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Noah Smith

Credit-Card Companies Know How Little You Know

Issuers maximize profits by targeting consumers who overspend, but not quite enough to go bankrupt.
Careful with that thing.

Careful with that thing.

Source: BSIP/UIG/getty images

When I was 22, I wondered how credit-card companies made money. I had two cards at the time. They were free to use. Every month I would buy things with the cards, and -- because I used auto-pay -- every month the balance would be deducted from my checking account. As far as I could tell, this was a free service. And if I decided not to pay my credit-card bills, and just go bankrupt, there was no way the card issuer would make money off of me. With things like cash back, it seemed like I was getting paid to use this card. What kind of business model pays people to use its product?

Ten years later, as I helped a friend figure out how to refinance his credit-card bills, I realized how the business model must work. Card issuers, mainly banks, profit by charging penalty fees when people pay off their credit-card balances late. Of course, that isn't the only way they make money -- they, along with MasterCard and Visa, also charge merchants fees to use the payment services, and they charge other fees for things like balance transfers. But a lot of their business model is just consumer lending -- which they do at rates of about 12 percent to 14 percent.