I understand Visa and MasterCard make money on transaction fees, but how much (if any) of those fees do banks see? Do banks make money on people who pay their bills on time, or are reward programs paid for by the people who don't?
There are 3 entities in a credit card transaction;
- The Merchant Bank/Acquiring bank that provides the POS to the Merchant where you buy / swipe your card. This bank is the one that acquires the funds at the end of transaction.
- The Card Network [Visa/Master/etc]
- The Issuing Bank [the Bank that issues you a credit card]
Typically when you swipe for 100, the merchant only gets around 97.5. The 2.5 is divided amongst the 3 entities, roughly around 0.5 for the Merchant Bank, around 0.5 for the Card Network and a lions share to Issuing Bank of around 1.5
The reason Issuing Bank gets large share is because they take the risk and provide the credit to customer. Typically the Issuing Bank would pay the Merchant bank via the Card Network the money in couple of days. So the Merchant Bank is not out of funds.
The Issuing Bank on the other hand would have given you a credit of say 10 to 50 days depending on when you made the transaction and when the payment is due. On an average 30 days of credit. So roughly the Acquiring Bank is lending money at the rate of 18%.
It is from this money the Issuing Bank would give out rewards, which is typically less than 1%.
Also in cases where say Merchant Bank and the Issuing Bank are same, Bank would make money on both the legs of transaction and hence launch co-branded cards with better rewards.
The above numbers are illustrative and actual practices vary from Bank to Bank to card Network to Country
Related question at How do credit card companies make profit?
One reason why some merchants in the US don't accept Discover is that the fee the store is charged is higher than the average.
Generally a portion of transaction fee for the network and the issuing bank goes to the rewards program. In some cases a portion of the interest can also be used to fund these programs. Some cards will give you more points when you carry a balance from one month to the next. Therefore encouraging consumers to have interest charges. This portion of the program will be funded from the interest charges.
- The network only makes money based on the volume of charges through the network. They encourage this by offering the consumer rewards. They do take some of the risk due to fraud.
- The bank that issued the card makes money from interest and fees, in addition to their portion of the swipe fee. The failure of the consumer to pay their balance is the responsibility of the issuing bank.
- The store or their bank takes a portion of the fees to run their portion of the network.
Some rewards are almost always redeemed: cash once the amount of charges gets above a minimum threshold. Some are almost never redeemed: miles with high requirements and tough blackout periods.
Credit cards that don't understand how their customers will use their cards can run into problems. If they offer a great rewards program that encourages use, but pays too high a percentage of points earned can lead to problems. This is especially true when a great percentage of users pay in full each month. This hurt Citibank in the 1990's. They had a card with no annual fee forever, and a very high percentage never had to pay interest. People flocked to the card, and kept it as an emergency card, because they knew it would never have a annual fee.
The banks don't have to pay for credit card rewards. The merchants end up footing the bill.
The merchants that accept credit cards pay from 2-4% in fees on the credit card purchase. Those fees go to support the rewards programs.
The merchants also take on most of the risk during a credit card transaction (although the credit card companies would have you believe otherwise). If a thief uses a stolen card to purchase a camera from Mike's Camera Shop for instance, any funds the merchant received will be taken away from the merchant. In addition, the merchant will be hit with a chargeback fee (usually around $20-$60). Finally, since the card was stolen, the merchant will never get their merchandise returned, so Mike's Camera is out the camera as well. No camera, no funds, and a $60 fee to boot. The credit card issuers make $60 on the chargeback fees and have no liability.
Michael Pryor's answer is accurate to the actual question asked. The current accepted answer from Dheer is not entirely true but roughly provides an overview of the different entities involved in a typical transaction, with some wrong terminologies, corrected and improved below.
- Acquiring bank, the one that acquires the fund at the end of a transaction. This is the merchant bank where the funds will be deposited.
- The credit card company.
The issuing bank, the one that issues the credit card to the customer.
When it comes to the service fee split, the issuer bank takes on the majority of the cut in the service fee paid by the merchant to the different entities. For example, on a 2.5% overall fee paid by merchant, roughly 1.5% goes to the issuer, 0.3% goes to the card network (visa, master card, etc) and the remaining 0.7% goes to the acquiring bank.
Reward programs have a partnership with participating merchants, where merchants are charged a higher service fee, for the likelihood of driving a higher volume of transactions to the merchant. A portion of the rewards also comes from the issuer, who shares a percentage of their fee back to the customer, in exchange for the same likelihood of making more profit through increased volume in total transactions. For example, a reward program may charge merchants 4.5% fee, with 3.5% of it going to the issuer. Upto 3% of this can be given back to the customer for their loyalty in using the card service. The banks can afford to take as little as 0.5% instead of their regular 1.5% due to the increased volume of transactions and the fixed fee they collect as membership fee. Note that costco has a similar business plan, but they make money entirely of membership fee. So with enough clients, banks can theoretically afford to run their program entirely on membership fees, costing no additional service fee to merchants.
The service fee depicted above is arbitrary, and it can be lowered if the merchant is also a client of the issuing bank, that is, both the issuing bank and acquiring bank are the same. So it is kind of a win-win-win situation.
And as usual, the banks can afford to make a larger income, if the customer ends up paying interest for their credit - although the rewards program is not designed accounting on this.