

Banks make money every time a card they issued is used to purchase something. For example, let’s assume that a business is paying an effective rate of 3.5% to accept credit cards (that 3.5% is usually comprised of a discount rate and a per transaction fee but I just used a flat rate for simplification purposes). Roughly 80% of that 3.5% is going to the issuing bank. The rest of the 20% is divided among Visa or MasterCard, the credit card processor, and if there is one, the Independent Sales Organization (ISO).

How do banks justify their fees?
Credit card usage has seen explosive growth in the past 20 years for a number of reasons. Consumers get 15 to 45 days to pay original purchases, rewards and other perks, a line of credit for extra spending power, fraud protection, a monthly accounting of all purchases, and plastic is more convenient than cash or check.

All of these conveniences cost banks money. They have costs associated with fraud, bad debt, customer support, rewards and other perks, and float (they pay for your purchases before you pay them). Putting two and two together here on the creation and payment of fees, banks come up with rewards programs but merchants end up picking up their tab!

Continuing our example, if you buy movie tickets for $20 and the movie theater is paying 3.5%, the bank that issued that credit card would make $0.56 ($20 x 3.5% = $0.70, x 80% equals $0.56). Visa and MasterCard add their respective fees of .0925% and .0950% on top of what the banks charge (Note: that’s 9.25 and 9.50 basis points. 100 basis points equals 1%). Adding the fees from the bank and Visa or MasterCard together form what is called ‘interchange’.

You now understand why you find a credit card offer in your mailbox everyday. Outside of the 18% interest rates, annual fees, and late fees, being a card issuer is a lucrative business! Banks are making money on both the front and back end.

That seems simple enough, why does everyone say it’s so complex?
There are over 100 different interchange ‘rates’ or ‘categories’. The particular rate that is charged on any given transaction depends on a number of variables, including:

1) The type of card that is used in the transaction i.e. debit, credit, rewards, or business card, international, etc.
2) Where the card is used i.e. restaurant, retail, gas, business to business, ecommerce, etc.
3) The method of usage i.e. swiped, over the phone, or via ecommerce.
4) What information the business captures during the transaction i.e. name, address, tax ID, tax amount, unit description, etc. (the information required is a whole other layer of complexity).
5) When the transaction is submitted to the processor for settlement and funds transfer after the initial authorization.

As you can see, it’s a very complicated matrix. Very few people, including those who’ve been in the industry for years, really understand interchange.

Qualifying for different rate categories and getting hit with downgrades can be expensive
Merchants can often do more than they think to better manage the credit card fees they pay. For example, transactions can be ‘downgraded’ when they don’t meet interchange requirements. Reasons for downgrades include not capturing the correct information when processing (such as billing address), settling the transaction after a certain period of time, not swiping the transaction and many more. Learning how to recognize these penalties and then making the appropriate adjustments can help you lower your fees.

One example is if an a restaurant employee hand keys your credit card number into the point of sale system because the magnetic strip can’t be read, the transaction falls into a different rate category . The transaction is penalized because ‘non swiped’ transactions carry more risk and therefore higher interchange fees. The increase in rate can be significant ranging from 30 basis points to 1.6%, or more. Actual rates of course vary according to the fee structure you have with your existing provider.

Different rate categories and downgrades are the dirty little secret for merchant service providers. It’s where they make most of their margin because they offer artificially low rates and don’t disclose higher market ups on transactions that don’t fall into a specific rate category. Too many merchants fall for this and think their paying the single, highly competitive rate that was advertised.

A quick search of merchant service providers will demonstrate that non disclosure of fees is a standard practice. See two examples here.

Your undecipherable monthly credit card statement
As icing on the cake, the unreadable format most merchant service providers use to present this information to you on a monthly basis doesn’t help. Of course, the format used is not because they have no other option, it’s because that’s what makes them the most amount of money.

The frustration with credit card fees
Some merchants accept credit cards because they find them to be a easier method of accepting money from customers. Most, however, accept them because they have no other choice and the costs can be significant. Many merchants and advocacy groups have cried foul lately with Visa and MasterCard increasing ‘interchange’ fees over 117% in the past five years while maintaining over 70% market share. The Card Associations have been accused of being monopolistic.

Interchange has come under increased pressure lately
A few years ago, Wal-Mart won a class action lawsuit against Visa and MasterCard. They claimed that interchange was being improperly priced with debit cards having the same interchange rate as credit cards. Among other things, they argued that debit cards should be have a lower interchange rate because money comes directly out of the account versus a credit card where there is 15 to 45 days between purchase and payment. The courts agreed and awarded Wal-Mart and other retailers billions of dollars in compensatory damages. There are currently a number of other legal battles against the Card Associations surrounding interchange.

Sick of Credit Card Debt? Pay it Off in 1/4th The Time. (No Crazy Schemes, Just Math.)

Credit card is amazingly easy to get into and almost seemingly impossible to get out of. When we’re young we naively get a credit card in hopes of building our credit, purchase a few things here and there with the best intentions of paying off our balance at the end of the month. We end up charging more and more because we like our new found purchasing power and really don’t consider the debt that we’re building up. Before we know it, we have thousands of dollars in credit card debt and it seems that the light at the end of the tunnel has been shut off. Fortunately, there’s hope to be had. You can pay off your credit card debt in a 4th the time you normally would.The problem with credit card debt is compound interest. With many credit cards you will be paying anywhere from 19% to 29% in interest, this will take you to the cleaners financially if you let it. Most of your payment will be going toward the interest and very little of it will be going toward your principal balance making it take seemingly forever to pay off your debt. Since most people are paying minimum payments or close to it on their credit card debt, it will often take them decades to get out of their credit card debt.

If you want to say goodbye to the balance on your Visa once and for all, the first thing you have to do is stop borrowing on it. You’ll never pay it off if you keep charging things up on it. Cut it up, or put it in water and freeze it so that you’ll not be tempted to use the card again. If you send in $100 a month on a credit card debt, change it so that you pay $50 every 14 days on your credit card. This is called the Eisenson method, essentially it will make it so that you’re paying extra payments without even realizing it. Over the course of the year, you’ll end up paying two extra payments which will go completely toward the principal balance of the credit card.

It’s shocking how fast you can get out of debt using this method to pay off your credit cards. Since the interest rates are so high on your debt, paying down extra on the principal will dramatically reduce the amount of interest you pay, in fact you’ll likely be able to get out of your credit card debt in 1/4th the time that it normally would.