Why banks pay you to use their credit cards
Patrick McKenzie (patio11) reads his Bits about Money essay on how credit cards make money. The prompt was a listener who wondered how a card can include free travel insurance for someone who never carries a balance. He covers the four ways a card earns revenue (net interest, interchange, fees and marketing contributions), and explains why rewards competition makes some customers in the middle of the credit score ladder persistently unprofitable. He also explains why Europe's interchange cap left cards at about half of electronic payments, while Japan's uncapped interchange quietly pays for the rest of its consumer banking. In a new postscript, he walks through what a proposed 10% APR cap would mean for cardholders at the low end of the market, and how First Republic made sub-10% unsecured loans work by treating them as a way to win deposits.
Presenting Sponsors: Mercury & Granola
Complex Systems is presented by Mercury—radically better banking for founders. Mercury Spend hands your team and agents their own cards with limits you set once, so nobody waits on you to approve a SaaS invoice and nobody chases a receipt. Apply online in minutes at https://mercury.com/.
If meetings consistently leave you with hazy action items and lost context, Granola handles the transcription so you can actually participate and gives you searchable notes afterward. Try it free at granola.ai/complexsystems with code COMPLEXSYSTEMS
Timestamps:
(00:00) Intro
(01:11) How credit cards make money
(01:55) Bundling and unbundling
(03:12) Revenue levers for credit cards
(03:23) Net interest
(06:19) Interchange
(07:34) Interchange makes cards so valuable you're paid to use them
(10:02) Fees
(10:50) Marketing contributions
(13:05) Debit cards: a horse of a different color
(13:32) Sponsors: Mercury | Granola
(16:54) Postscript
(25:27) Wrap
Transcript
This transcript will be annotated in Patrick’s usual style by the end of this week — be sure to check back.
Hideho, everyone. My name is Patrick McKenzie, better known as patio11 on the internet. So someone wrote in after last week's episode regarding airline travel disruption, and how one's credit card can offer oneself insurance about it without actually charging an insurance premium, and was confused. They said, "I presumptively don't borrow a lot of money using a credit card, so how does the bank actually make enough money from my custom using the credit card to underwrite insurance, to say nothing of the other things they need to do to successfully issue a credit card?"
And I answered this in a classic post back in the day on how credit cards make money for Bits About Money. At the time, I was working at Stripe. I no longer work at Stripe, but I'm still an advisor there. And this is very fundamental knowledge to everyone who works in payments, but it's very illegible to people who don't. And so, as a little bit of public service, I would like to read this essay from November 5th, 2021.
How credit cards make money
Payments are deceptively complicated—everyone has used them and thinks they have good intuitions for how they work. However, payments require coordination of a dance between different parties who have extremely different incentives, both on a transaction-by-transaction basis and what they get out of participating at all.
Consider the humble credit card. Swipe it. Tap it. Dip it. HTTP GET it. You have probably used one, mostly oblivious to how it is a complicated bundle of services with a pricing structure strictly more complicated than a venture capital fund's.
Here is how your bank thinks about it. (A useful jargon word to know: if you have plastic with your bank's name on it, that makes the bank the issuer of that card. This helps to distinguish it from the other banks involved in a credit card transaction.)
Bundling and unbundling
It's a truism that there are two ways to make money in financial services: bundling and unbundling. Credit cards aren't just a bundle, they're a Mandelbrot set of bundles. The bundles contain bundles. It is bundles all the way down… and all the way up.
One way to think of bundling is as cross-subsidization: you can charge users (or other parties, but we're getting ahead of ourselves) more for X to give them Y for less than they expect, or even free (or negative!). Credit cards are cross-subsidization engines, both within a particular card as used, within a portfolio of customers using a particular card, and across a financial institution's customers.
This last bit is very important: sometimes credit cards make money by losing money on the card itself. This is fairly rare, and mostly limited to a small number of issuers at the higher end of their product lines and customer archetypes. You can lose money on e.g. a particular entrepreneur's personal rewards card to capture their deposit banking business, mortgage, and business banking, and while most financial institutions don't set out to do this, individual accounts being single-product losers within large portfolios of users is unexceptional and very, very planned.
But let's talk about the vastly more common case cards are designed around, where a good-fit, non-fraudulent user is expected to pull their own weight revenue-wise.
Revenue levers for credit cards
Net interest. Interchange. Fees. Marketing contributions. There, that's (just about) every way your card can make money. Taking them in turn:
Net interest
Credit cards facilitate high-frequency minimal-human-involvement extensions of relatively tiny consumer loans bundled (ba dum bum) into an ongoing relationship with parameters negotiated very infrequently relative to individual transactions.
It's often forgotten, but prior to credit cards, many Main Street retailers like e.g. pharmacies maintained hundreds or thousands of credit accounts for customers individually, necessitating their own back offices, accounting, and collections headache. This was in the ultimate service of getting customers to choose them over competitors, transact in larger sizes, and come back more frequently, the "only three aims of marketing."
Credit cards represented banks saying: "You know, if you had a specialist doing that for you, it would be much more efficient. They'd have computers doing the math, not bookkeepers. They'd have departments doing collections, not clothing salespeople worried about offending customers who they'd need again at Christmas. They'd have access to cheap deposits to fund loans, rather than expensive working capital. They'd be adequately capitalized against losses, rather than having tiny margins backed by almost no equity, like most retailers. They'd diversify against regional and sectoral risk, rather than being all-in on the plant down the road still being open."
So credit cards generate loans. A lot of loans. The traditional business of banking makes money on loans by funding them with a mix of cheap deposits and more expensive equity, charging adequately, collecting a spread, and using a portion of that spread to pay for operational costs and defaults.
Credit cards made the business of making loans work much better, by encouraging loans to be automated (rather than bespoke), by encouraging them to be more frequent, and by making them be iterative games rather than one-shots. This, and credit cards' other revenue streams, let banks relax the "credit box" for loans originated by cards versus comparable unsecured signature loans.
The credit box, a metaphor from consumer underwriting, is conceptually a matrix which maps customer quality, loan amount, and similar to the prices you'd need to justify the underwriting decision or an outright denial, representing "This loan is negative expected value at all conceivable prices and we shouldn't make it, at all." Relaxing the box means approving more customers, approving smaller (less lucrative) and larger (riskier) loans, and giving borrowers better pricing.
Interestingly, credit cards make originating loans a distinct business from holding loans. Depending on a bank's appetite for consumer credit risk and how much in deposits and equity they can back their loan portfolio with, they might not be able to satisfy all customer demand with their own resources. Some banks will package "pools" of those originated loans and sell them on to investors, earning a fee for the ongoing servicing of the loan (they are still the ones receiving payments and on the other end of the telephone, after all) and generally a premium to the pool's face value (because investors are willing to pay more than $100 for the promise to repay $100 and 12% annual interest over time).
But as mammoth of a business as lending is, lending is not the reason credit cards took over payments in much of the world. Interchange is.
Interchange
When you swipe your card at the local cafe, multiple sales have necessarily happened. One is selling you a coffee. One was selling you a credit card. And one was selling the cafe on the desirability of accepting your credit card brand.
The sale to the cafe went something like this: You'd sell a lot more coffee if you accepted our credit cards. The best coffee drinkers carry our plastic, and they will drink coffee where they can use our plastic. You should pay us a bit for bringing you these desirable coffee drinkers, just like you'd pay for an ad in the paper that brought you desirable coffee drinkers.
That fee is called interchange. (Technically speaking, the industry dices up the fee into a few different parts and has different names for them, but let's agree to call it interchange for the moment.)
The lion's share of interchange goes to the card issuer… at least for the moment (oh don't worry, we'll get to that). Issuers have this argument for why they should get most of the fee: they do most of the work in the ecosystem. They signed you up for a card. They take the credit risk if you drink your coffee but don't pay your bills. They will answer a phone call at 3 AM in the morning on the second ring if you have a problem with the card.
A much smaller portion of interchange goes to the credit card processor, to the acquiring bank, and to the credit card network. (Stripe makes a very large portion of our revenue by taking a small portion of the cost of interchange which we charge our business users.)
Interchange makes cards so valuable you're paid to use them
Interchange ended up with different regional equilibria as credit cards ate parts of the payments pie worldwide.
In the United States, issuers quickly discovered some customer archetypes which absolutely printed money via interchange. A major one was business travelers, who were largely not customers of the credit but only needed the cards for money movement. And they moved a lot of money, mostly between their employers and airlines/hotels.
Competition for the business of business travelers caused one of the most important innovations in both consumer banking and the travel industries ever: cross-subsidization of credit card customer acquisition with travel company loyalty points. This economic engine became so massive that it is now worth strictly more than the airlines themselves, and it sparked a change of practice across U.S. cards: competing aggressively for customers by rebating interchange in the form of either rewards (such as airline loyalty points) or cash back (a post-transaction discount).
This had fascinating implications for the microeconomics of credit cards. For one, competition for desirable credit card users is so intense that profit margins for banks decline midway up the credit score ladder (and for some segments are actually persistently negative), before recovering for the most desirable users (who spend so much that their interchange finally outruns the rewards expense). (See Table 3 in this PDF — a PDF that I describe as the Rosetta Stone for understanding the consumer credit card market. It's linked in the show notes.)
For another, this ended up being an almost peculiarly American experience. In Europe, regulators were worried about the cost of interchange to businesses (rather than consumers) and capped it. Since issuers didn't have the margin to compete on rewards paid for by interchange, they instead leaned into branding and convenience, and credit cards became a smaller portion of the payment mix (about 47% of electronic payments, compared to almost 70% in the U.S.).
Curiously, in Japan, interchange is uncapped (and, according to the government in the recent past, maddeningly opaque — they did something about it; I will drop a brief explanation into the show notes) but financial institutions held the line on rewards at 1%. This makes card issuance an extremely profitable business to be in in Japan, so much so that it subsidizes the rest of consumer banking in Japan's persistent low interest rate environment — somewhat less low these days, but still kinda low (which depresses the net interest margin that consumer deposit accounts generally generate most revenue from, historically and in much of the world).
Fees
Fees have gone out of favor in much of consumer-facing finance, but credit cards have historically been rich sources of them. You can broadly categorize them into account fees and usage-based fees, with the former applying to most holders of a particular card (though issuers frequently waive them for marketing/etc. purposes) and the latter based on user behavior that the issuer wants to discourage and/or price.
The two dominant types of credit card fees are over-the-limit fees and late payment fees. Both have declined as a percentage of the revenue mix over the last several years, due to consumers having better visibility into their usage (largely via mobile apps and IVR systems — interactive voice response, when you call up your bank's 1-800 number and they will read you your account balance) and due to regulatory pressure to compress fee levels. The CARD Act alone probably returned over $10 billion a year to consumers.
Marketing contributions
One insight the industry had is that there is a limit to businesses' desire to pay for payment acceptance but a much higher willingness to pay for customer acquisition. As technology has allowed credit card companies tight loops to their customers, they are increasingly attempting to nudge their purchase behavior in provable ways then invoice businesses for a portion of the marginal revenue driven.
A very customer-visible example of this is on Square's (now Block's) Cash App, which periodically offers "Boosts" which rebate much more than interchange rates for particular purchases. These are sometimes paid for by the issuer as a marketing expense, but more frequently they're the marketing spend of the boosted business. For example, Cash App (as of this writing — at least as of the writing of this essay a few years ago) offers 10% off on one use at any grocery store and 5% off up to ten online purchases at Adidas. Without any internal knowledge, the first of these is very likely to be Square subsidizing the customer to motivate future behavior; the second is likely Adidas paying Square to send them more sneakers-hungry consumers (and send less to Nike). This sort of thing makes credit cards into a "channel" where advertisers compete with money, just like they compete for placement on retailers' shelves or in the weekly insert in a newspaper or on paid search results.
If you are familiar with Bank of America or Chase mobile apps, you may have noticed partner rewards programs that periodically offer you, e.g., 5% cash back for a transaction at Starbucks. These are administered by a publicly traded company called Cardlytics, which charges the likes of Starbucks to drive them business, pays the consumer incentive out of the marketing spend, and also pays the bank for lending them the customer relationship. It is real money; they paid banks more than $100 million in 2020.
It is believed by many that banks make lots of money selling "your data." This is not a significant contributor to the economics of credit cards, for reasons which are slightly too complicated to get into in this piece. The short version: much like Google and Facebook, issuers can demonstrate to the most sophisticated organizations on the planet that they can deterministically influence actual purchasing behavior. That's easier to sell than a CSV file and worth more to more businesses.
That is substantially every way to make money with credit cards. Balancing these against each other is a fascinating exercise in marketing and product design, which we'll revisit later in this series.
Debit cards: a horse of a different color
Debit cards are a very similar product with enough under-the-hood differences that they deserve their own moment in the sun. In particular, due to a quirk of U.S. interchange regulation, they basically fund most of the fintech industry.
See you next time for it. Later in the series, we'll discuss how the microeconomics of these products have helped turn payments infrastructure into a platform and ecosystem.
I cover that in a later issue of Bits About Money, which goes into the Durbin exemption to the debit card interchange cap that was instituted after the 2008 financial crisis, in some detail. You're welcome to read it if you are interested in that sort of thing.
Postscript
And as a postscript to the essay: one thing that's underappreciated about interchange — and, for that matter, the other features of a credit card — is that it bids down the cost of credit. You can sometimes see this mechanically in reverse when you go to various credit card issuers. The cards that they expect to be used the least in the typical month, by people who are attempting to use the card primarily as a way to access borrowed money, will have relatively high APRs. And the cards that they expect to be used the most in a particular month, primarily by what are called [transactors] in the industry, will sometimes have lower APRs than the headline number.
There was recently a proposal by a U.S. politician — Trump, I believe, in January '26 — for a one-year APR cap at 10%. Mechanically, here's what you should expect the credit card industry to do if APRs ever get capped. One is they're going to sort by customer sub-segment where the APR is actually meaningful. And so the APR is largely not meaningful for the subsection of higher-end cards that are [transactors] and basically never revolve a balance. There are still people on higher-end cards that revolve balances. That fact is surprising to people, because they assume that rich people would not pay to borrow money when rich people actually have money. Rich people routinely pay for many goods and services despite not needing to. That's one of the things that you can afford when you're rich.
But be that as it may, it is more impactful at the lower end of the socioeconomic ladder: for starter cards, cards for people with poor credit, and similar. What it would likely result in is an immediate closure of some accounts, or a de-risking for them. So, for example, you might have a credit card line get cut for the duration of that one-year APR holiday, with potentially a re-expansion of the line after the APR holiday is over.
Credit cards are generally loath to lose customers. They pay really substantial costs of customer acquisition up front — typically hundreds of dollars per new account — and need to sort of amortize that over the lifetime of the customer. And so, in preference to kicking everybody off, they would love to come to a new accommodation which allows the card to still be active and hopefully still capturing a lot of someone's wallet. Share of wallet is the term of art in the industry. But they, you know, can't take unlimited risk without getting paid for it.
Credit card defaults tend to be low for most users of credit cards almost all the time. But then, particularly for people in lower socioeconomic strata, folks with lower FICO scores, et cetera, they spike when there is macroeconomic stress, to higher than 5%. And so the combination of — you know, nobody wants to underwrite the next year of the global economy; if you could do that, you have better ways to make money than lending money to customers at 10% — and the possibility for that to swerve sharply contribution-margin negative if a large subset of customers were to default in that year, make 10% not maximally viable for credit card issuance.
That number prevails basically nowhere for unsecured consumer debt. I shouldn't say that, actually. It does prevail in a few cases where the unsecured consumer debt was essentially a loss leader. For example, First Republic — before it went under; they're no longer with us, now absorbed into Chase as a result of the 2023 miniature banking crisis — routinely did offer unsecured consumer debt for loan consolidation and other purposes at rates rather below 10%. I think mine is still at 2.75% or so, and I am not paying that one off readily. Thank you very much, Chase.
The reason they did that was — and this is extremely explicit in their quarterly reports and other discussion with investors — that they were using the loan as a way to capture deposit business. And their idea was that they offered loans to — they couldn't call them young professionals; Compliance would flag on that play pretty hard, and indeed, I believe, actually did — but people who were entering the professional class, who had a wonderful, in-expectation increase in the value of their equity, in their direct cash returns to doing their career, et cetera, but who might have had a one-time need for money which was not going to recur in the next couple of years for structural reasons — such as, for example, they just graduated university, or they had just gone to law school, or similar. They could satisfy that one-time demand for money and then start, you know, paying it back slowly, but also putting a lot of money into their checking account, because they get paid a lot of money every month.
And an interesting argument that First Republic made is that, not on an individual basis but on a cohort basis, the new deposit accounts that they were attracting through this very — or, frankly, almost absurdly — attractive offer on the debt side were funding all of the debts that they were issuing to get these new accounts. So they were self-funding after a relatively short period of time. And then, after the point where they're self-funding via deposits, it's all gravy, because, you know — well, play with the math a little bit. You are paying people one basis point and taking in 275 basis points of revenue. So okay, that's a pretty good business already. And if you're doing that for $100 but have $400 behind it, where you are paying one basis point and then putting it in T-bills for, you know, 5% or whatever a T-bill is earning these days, it is just a wonderful, wonderful business to be in. And indeed, that worked for First Republic for a number of years until, again, 2023 made that a much tougher business to be in, for a variety of reasons that I've gone into in other places and won't rehash here.
All right, so that's a little bit of a postscript detour on why consumer debt is as costly as it is. There have been a few interesting takes at reducing the price of it over the years. They largely have to make the numbers work somewhere. Again, there was the example of First Republic, where they're making it on the deposit side of the business. So you can write low-cost loans if you expect the customer to become relatively wealthy in the next couple of years. That is an unsatisfying answer, for the shape of the solution set, to many people.
In a very different fashion, another thing that has been tried, at least — and I don't know the current status of it — was Cash App attempting to do very, very low-cost loans — low-balance loans, rather — on the order of $20, at very, very low costs relative to, like, traditional costs for a payday loan. And that was also, similarly, largely a cost of customer acquisition, where if you are able to smooth over the customer's urgent need for $20 a few times a year, then you will be at the top of their wallet when they are, for example, spending on their card. And however much interest you want to charge someone on $20 for a week, you can make that up by essentially having a bank rebate you 1.5% of their purchases on a linked debit card or credit card, or whatever the sort of project strategy reason was there.
So anyhow, that's a little bit more information than you probably wanted to know. But there are indeed some opportunities to make the world better with a bit of financial innovation on behalf of people at many points on the socioeconomic spectrum with regards to the cost of debt specifically. And as always, this is a non-political broadcast. I don't particularly endorse or oppose any proposal for regulating the financial industry in most cases, but most of them do indeed have consequences. And it's salutary, I think, if the people that are advancing them actually understand those consequences before the proposal is written into law. And with that, see you next week on Complex Systems.
