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I have a couple of questions about the notion of "cash advance" on credit cards.

  1. How does the credit company decide if some transaction is a "cash advance"? Does the merchant tell the credit company it's "cash" or does it depend on the type of the merchant (e.g. anything I buy from certain merchant is considered "cash")? For example, if I buy a foreign currency from some merchant, would it be "cash" (even though I can't use that currency to buy stuff until I go to a country where it is valid)? What if it's a collector's item (but also a circulating currency in some country)? i.e., who decides that and by which rules?

  2. Why do credit companies charge high fees on "cash advances"? i.e., why do they care how I used the balance – if I directly exchanged it for an item or took cash and then bought an item? I understand it may be the loss of the transaction fees in the second case but the fees they charge and the interest they charge are much higher than any transaction fees. Is it just the case of charging extraordinary fees to discourage certain behavior?

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  1. It has more to do with who is paying the credit processors for the service, than what the goods really are.

Essentially speaking, when you purchase goods worth $100 using your card, the store has to pay about $2 for the transaction to the company that operates that stores' credit card terminal.

If you withdraw cash from an ATM, you might be charged a fee for such a transaction. However, the ATM operator doesn't pay the credit processor such a transaction fee - thus, it is classified as a cash transaction.

  1. It's an attempt to discourage certain behavior. It is also used (at least deciding to accrue interest immediately) to prevent users from paying back one CC using a cash advance from another - this way one could run on grace periods indefinitely.

Additionally, performing cash advances off a CC is a rather good indicator of a bad financial health of the user, which increase the risk of default, and in some institutions is a factor contributing to their internal creditworthiness assessment.

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    I didn't think about the balance cross-payment trick, that makes sense :) – StasM Dec 13 '10 at 1:24
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Think about the credit card business model... they have two revenue generators: interest and fees from borrowers and commissions and fees to merchants. The key to a successful credit card is to both sign up lots of borrowers AND lots of merchants. Credit card fortunes have improved dramatically since the 1990's when formerly off-limits merchants like grocery stores began to accept cards.

So when a credit card lets you just pull cash out of any ATM, there are a few costs they need to account for when pricing the cost for such a service:

  • The lost transaction fee/commission paid by the merchant.
  • The risk of being liable for fraud (If someone clones your card and PIN, the credit card is liable for cash advance losses. If someone steals your card and buys stuff, the credit card stiffs the merchant.)
  • The loss of "float" -- with a cash advance, a credit card must provide cash on demand. With a credit transaction, there is a settlement period during which time the credit card company doesn't have to pay the merchant.
  • Opportunity cost. If it were cost effective to have customers withdraw cash, merchants would setup ATM machines and direct customers to withdraw cash instead of getting merchant accounts.

Credit card banks have managed to make cash advances both a profit center and a self-serving perk. Knowing that you can always draw upon your credit line for an emergency when cash is necessary makes you less likely to actually carry cash and more likely to just rely on your credit card.

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